Pumping funds into failing banks is throwing good money after bad
An Taoiseach Brian Cowen has a lot to think about as bank shares continue to slide
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The 1930s American bank robber Willie Sutton was once asked why he robbed banks. Sutton replied, "because that's where the money is". Not any more.
Far from having all the money, banks around the world are desperately in need of funds in the form of capital injections to help them absorb the massive losses that are coming down the tracks as a result of bad investments and dud loans.
Governments in many countries have already pumped money into ailing banks by buying shares, though in some cases the amounts involved may not be sufficient. In the UK, for example, a second round of injections into some banks is looking increasingly likely as economic conditions deteriorate and loan losses mount.
The UK experience also cautions that capital injections do not automatically mean increases in bank lending. Fresh capital may be a necessary condition to prevent a severe credit crunch, but it is not a sufficient condition.
Here, the Government plans to recapitalise Irish banks using a fund of up to €10bn. The Government has said that some of this money may come from the National Pensions Reserve Fund, possibly alongside funds from existing shareholders and private investors.
Contentious
The first question is whether €10bn will be enough to put the banking sector on a sustainable sounder footing? The issue of how much new capital Irish banks need is highly contentious. We are told by the authorities and the banks themselves that the banks are well capitalised.
The reason the Government gives for injecting capital is that it believes that "in current market conditions even fundamentally sound banks may require additional capital to respond to widespread market perception that higher capital ratios are appropriate for the sector internationally".
In other words, the Government believes that the banks have sufficient capital to write off the bad debts that they will incur over coming years without violating regulations on minimum capital requirements.
It is just that markets have raised the bar in relation to what constitutes an acceptable capital ratio -- and therefore Irish banks need injections to meet these new international norms.
The difficulty with this argument is that definitions of bank capital vary from country to country. For example, some complicated securities are included as capital in some countries, but not in others. Moreover, the method for calculating banks' risk-weighted assets differs across countries and across banks within the same country.
Comparisons
This makes direct comparisons of capital ratios (that is, the amount of capital relative to assets) across banks difficult and potentially misleading. Market participants presumably understand this problem. It means that there is no single magic number for an appropriate capital ratio.
It is hard to believe that markets are insisting on capital injections for Irish banks in the mistaken belief that such a number exists.
Rather, the depressed prices for Irish bank shares suggest that investors expect that loan losses will be substantially greater than the banks themselves are projecting.
The banks expect to write off between 1pc and 1.5pc of loans as bad debts each year over the next few years. These loan losses are a bit below expected operating profits, and therefore manageable from the banks' perspective.
They point out that write offs in this range are above those recorded in past downturns in this country. The problem is that the current recession is unlike any other. The banks face the fallout from the bursting of one of the biggest property bubbles on record.
Economic activity here and aboard looks set to contract next year at a pace not seen since the Great Depression in the 1930s. The global credit crisis shows little signs of abating.
Is it not reasonable to conclude that the loan losses that Irish bank will suffer over coming years will far exceed anything they have experienced in the past?
Consider the scale of losses suffered by banks in other countries during property busts. Data from Sweden's central bank show that loan losses in that country jumped from practically zero during the property boom in the late 1980s to 6.5pc of total loans in 1992. Over the five-year period 1991-1995, Swedish banks wrote off roughly 19pc of loans as bad debts.
Around the same time, US banks were writing off around 3pc of loans each year. Japanese banks disguised many bad debts as performing loans after the bubble burst, but still incurred annual bad charges of about 3.5pc over the period 1995-1999.
There is not much we can say with confidence about the state of Irish banks' loans books.
But one thing we know for sure is that if what happened in Sweden happens here, then a multiple of the €10bn on offer by the Government will be needed to recapitalise the banks.
That seems to be what investors are pricing into Irish bank shares.
The signs are not encouraging. Most of the losses for banks in other countries resulted from a collapse in the value of commercial property collateral.
As the economists at the website www.irisheconomy.ie point out, the European Central Bank's latest Financial Stability Review highlights that Ireland has seen the sharpest decline in commercial property values, from the fastest-growing market in early 2007 to the greatest contraction in 2008, with the gap growing over the course of the past few months.
Terms and conditions
Another question is, what terms and conditions should accompany the State's investment to safeguard taxpayers' interests?
The Government has said that injections could take the form of preference shares or ordinary shares, and the State may underwrite an issuance of new shares.
The terms associated with these investments will have to comply with EU state aid rules and may be significantly shaped by recent guidelines from Brussels.
Much depends on whether individual banks are deemed "fundamentally sound" or not.
In the case of a failing bank, the EU will only allow state funds to be used to wind up the bank or for a complete restructuring. Rightly so. Pumping funds into failing banks is simply pouring taxpayers' money down the drain. Even bank robbers would disapprove.
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
