Banks over-cautious on lending as private equity firms loom
Bad practices fuelled the boom, and now threaten to exacerbate the bust
Are the vultures lurking?
Related Articles
Who's afraid of private equity firms? The answer is lots of people, at least judging by the response to reports that the investment group Mallabraca is looking to take a majority stake in Bank of Ireland.
Some of the alarm at the prospect of private equity investors acquiring a stake in Irish banks is unjustified, and is being sounded by parties with a vested interest in keeping private investors at bay. But there are legitimate concerns about handing over control of strategic assets to private equity investors, especially at a time of economic crisis here and abroad.
What do we know about the desirability or otherwise of substantial private equity involvement in our banks? We know that private equity groups would bring to the table welcome injections of capital.
The greatest danger facing the Irish economy at the moment is the ongoing risk of an abrupt deleveraging by banks, whereby troubled banks slash lending to businesses and households.
Anecdotal evidence suggests that a credit crunch is already under way, with viable small and medium-sized businesses struggling for credit to finance working capital.
Having paid too little attention to risk for many years and lent money for projects that probably should never have been financed, the banks are now doing completely the opposite and have become dangerously over-cautious.
Their banking practices exacerbated the boom and threaten to greatly intensify the bust.
A large injection of fresh capital into banks is necessary to stave off rapid deleveraging. For regulatory reasons, banks must maintain loans in proportion to the amount of capital on their books.
Large losses from property loans that will inevitably turn sour over the next few years will diminish those capital reserves and force banks to cut lending. Senior management at Irish banks claim that their institutions have ample capital to ride out the storm.
Markets
But markets don't believe them -- and for good reason. The loan losses that the banks are projecting look moderate, not only compared with losses suffered in other countries during boom and bust cycles, but also relative to losses incurred by the banks themselves in the early 1990s.
When the dust has settled in a few years, Ireland will have experienced one of the largest property booms and busts on record.
The downturn in property will be associated with one of the largest cumulative drops in national income in an advanced economy since the Second World War. This contraction will have coincided with the worst global financial crisis and economic recession since the Great Depression.
How could it be even remotely plausible that Irish banks will escape this economic and financial carnage with losses comparable to those experienced during normal recessions?
Capital injections also provide banks with a more stable source of funds than the interbank borrowings that some institutions have relied on over recent years.
Notwithstanding the Government's €440bn guarantee of banks' debts, a heavy reliance on interbank lending is no longer a viable business model. The other source of funding for banks, deposits by customers, has also become more attractive for the same reason.
It is interesting to note that many bank managers around the country talk about spending most of their time looking for deposits. During the boom, they were preoccupied with making loans.
Private equity groups would also bring fresh managerial expertise. The consortium interested in investing in Bank of Ireland reportedly includes private equity firms JC Flowers, Sandler O'Neill, and the Carlyle Group.
These firms have experience in successfully restructuring businesses and in managing and recovering maximum value from distressed assets. That know-how should come in handy over coming years as the Irish banking sector faces the reality of the property bust.
Not everyone would welcome the restructuring that private equity groups have in mind. The Irish Bank Officials Association (IBOA) earlier this week warned that thousands of jobs could be lost as a result of consolidation in the banking sector.
The IBOA opposes allowing private equity groups to take major stakes in the banks, and instead favours injections of public capital from the National Pensions Reserve Fund. But these arguments seem to ignore the simple fact that Ireland's banking sector must shrink, irrespective of who owns the banks.
The demand for banking services in the future will not support the current size of the sector. For example, lending for mortgages and property development will pick up eventually from current depressed levels, but will not rebound to the highs witnessed during the boom. The IBOA would, presumably, have more clout if the Government owned the banks, hence the preference for public injections.
The IBOA's other claim -- that private equity funds would slash costs by cutting staff numbers and pay, squeeze customers and cut services to generate a quick turn on their investment -- also looks questionable. Private equity funds usually aim to sell their stakes within five to 10 years.
Those stakes only have value if a potential buyer is attracted by the long-term viability of the business. The caricature of private equity funds as money-grabbing, asset strippers can serve a political purpose, but the reality of what these firms do and the value added that they create is more complicated.
Conditions
Crucially, what we don't know is what effect the involvement of private equity will have on the Government's efforts to kick-start lending to small to medium-sized enterprises (SME).
Special credit facilities for SMEs such as government-guaranteed credit schemes may be coming down the tracks. But it may be too late for such schemes, given how rapidly credit conditions have deteriorated.
What is probably needed now is a brute-force approach, whereby banks are compelled to maintain credit lines to SMEs at reasonable interest rates and charges. This may not be in the narrow interests of the private stakeholders in banks.
The actions that the Government needs to take to rescue the economy from a devastating credit crunch may well frighten off private equity. So be it. If private equity groups do want a bit of the action, the Government has to make sure that they don't get in the way. The economy must come first.
Alan Ahearne lectures in economics at NUI, Galway, and is a research fellow at Bruegel, the Brussels-based think tank. He is a former senior economist at the Federal Reserve Board in Washington DC
- Alan Ahearne
