Thursday 30 March 2017

State of emergency: some truths on the funds keeping our banks afloat

We must be able to understand the mechanisms Europe is using to keep the financial system on life support, writes Laura Noonan

Finance minister Brian Lenihan. Photo: Frank McGrath
Finance minister Brian Lenihan. Photo: Frank McGrath

THE imprint of Brad Pitt is the last thing you'd expect to find at the European Central Bank's nerve centre in Frankfurt, but the Hollywood star and Europe's most powerful bankers have more in common than you might think.

In 1999, Pitt gave life to the now-iconic phrase: "The first rule of Fight Club is you do not talk about Fight Club, the second rule of Fight Club is you DO NOT talk about Fight Club."

Twelve years later, the spirit of that declaration is pulsing through the ECB and banks throughout Europe when it comes to fielding questions on the emergency liquidity assistance (ELA) that's keeping embattled institutions afloat.

"The first rule of ELA is you do not talk about ELA, the second rule of ELA is you DO NOT talk about ELA, the third rule of ELA is you DO NOT EVEN THINK about talking about ELA."

ELA has been a key piece of the policy response to the crisis that's engulfed the world's banks since 2007, helping the likes of Northern Rock and Fortis to hold out for long enough to be rescued.

Biggest scheme

Ireland is now home to the biggest ELA scheme in the world -- in proportional terms -- with taxpayers here on the hook for about €50bn of emergency cash that's been channelled through the Central Bank of Ireland (CBI) into our banks.

Despite the massive sums involved, the CBI and the Department of Finance have repeatedly refused to comment on the operations while the money maestros at the ECB have been similarly reticent.

Banks in receipt of the support are kept on a tight leash. "Talking about ELA comes with serious health warnings," one banker says. "It's a serious no-no."

With radio silence from Irish banks and central banks, rumours about how our ELA operates have swept through the markets like wildfire, with some suggesting Ireland has been "counterfeiting" euro to prop up its own banks.

Others, most notably the London office of Citibank, have suggested that our ELA operations are now so out of hand that the Central Bank of Ireland is risking its own solvency to carry out the funding rounds.

Those with intimate knowledge of how Ireland's ELA scheme actually works describe the bulk of the rumours as "ridiculous", "impossible" and "wild speculation".

But some of their insights into the "evolving" nature of Ireland's ELA policy and the central banks' near-absolute certainty of getting back their cash may well give further cause for alarm.

Misconception

The biggest misconception about Ireland's ELA is the notion that the Central Bank of Ireland (CBI) is "creating" money to fund what is now a €50bn-ish operation.

"That's crazy talk -- the European Central Bank is the only one who can create money and increase the amount of cash in the euro system," says one well-placed source.

Ulrich Kater, chief economist with Frankfurt-based Deka bank has a similar take on things.

"I don't see any capacity for individual countries to create their own money," he says flatly, pointing to the over-arching role of the ECB.

The rules of ELA mean that the national central bank -- in our case the Central Bank of Ireland -- is the one who decides to help banks that need money but don't have enough high-quality assets to get cash from the ECB's "main" operations.

The national central bank is the one who allocates the emergency cash, dubbed ELA, to those banks and the national central bank is the one who assumes the risk for any of the cash that's not paid back.

Cheque

But the actual cheque is always written in Frankfurt.

"It helps if you consider that the Central Bank of Ireland is a branch of the ECB," says one source.

"The CBI is the one giving the money to the banks, but it's all ECB money."

So those waiting for the printing presses to crank up at the CBI's Dame Street base might want to bring a along good crossword puzzle, or perhaps a copy of 'Ulysses'.

Another notion that's generated massive international debate is the idea that the CBI is jeopardising its own solvency by assuming the repayment risk for all €51bn of ELA money drawn down by Irish banks.

Citibank made the case eloquently in a recent note, pointing out that the CBI's reserves of €1.5bn are completely inadequate to deal with any significant hit on a €51bn debt pile.

Those in the know, however, dismiss the suggestion that the CBI could go bust as "ridiculous", pointing out that the CBI has numerous layers of protection for its ELA lending.

The first is that all banks are required to stump up collateral in exchange for ELA cash, under a model that essentially transforms the CBI into a massive pawnbroker.

If the bank defaults on the ELA and fails to pay it back, the CBI goes after the collateral or the assets that have been pledged.

Given the state the Irish economy is in, the CBI has been applying "aggressive" haircuts to any assets that banks are pawning in exchange for ELA, so a bank presenting a loan book with a face value of €100m may only get ELA for, say, €40m.

