Tuesday 26 March 2019

We have fallen prey to a failed and costly policy

A crushed Irish Exchequer should no longer continue to pay off unguaranteed bondholders of bust banks, writes Colm McCarthy

University of California economist Barry Eichengreen has been a persistent critic of eurozone policy failures through the current crisis and he explained, on RTE radio last Thursday morning, that Europe's leaders must now accept the inevitability of a Greek sovereign default.

He also argued, as he has done consistently in recent years, that Europe is in denial about its banking crisis and that Europe's banks must finally be re-capitalised. It has been Ireland's misfortune to have faced the music early in the banking crisis and to have fallen prey, partly through our own errors, to a European policy of extend-and-pretend which has finally run out of road. Ireland has shouldered too large a portion of the costs of the failed attempts to fix the European banking system and must seek to reduce this burden as the crisis approaches the endgame.

At the end of September 2008, Anglo Irish Bank had €4.1bn in book capital. Bank managements and the Financial Regulator maintained that Anglo and the other Irish banks were adequately capitalised and that their problem was just a temporary shortage of liquidity. The Government decided to guarantee virtually all of the liabilities of the banking system, Anglo included. For the 27 months up to the end of 2010, Anglo has booked €34.4bn in loan losses.

It has written off almost half of all the loans it had made. Bank capital is there to absorb loan losses and a well-run bank can experience above-average bad loans occasionally. Provided these losses deplete only a small portion of book capital a bank can survive a jump in bad debts. The losses in Anglo equal 8.4 times its book capital. To be clear, this bank has blown all of its capital not once but eight-and-a-half times. Bank busts on this scale have rarely happened anywhere in the world.

Anglo has, for all practical purposes, been closed down by the Government. The bank does not lend, does not accept deposits and is now devoted to collecting whatever it can from those borrowers still on its books. It will be gone altogether as soon as this task is accomplished. Most Anglo bondholders have already been paid. But the remaining bondholders, remarkably, live on, including holders of senior unsecured bonds which do not enjoy a guarantee from the Irish Government. At the insistence of the European Central Bank, these unsecured, unguaranteed bondholders are to be paid in full.

Why should the over-stretched Irish Exchequer continue to pay off these unguaranteed bondholders? The only reason is that the Irish Government was bounced into this commitment last November by the European Central Bank in Frankfurt, with additional pressure allegedly applied, for reasons which remain obscure, from US Treasury Secretary Tim Geithner. The ECB threatened to withhold liquidity from the Irish banks and the Government must have believed the threat. The result would have been the collapse of a functioning Irish economy. The sole beneficiaries of the ECB policy are the bondholders in this defunct bank, and the same generosity is being extended to unsecured, unguaranteed bondholders in other banks which are either defunct, like Irish Nationwide, or would be were it not for Exchequer capital.

It is unprecedented for bondholders in defunct banks to be paid by a country already in an IMF programme and unable to re-finance its own sovereign debt in the market.

It is an extra irritation to have to endure lectures from EU and ECB officials about their generosity to Ireland, as if the lucky beneficiaries were the Irish public.

The Irish Times interviewed departing ECB executive council member Juergen Stark and reported on Monday last: "He is dismissive of a renewed Government push to avoid repaying about €3.8bn of the senior debt in Anglo Irish Bank and Irish Nationwide Building Society. The ECB remains opposed to such an initiative and Stark says Ireland is 'not autonomous to take this decision'. The question is a 'non-issue' for the bank."

The phrasing is interesting. Ireland is ". . . not autonomous to take this decision". The government of an EU member state, accountable to its electorate, is not free, according to Stark, to decide whether or not creditors in utterly insolvent and defunct banks, no longer trading and in wind-down, should be paid by a Government which has not guaranteed these debts. The funds to pay these bondholders are being provided by the IMF and EU, since the country cannot borrow elsewhere. Each payment adds to a debt mountain already so large as to threaten the ability to service the State's own sovereign debt.

"The question is a 'non-issue' for the bank," says Stark. It has been a non-issue only because the ECB has threatened successfully to withhold liquidity support, otherwise available to all eurozone banks, from Irish banks, unless the distressed Irish Exchequer keeps paying unsecured, unguaranteed bondholders in banks which are effectively closed. For an unelected ECB official to deem a sovereign government "not autonomous" on such an issue is a remarkable development in European politics. In their recent review of the rescue programme for Ireland, the IMF team made it clear that it is certainly not a "non-issue" for the IMF:

"It should be recognised, however, that there is a strong sense that burden sharing between taxpayers and creditors for the cost of supporting the banks has been unfair. In this respect, the authorities have reiterated their absolute commitment to servicing sovereign debt and the debt of the pillar banks (AIB/EBS and BoI) that will meet the banking needs of the Irish economy.

Regarding the banks in resolution (Anglo and INBS), which have received €34.7bn (22 per cent of GDP) in capital from the Government, the authorities have stated that any burden sharing with holders of unsecured and unguaranteed senior debt (about €31.2bn remaining) would be undertaken in consultation with the European authorities. Staff stressed that to effectively mitigate contagion risks such burden sharing would need a robust legal and institutional framework that strikes a reasonable balance between creditor safeguards and flexibility."

IMF statements need to be de-coded. This one means that the IMF do not agree with Stark and the ECB that the cost of bailing out remaining bondholders in these defunct banks should be borne entirely by the Irish Exchequer. Finance Minister Michael Noonan has been attending the meeting of EU finance ministers in Wroclaw, Poland, over the last two days and he signalled some weeks ago his intention to raise the matter with ECB president Jean Claude Trichet.

I hope Noonan posed the following question: When have unguaranteed bondholders in a defunct bank, which has lost eight times its shareholders' funds, been paid off by a government already removed from the bond market and in an IMF rescue programme?

Trichet, an experienced and knowledgeable central banker, will be aware that this has never happened before, anywhere in the world. Geithner is also attending this meeting and would have been able to confirm that the Federal Reserve does not expect the US states to pay off unguaranteed bondholders in local banks that have gone bust eight times over.

Last night's announcement that the government plans to meet this unguaranteed payment to Anglo bondholders was hopefully extracted in exchange for credible committments to burden-sharing down the road. The amounts outstanding to Anglo and Nationwide bondholders are now modest compared to the prospective national debt. Overall the Irish bank rescue will have added at least 40 per cent of GDP to Ireland's debt burden if the costs are contained within current estimates.

Very little of this cost has been borne by the creditors of the insolvent banks but has instead been added to the national debt, pushing the State into prospective insolvency and official rescue. Had the September 2008 bank guarantee been avoided and a more practical sharing of the burden been pursued, Ireland could arguably have been kept off the list of European sovereign casualties.

The ECB's persistence with the 'no-bondholder-left-behind' policy has failed in its principal objective, a sustained pretence that European banks are sound. Irish policy failures invited this persistence of course, but the ECB has forced the Irish to maintain an infeasible policy even after the penny finally dropped in Dublin. This is a footnote to the larger European failure to deal with the banking crisis but it leaves Ireland's finances suffering grievous collateral damage from a policy which has failed.

It is bad enough to have to "take one for the team" without acknowledgement. It is much worse to see the team lose the game so ingloriously.

Colm McCarthy lectures in economics at UCD. He headed an expert group examining State assets and chaired the Special Group on Public Service Numbers and Expenditure Programmes, An Bord Snip Nua. He also auth-ored the report into the semi-state sector from the Review Group on State Assets and Liability.

Sunday Independent

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