ANALYSIS: It is imperative that the banking initiative succeeds yet there is no guarantee that it will, writes Ray Kinsella
THE STATEMENT by the Minister for Finance on recapitalisation has brought some recovery in the share price of Irish banks, albeit from exceptionally low levels. The Minister's initiative is welcome, if overdue, and provides a window of opportunity to bring some measure of stability to the Irish financial system. It is important to grasp this opportunity. There may not be another one. It is unlikely to wait upon lengthy discussions such as it would appear are envisaged.
Capital plays a key role in ensuring the stability of credit institutions. Its function is to help absorb unexpected shocks. Standards of capital adequacy are set by the EU in line with the Bank for International Settlements (BIS) - the de facto central bank of developed economies.
By these standards, Irish institutions are adequately capitalised. It is, however, the markets that have reasserted themselves as the ultimate arbiter of capital adequacy. These same markets have unambiguously signalled their demand for Irish banks to strengthen their capital base. This reflects a number of factors, including the large existing and even larger prospective write-downs and the implications for banks' loan-books of the vicious collapse in economic growth, employment, and in the public finances. In addition, banks in other countries have recapitalised.
The Government has no other possible option than to recapitalise Irish credit institutions. In reality it is the responsibility of banks themselves to take action to strengthen their capital base. This normally involves a rights issue. But these are not normal times. Other options can include retained earnings. While there are differences across the banks, the scale of recent and likely future bad loans - as we enter the portals of recession - means that this is simply not an option. AIB and Bank of Ireland could raise additional capital from the sell-off of overseas subsidiaries. But not enough.
Had the banks moved to recapitalise in the immediate aftermath of the deposit protection scheme, it is possible they would have met with a sympathetic response from the capital markets and large institutional investors. That moment has passed. Failure to act early and decisively has meant the proper responsibility of banks has devolved on to Government.
The cost of this recapitalisation will further exacerbate recent cuts in public services. It is a high price for a small and vulnerable open economy to pay for the collateral damage caused by a foreseeable and inevitable, financial crisis. A crisis, moreover, which has developed into an unprecedented economic recession, the full magnitude of which we can only guess.
The recapitalisation initiative is not a detailed plan which the Government intends to press ahead with decisively. It is, instead, "an approach to recapitalisation", setting out broad parameters within an extensive timeframe, the exact form of which still remains to be announced.
The key elements are three-fold. Firstly, there is the willingness of the State to "supplement and encourage private investment in the recapitalisation of credit institutions . . . with State participation".
Secondly, there is an indicative amount for a private/State recapitalisation fund - €10 billion.
Thirdly, there is a decision that the mechanism for the State's participation would be either through the National Pension Reserve Fund, "or otherwise". It is imperative that the initiative succeeds yet there is no guarantee that it will. The amount of the fund, as well as the timescale, and even more so, the nature of the co-funding, is highly problematic. Even if it does, it will make a necessary, but limited contribution to financial stabilisation and to mitigating the effects of the malign financial pathology on growth, jobs and public services.
There are four issues that need to be addressed:
Firstly, the business model is inherently unstable, unbalanced, and without any economic or ethical foundation. This has to change.
Bank managements give, and are incentivised to give, overriding priority to the interests of shareholders, at the expense of depositors (who provide core stable resources), borrowers (who provide the demand for funds which drives profitability), employees (who create the embedded value of the business) - and the "public interest".
The public interest is at the heart of the deposit protection scheme. It is invoked by the Minister throughout the Act. Distinguished and highly credible non-executive directors have been appointed to each of the covered institutions to monitor the public interest. They are, however, observing more closely and diligently a model which has brought about the present state of affairs and which remains fundamentally unchanged.
Secondly, there is the issue of co-funding by the Government with external private equity. In general such institutions are focused on securing high returns over a short time period. It is this mindset that spawned the present crisis. Institutions would also be coming in on the back of the deposit protection scheme, underwritten by the Irish people, and buttressed by co-investment by the State. Hardly a "public interest" perspective.
Thirdly, the recapitalisation initiative ignores the whole issue of consolidation. This is, quite simply, flying in the face of what is necessary and what is known to be necessary, and which is, more over, provided for in the Act.
Fourthly, there is the prospect of using the National Pension Reserve Fund to help recapitalise the banks. This may be necessary but it makes it no less reprehensible. The NPRF is an important and far-seeing initiative intended to help fund future pension provision in the light of a projected growth in the proportion of older people.
Irish credit institutions did not cause the global financial crisis. They remained within the parameters set down by the regulator. Nonetheless, the culture of pushing product, the flaws of the business model and the sheer scale of the losses and write-offs provide the backdrop against which this raid on the NPRF needs to be evaluated.
The Minister has left himself a let out clause; recapitalisation is to be supported by the State via NPF "or otherwise". Flexibility is a good thing but the intent is clear. This subversion of a sensible and far-seeing initiative is a metaphor for the lasting damage caused by adventurism.
Recapitalisation will not lead to business as usual. Banks are now highly risk averse - there is more risk in this system. Excessive lending in these circumstances could trigger more bad loans, further cutbacks and a vicious cycle. In these circumstances there may be a case for some form of loan guarantee fund so as to mitigate for the banks the risk premium which is constraining the availability of credit to businesses and households.
The process of rebuilding our financial system and economy within a value-based society will take a generation to achieve. Still, it is the least we owe to those who will inherit the problems which we helped to create.
Prof Ray Kinsella is the author of Trust in Banking(to be published shortly)