The haircuts give the CBI added confidence that even if asset values fall, the collateral will still be enough to ensure the cash is repaid.

The second line of defence is an "explicit" government guarantee covering all ELA cash advanced by the ECB on the say-so of the CBI.

That means that if the banks can't pay back the cash, and if their collateral doesn't cover the amount that's owed, the Central Bank of Ireland would go knocking on the Government's door for repayment.

If the Government can't come up with the cash, the CBI can go after the Government's assets, with everything from semi-state companies to the Dail itself potentially coming into the firing line.

"While there are still assets in Ireland, the central banks will get their money back," says one source.

The prospect of the Central Bank of Ireland seizing the Dail or ESB might sound ludicrous from a political point of view, but sources insist the CBI would be free to take whatever action was deemed necessary.

"The Central Bank is independent of government," says one source.

"It would be taken very poorly [by the European institutions] in Brussels if the Government tried to interfere in its operations."

In short, despite taking on the risk of €51bn doled out to banks with rapidly deteriorating credit ratings, well-placed sources say the risk to the CBI is "actually not very large at all".

Criticisms

While bankers are quick to dismiss the common criticisms lobbed at the ELA scheme, the picture that emerges of how ELA actually operates isn't an entirely comfortable one.

The ECB does regular pawnshop-style operations where it gives banks unlimited cash at a fixed interest rate provided they pledge "eligible assets". A clear list of those eligible assets is widely available.

The Central Bank of Ireland, on the other hand, has no such list. "They look at things on a case-by-case basis, over time you get to know the things they will accept," says one source.

Banks have so far been mainly presenting the CBI with pools of loans as collateral. Haircuts are applied "on a risk-adjusted basis", varying widely depending on the state of the particular batch of loans.

"It [the haircut] doesn't just depend on one thing, it depends on things like, is the loan in default or is it in arrears, what type of loan is it," says one banker. "There's no rule."

There's no evidence that Ireland's banks have resorted to posting non-financial assets like actual buildings or businesses in receivership, but it's not beyond the bounds of possibility since Belgium's central bank accepted Fortis' branch network as collateral for an ELA advance back in 2008.

Whether the CBI would accept buildings and the like is anyone's guess. "ELA [in Ireland] doesn't really have any rules around it," says one source.

"Practices are evolving according to sound banking practice."

The on-the-hoof policy-making is understandable given the unprecedented territory traversed by Ireland's stricken banks, but the uncertainty created by such a fluid system has the potential to be problematic.

Uncertainty

Another major uncertainty in the whole thing is how long the ELA will go on for. The bulk of the €50bn or so ELA is advanced on a seven-day basis.

"We go back to roll over the money every week," said one source.

"Technically, the central bank could withdraw the funding on any given week, that's always the risk."

The Central Bank of Ireland's ELA operations already go far beyond the "norms" of ELA.

ELA is typically applied for a period of days -- as in the case of Fortis -- or occasionally for a couple of months.

In the case of Ireland, ELA

has been soaring at an alarming rate since August (see graph). Banking sources confirm that what began as "emergency" aid is now included in their regular liquidity planning.

How long the ECB will tolerate this situation remains to be seen. The Frankfurt powerhouse implicitly gave the nod for ELA when the CBI first dove in, but the permission must be renewed regularly.

Most believe the chances of the ECB pulling the plug are extremely slim, since the ECB is keen to keep the Irish banking system afloat, but the risk remains.

Risk

The risk to the Irish State, though, is by far the biggest concern. The descent into ELA essentially saw the Irish taxpayer assume a massive amount of risk for the non-repayment of that €51bn given to our stricken banks.

On the face of it, it seems like an outrageous development, particularly given the lack of consultation or debate around the measures -- Belgium, for example, passed an explicit guarantee for its ELA in parliament.

But sources point out that the circumstances surrounding the surge in ELA mean that the taxpayer didn't actually take on more risk, the taxpayer simply renamed a risk it was already on the hook for.

"ELA really began to pick up around September, when banks needed cash to pay back billions of deposits and bonds that were maturing," says one source.

"Those were government- guaranteed bonds and government guaranteed deposits.

Taxpayer

"If the ELA hadn't kicked in and the deposits and bonds hadn't been repaid, the taxpayer would have had to pay up then anyway."

If that had happened, all hell would have broken lose and the wheels of Ireland's banking system would have finally come unstuck, or at least that's the common belief.

For all its quirks and potential risks, defenders argue that ELA at least keeps the show on the road, giving the Irish banks a chance to recover their mojo, find new owners and become productive again.

Or at least that's the idea.

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