UCD Boy Whelan says Debt for Equity Swap is your only man

Joined-up thinking can solve crisis in Irish banks

OPINION : €150bn debt-for-equity conversion could facilitate sale of banks and help the State avoid a much-mooted sovereign default
THE KEY thing to understand about the current Irish economic crisis is that it’s mainly about the banks. Even without the banks we would have a large fiscal deficit. However, without the banks, we’d also have a debt-GDP ratio of about 80 per cent and a sovereign weath fund worth about 15 per cent of GDP, a situation that would be sustainable.

It was banking problems that triggered the EU-IMF bailout deal. Despite having sizeable cash balances, the Irish Government did not have the money to provide the liquidity support to banks that were haemorrhaging deposits and other sources of funding. Instead, the banks were being propped up by massive amounts of funding from the ECB as well as emergency liquidity assistance (ELA) from the Irish Central Bank that required assent from the ECB Governing Council. Ultimately, it was the ECB’s decision to make further funding for the banks conditional on Ireland seeking a bailout that triggered the EU-IMF agreement.
Back in November, the plan to fix the banks was to get the Irish State to put in up to €35 billion (half of this borrowed from the EU and IMF) to recapitalise the banks. It was hoped that this would restore market confidence, thus allowing the banks regain access to market funding and repay the fortune they owe the ECB.
The availability of these funds to recapitalise the banks has not had the desired effect. Large amounts of deposits have left the Irish banking system since November to be replaced by yet more Central Bank funding. The six banks guaranteed by the State now owe about €150 billion to central banks, with about €70 billion of this owed to the Irish Central Bank in the form of loans that were guaranteed by the former minister for finance (without, to my knowledge, any consultation of the Oireachtas).
Consider the magnitude of this funding. Irish GNP is projected to be €128 billion this year. So if every Irish person gave all their income this year to the banks, it would still not be enough to pay back the ECB and the loans due to the Central Bank.
It is possible that the stress tests to be announced at the end of this month could, in conjunction with recapitalisation, restore international confidence in the Irish banks. Possible but unlikely. Stress tests are somewhat discredited at this point with most investors believing they are usually rigged to produce a positive assessment.
Given the apparent failure of this approach, the EU authorities have focused on an alternative approach: deleveraging. That’s a big word for Irish banks selling off their loan books and using the proceeds to pay off the ECB and Irish Central Bank. The problem with this idea is that the scale of such a sale would be enormous relative to the market demand for these kinds of assets. Put simply, there just isn’t much interest out there in buying €100 billion in Irish mortgage loans. A sale of this sort would probably see the Irish taxpayer losing a fortune and push the State that bit closer to sovereign default. I suspect some of our European partners are slowly beginning to accept that this plan simply can’t work.
So how is the €150 billion supposed to be paid back? In the absence of the banks raising private funding of anything close to this amount, I believe the answer is that the Central Bank loans need to be converted to equity. The problem is that many suspect the banks are insolvent but the scale of the insolvency hole is simply unknown. Under these conditions, it is hard to expect international stock or bond investors to hand over their money. However, if the €150 billion in funding from the ECB and Irish Central Bank is converted into equity, then these banks will immediately be solvent beyond even the doubts of the most pessimistic observers and, at that point, they could be sold into private ownership.
This equity conversion could work as follows. The European Financial Stability Facility could issue €80 billion in bonds, loaning these funds to the Irish banks, who would then pay off the ECB, allowing it walk away unscathed. The EFSF would then convert its €80 billion loan into an equity stake. Similarly, the Irish Central Bank would convert its ELA loans into equity with a legal promise from the Minister for Finance that any losses on the equity share would be covered by the State. The banks would then be owned by the EU and the Irish State but would be prepared for sale to private ownership.
The conversion of the €150 billion to equity would not represent a great investment for either the Irish or the European authorities. For example, suppose the true underlying value of the Irish banks turns out to be minus €30 billion. The equity stake would then turn out to be worth €120 billion, with losses shared between Ireland and the Europe. The Irish ELA loans of €70 billion would end up as €56 billion of equity and the ECB’s loans of €80 billion would end up as €64 billion in equity held by the EFSF.
This kind of proposal will hardly be popular with our European partners. However, it would achieve many common goals. It would restore the credibility of the ECB, who would hopefully learn a few lessons about lending to insolvent banks. It would restore the Irish banks to stability without seeing defaults on senior bank bonds, which has been a high priority for the European authorities. And it would give the State a chance to avoid a sovereign default, which should be in everyone’s interests.
The Irish banking crisis has rumbled on for 2½ years. The ability to resolve this situation without inflicting massive losses on taxpayers has been lost because of a failure of Irish policy-makers to deal promptly with insolvent institutions – we nationalised Anglo in 2009 – and because the ECB continued to supply the funds that allowed insolvent banks pay off private bond investors.
For this latter reason, the European authorities share much of the blame with Irish regulators and politicians for the situation that exists today with the Irish banks. The time has come for them to share in creating the solution.
Karl Whelan is professor of economics at University College Dublin