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ECB move only way to end banks' Catch-22

WITH almost a third of all Irish lending now funded by overseas borrowing the Irish banks face a Catch-22 situation. Mounting bad debts and an overvalued currency could force us to leave the euro, but if we do then the cost to the banks of repaying these foreign loans will soar.

In the 10 years to March 2008, Irish bank deposits grew by 250 per cent from €50bn to €175bn. However over the same period, Irish bank lending grew by 540 per cent from €59bn to €378bn. In other words, Irish bank lending has grown more than twice as quickly as deposits over the past decade.

So how have the banks managed to plug the growing gap between deposits and loans?

Until we joined the euro at the beginning of 1999 the amount the Irish banks could lend in domestic currency to their customers was effectively limited by the amount of savings held in Irish pounds by Irish companies and individuals. If they wanted to lend more than was available from local savers then they had to borrow in foreign currency.

That all changed on January 1, 1999. Suddenly the Irish banks could borrow in euro from banks throughout Europe and lend it to Irish customers. The limited stock of Irish savings was no longer a constraint on the amount the Irish banks could lend to their customers.

In March 1998, the net external liabilities of the Irish monetary system was just €6.8bn.

However, after an initial sharp jump they grew relatively modestly in the early years of Ireland's membership of the euro reaching €18bn by March 2003 and €23bn by March 2004.

It was in the final years of the credit-driven property boom that the external liabilities of the Irish monetary system soared, reaching €42bn by March 2005, €63bn by March 2006, almost €87bn by March 2007 and €119bn by March 2008, a six-and-a-half-fold increase in just five years.

This explosion in the external liabilities of the Irish monetary system was taking place at the same time as the Irish banks were becoming more and more dependent on inter-bank lending to fund their expanding loan books.

While the two figures are not synonymous there is no doubt but that there is a close correlation between the rising external liabilities of the Irish monetary system and the increased reliance of the Irish banks on inter-bank funding, most of which is sourced overseas.

Between March 1999 and March 2008, the proportion of Irish bank lending funded by customer deposits fell from 84 per cent to 46 per cent. Over the same period the volume of inter-bank lending and debt securities of the Irish banks rose from €31bn to almost €150bn.

Why should it matter where the banks borrow money? Surely, so long as they borrow in euro, there is no foreign exchange risk?

Only if we stay in the euro. If, for some reason, we were forced to leave the euro the cost to the banks in Irish currency of repaying these overseas loans would soar.

Such an outcome is not as far fetched as it might seem. With property prices falling and bad debts rising, Merrion Stockbrokers is calculating that the four quoted Irish banks will write off almost €13bn over the next three years. It has been suggested that by leaving the euro and cutting interest rates we could stem the flow of red ink from the banks.

Yes, but walking out on the euro would create, at least, as many problems as it would solve for the banks. Even a 10 per cent decline in the value of an independent Irish currency would push up the cost for the banks of repaying money borrowed overseas by about €13bn while a 20 per cent fall would bump it up by €30bn.

If we stay in, the ECB's high-interest rate policy will push up the banks' bad debts. Leave, and they face massively increased repayments on foreign borrowings. The only way out for the banks is if, starting on Thursday, the ECB cuts interest rates aggressively.