It's time to decide what kind of banking system we really want
The Government has recapitalised the country's two main banks to the tune of E7bn but time will tell if this latest move will work
What now for Irish banks? We are told that today will mark the latest phase of the Government's battle to save the banks -- and save our economy from the banks.
According to reports, the recapitalisation of AIB and Bank of Ireland will see taxpayers inject €7bn of new capital into the banks by buying preferences shares. Like ordinary equity, preference shares are counted as part of the banks' capital.
Unlike ordinary equity, however, preference shares pay a fixed dividend -- usually expressed as an interest rate. The 8pc rate that the two main banks will reportedly pay might be considered generous to the banks. After all, the US and UK governments looked for between 10-12pc on preference shares from their banks. The Irish terms highlight the dilemma faced by the Government in trying to shore up the two main banks.
The banks need fresh capital to help them absorb the large losses that will arise on bad loans over the next few years. Many of these loans relate to property.
The drawback with preference shares is that the burden of paying a dividend, by eating into banks' operating profits, tends to lessen the availability of credit. Governments in other countries have found that demanding a punitive interest rate on preference shares proved counterproductive. For the same reason, there is a limit on how big a capital injection a bank can tolerate in the form of preference shares.
But how much capital is enough? The €7bn figure (that is, €3.5bn per bank) chosen by the Government probably reflects the results of a recent report by accountants PricewaterhouseCoopers on the financial position of Irish banks.
The figure is at the lower end of most analysts' estimates of how much capital will be required for the banks to deal decisively with their bad loans. Davy stockbrokers estimate that an injection of this amount will allow the two banks to write off between 4-5pc of their loan books as bad loans over the period 2008-2010, while still keeping core equity levels above 5pc.
Write-downs of this size are large from a historical perspective, but may prove insufficient given the unprecedented scale of the crisis facing the banking and property sectors.
This suggests that what Irish banks, like many banks around the world, may need is injections of common equity, not hybrids of debt and equity like preference shares. Given the depressed levels of banks' share prices, large injections of ordinary equity would effectively amount to nationalisation.
This is what happened in Scandinavia in the early 1990s, following property crashes in those countries. The governments then dismantled the nationalised banks into so-called "good banks/bad banks" by separating the good loans from bad loans at each bank. The Government here -- and the bankers themselves -- seem keen to avoid this alternative, but presumably will go beyond the preferred shares presently being used if that fails.
How will we be able to judge if the recapitalisation efforts are a success? For starters, the plan will not have worked unless it alleviates the credit crunch facing businesses, especially small and medium enterprises (SMEs).
That the banks have ample capital is a necessary condition to loosen up credit, since the quantity of loans that a bank can make is proportional to its capital. But the experiences of other countries over the past year suggest that injecting capital is not a sufficient condition for restoring the normal flow of credit in the economy.
Perhaps that is because governments did not inject enough capital. But it is more likely that other factors account for the drop in bank lending around the world.
Demand for credit has fallen, as households and businesses are trying to deleverage. In addition, banks are rightly deciding to restrict credit to some businesses whose prospects for survival have dimmed.
Moreover, banks are trying to reduce their reliance on wholesale markets and capital markets as sources of funds, because these sources have become extremely unstable.
The new model for banks is to return to old banking practices under which banks financed the loans they made using deposits. For Irish banks, on average, that means reducing loan-to-deposit ratios to 100pc from about 150pc during the boom. This implies a sharp retrenchment in lending.
While the Government has reportedly received promises from the two main banks in relation to lending to SMEs, it may be that special credit facilities will have to be introduced as conditions continue to deteriorate. Designing a scheme that would work well for this country is a major challenge.
The Government's actions also will not have worked if they don't force the banks to face up to the reality of bad debts on their books.
Whether the two banks now have enough capital to deal effectively with their bad loans is an open question. What this country does not want is for the banks to spend the next decade protecting their meagre capital and managing bad debts instead of contributing to economic growth by financing new projects.
In other words, the focus should be on the type of banking system that we want to emerge from the crisis and how well it will promote medium-term economic growth.
In particular, a key question is how the credit crunch and the Government's responses to the crisis are affecting the country's ability to foster emerging companies. This question is important because potential high-growth businesses may thrive even in the worst of economic climates, as entire industries are restructured and new business models supersede older ones.
But if emerging players are hamstrung by the shortage of financing, these promising businesses may not be able to seize the opportunities of the moment. So the question is: what kind of banking system are we creating?
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
