We will only get one chance to recapitalise our banks. Our banks have insufficient capital to cover their losses on their loan books and they have a drastic funding shortage. Without the government guarantee, most of them would surely be bust, because no one would lend to them. Without a properly functioning banking system, the economy will continue to contract.
This week, three separate businesspeople told me they were going out of business. They do not have sufficient cash flow and are beginning to renege on debts. Last night, a friend indicated that he would simply have to default on his rent payments because the landlord of his premises was insisting on rent covenants signed last year which he couldn’t pay because business has dried up. Apparently, last year’s business plan now reads like Alice in Wonderland.
In a similar vein, a liquidator friend – a man who likened his position to ‘‘an undertaker waiting for the plague’’ – summed up the banks’ position in a simple story.
A desperate man arrived in his office this week with property debts of â‚¬48 million for which he had put up a total of â‚¬400,000 cash. Each property, all in mid Munster, was cross-collateralised against others. There were six separate banks involved. All the loans had been taken out in the past three years and covered commercial property, residential property and development land, as well as the ubiquitous second apartment.
Obviously, the man was broke and couldn’t meet any of his repayments. The ‘assets’ were now worth a fraction of the borrowings and there was no way the banks would ever get their money back. Nor should they have ever lent this money to this character, but they did and now we are being asked to cough up to cover the obvious bad debts associated with thousands of ‘entrepreneurs’ like this.
Out in the rest of the country, the unemployment figures announced this week are not only a personal tragedy for thousands of families but, for the banks, rising unemployment means rising mortgage default. These defaults will also have to be covered by the recapitalisation.
So you can see a huge amount rests on the recapitalisation of the banks. If it is not successful, the banks will sink under the weight of bad debts. When the government makes its decision this week, it has to fix the problem. If it fails, the money will be wasted, and the banks will burn through the new capital as they try to maintain their capital adequacy ratios in the face of a meltdown of their loan books.
Let’s cut to the chase: the proposed recapitalisation will fail. There’s little point pussy-footing about: â‚¬7 billion of your cash is about to be blown this week on our dysfunctional banks. The reason for using the term ‘‘blown’’ is that the money will be wasted and we will be back at square one by summer, with a larger hole in the balance sheets.
Remember that this deal to be announced, probably on Tuesday, is likely to be a worse deal than the nonsense that was proposed a few days before Christmas. The Irish banking system faces two disasters and one problem is driving the other.
The first disaster is a funding disaster, where the average loan-to-deposit ratio of Irish banks is between 150 and 160 per cent. For the likes of Irish Life & Permanent, it is no less than 260 per cent. For the big two, this ratio is about 160 per cent. This ratio means that for every â‚¬160 the Irish banks lent out, they only had â‚¬100 in deposits. So they borrowed â‚¬60 from the wholesale money markets – which are now shut.
As long as the money markets are shut, the banks are being kept on a life support machine by the state’s guarantee. The strategy to borrow for growth was implemented by the managements of our banks who – amazingly – are still drawing hefty salaries. Without the state guarantee, the banks would have to pay so much for funding that most of them would be likely to go under.
Even with the guarantee, the banks will have to get the loan-to-deposit ratios down to somewhere around 80-100 per cent. This is a process called ‘‘deleveraging’’ and can only be achieved by increasing deposits and reducing lending.
This contraction of credit will have a monumental knock-on effect on the second big problem for the banks: bad loans. At the moment, Irish banks are telling half-truths about their bad loans and, given that the management of Ireland’s banks has got nothing right in the past two years, it is difficult to believe them now.
To get a better idea of what is likely here, we can examine the experience of other countries. Switzerland and Sweden both suffered a banking crisis following a property bust in the early 1990s. In both cases, the banks had to write off close to 8 per cent of their loan books. This was traumatic and the banks lost fortunes, but they recovered.
Given that the Irish loan book is more than â‚¬400 billion, a similar write down would reveal a black hole in the Irish banks of about â‚¬33 billion. As Bank of Ireland and Allied Irish Bank account for the lion’s share of the market, we can guarantee that their bad loans will be considerably greater than the â‚¬8 billion recapitalisation expected to be announced for the two big banks this week.
Take Bank of Ireland alone. Its loan book rocketed from â‚¬80 billion at the start of 2005 to a whopping â‚¬145 billion by the middle of last year. An enormous 26 per cent of the total loan book (or â‚¬38 billion) has been lent to the property sector.
If I can figure this out, what of investors who are being asked to buy into the government’s plans? Brian Lenihan should understand that investors will only come back to Ireland if we make it attractive for them. This means the Irish state has to take a bigger risk in the deal than they do. Given the basic mathematics of why â‚¬8 billion will not be enough, don’t be surprised if the shares of Irish banks fall and fall again on the news that this botched recapitalisation has been announced and Ireland has used up all its ammunition.
If you want to recapitalise, you need a much bigger state package that cleans up the banks and gives potential new investors the comfort that they are buying a clean bank If they suspect that this will not be enough to pay for the sins of fellows like our friend with 40 properties in Munster, they’ll wait on the sidelines until all Lenihan’s cash is gone and then snap up the good parts of the Irish banks for free.