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David McWilliams: Our bailed out banks are in process of going bust again

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Ernest Hemingway was once asked how did he go bankrupt. The great man thought for a second and then replied: "I went bankrupt in two ways, gradually and then suddenly."

When we see the figures coming from the various banks, it is not difficult to see that something similar is happening in Ireland. Whether the banks end up bust again, the second time in three years, will depend on how the ECB reacts but it looks like the banks, having been bailed out and having received huge government capital injections, could now be in the process of going bust.

As Mr Hemingway observed, people and entities go bust gradually, at first -- this is the phase we are in. Then they go bust overnight. History suggests that after that happens, the economy will recover because we have to start again.

Interestingly, the reason that the banks might be going bust gradually is because the ECB is giving them money at 1pc so that they can mask the inconsistencies in their business model for another year or two. But when that money runs out or the ECB's policy reverses, which it must eventually, where will they get the cash to operate?

Figures for Irish Permanent released the other day reveal what similar figures for AIB and Bank of Ireland indicated in the past few weeks. The mortgage book is unravelling. The negative equity, which up to this was being shouldered by the population, is now forcing people to miss payments.

Obviously the place you are seeing this is in the "buy-to-let" portfolio where 25pc of Irish Permanent's loans are not only in negative equity, but are actually non-performing. In other words, they have been defaulted on. The other part of its total loan book, the normal residential mortgage book, is deteriorating rapidly.

For example, close to 21,000 customers are in arrears of 90 days. This is up a quarter on last year to 12pc of all loans. The pace of deterioration in the loans book is alarming because it seems that bad loans have risen by 100pc in two years.

When you take a bit of altitude from the grim reality of a shrinking economy and too much debt and you look at the bank's net position you can see the roads to penury even more evidently.

Irish Permanent's loans-to-deposits ratio remains 227pc, down from 247pc last year. What this means is that the delinquent management of this bank borrowed so much in the boom to lend out that now -- even after three years of contracting -- for every €1 deposit the bank holds, it has lent out more than €2.27. For the bank to be viable, it has to get this ratio back to €1 of deposits equal to €1 of lending.

This implies that it has to aggressively cut lending or aggressively increase deposits or a combination of both.

Now, in order to attract in deposits the bank has to engage in a deposit war with the other banks. The only way to do that is to increase deposit rates on offer over and above what is available in the other banks.

Now here is the rub: banks make their money by borrowing money cheaply from me and you in the guise of deposits. The deposit is the only asset a bank actually has because it is money that is both cheap for the bank to get and it is also what is termed "sticky", which means that it takes a lot for people to change banks or take out their money.

In contrast, other bank capital, like bonds or shares, can be easily sold by investors. This makes them liquid for the investor, but for the bank it makes them both an expensive and an unreliable source of capital.

If the bank gets into a deposit war at a time when there is no demand for loans because people and companies don't want to borrow, it is toast.

Why? Because its cost of capital is likely to be greater than its return from that capital. That is how you go bust.

But why doesn't this happen quickly and why is it more likely to follow the Hemingway dictum of gradual followed by sudden?

This is where the ECB comes in. The central bank's job is to prop up banks in trouble. So it is providing a huge amount of liquidity at 1pc to all eurozone banks. The total of this quantitative easing now amounts to €1trn. All this money finds its way back into the banks because they offer dodgy collateral to the ECB and the ECB gives them cash at 1pc for three years.

So it is unlikely that Irish banks will go bust as long as this remains in place.

So gradually the banks will just become safe deposit boxes for the ECB, taking in money but not lending out because they have to get that loan/deposit ratio down to 100pc.

What does this mean for the Irish economy? It means a zombie banking system presiding over a zombie economy where credit conditions tighten progressively because they have to if the banks are to become functional again.

But there is the conundrum. The more credit the banks take out of the economy, the more house prices continue to fall and the higher negative equity becomes; therefore arrears get higher, and the greater the pace at which arrears translate into defaults.

This is how the gradual becomes sudden, because the gradual is making the sudden more and more likely.

The only way out of this is to default on many of the Irish banks' creditors. But as much of the debt has already been turned into sovereign debt and as the ECB is the creditor, the ECB will need to be central to a deal.

The hardliners at the European Central Bank, who are obviously in the ascendancy now, would baulk at the ECB being involved as a broker in such a debt restructuring. But then again, in Greece, the ECB took a massive 50pc-plus haircut on its exposure to Greek bonds. So stranger things have happened.

Either way, the only way to avoid Hemingway's law of finance is for the gradual to become sudden and the sudden to become gradual. The choice is ours.

For an easy way to understand economics check out the new Punk Economics 3 on YouTube. www.davidmcwilliams.ie

Irish Independent