Getting banks back on track

IT is five years since the collapse of Lehman Bros in the US, but in Irish terms, Lehman was just the final hiccup which served as the precursor to the inevitable retching that Irish banks were about to endure.

Seamus Coffey: "The case for rescuing Anglo Irish Bank and Irish Nationwide Building Society was always weaker"

Banks rarely go bust overnight. It was the profligate lending of the boom that broke them. By the time of the Lehman’s collapse, the bank share prices had been falling for 18 months and were down 50% from their peak.

The blanket two-year guarantee issued in Sept 2008 tethered the State to the banks just as they went into freefall. In some cases, a bank rescue, and the ensuing costs, was inevitable. The costs of a collapse of the domestic banking system would have been even greater. The case for rescuing Anglo Irish Bank and Irish Nationwide Building Society was always weaker. They should have been put into resolution rather than rescued.

This mistake was further compounded by the repayment of around €6bn in unsecured bonds.

One issue that frequently arises is whether the banks will need further recapitalisation. A bank’s capital is the difference between the value of the assets and the liabilities on its balance sheet. It is the amount left over for the owner after all the obligations to and by the bank have been paid. Only banks with sufficient capital can trade.

The problem for the Irish banks was that the value of the loans on the asset side collapsed when it was finally realised that many of the borrowers could never repay. This quickly absorbed the capital the banks’ shareholders had in them and unless the liabilities could be written down, the banks needed funds from somewhere to ensure their solvency.

About €15bn of subordinated bond liabilities were written down.

The recapitalisation of the six covered banks in the three years after Sept 2008 saw the State promise to provide €65bn to keep their balance sheets solvent. Over the last two years, the long slow process of getting some of this money back has begun while the payment for the commitments made to Anglo and Irish Nationwide have been pushed out by 20 years.

Will the banks need more capital? Changes to banking rules means that in future, banks will need to have more capital to absorb loan losses but this does not become a requirement until 2017. The immediate concern is whether the banks will need more capital because of mounting loan losses. They probably won’t.

One area where loan losses have yet to be fully realised is mortgages. The latest statistics show there are €27bn of mortgages in arrears of 90 days or more. Around one-third of these are in banks the State has no ownership interest in such as Ulster Bank, Danske Bank, and KBC, as well lenders who have left such as Bank of Scotland (Ireland) and Start Mortgages. There will be no recapitalisation requirements for the State because of mortgage losses in these banks.

When the recapitalisation requirement was last calculated in 2011, €10bn was set aside for loan losses on residential mortgages in the covered banks. It would take an outright default on all of their mortgages in arrears and a recovery rate of just 40% for the banks to incur a €10bn loss. That is highly unlikely.

It is frequently stated that 50% of SME lending is in arrears. This is not true. The most recent figures from the Central Bank show that 25% of SME loans are in arrears. A figure of 44% arises if loans that are ‘vulnerable’ are added to those actually in arrears.

The banks have incurred and will continue to incur massive loan losses. At the end of 2012, the covered banks had €27bn of loan provisions available for writedowns and still had €22bn of capital remaining on their balance sheets. In large part, this is the money the State has put in and gives the banks an aggregate capital ratio of near 15% which is well in excess of the regulatory requirements.

As a result of the recapitalisation to date, the banks do have a large capacity to meet the loan losses on their balance sheets. In reality, the key is working through the loan losses and dealing with the borrowers in trouble.

The remaining banks are showing tentative signs of stability. Lots of mistakes have been made, but getting the banks back on a sound footing is one of the many conditions necessary to restore growth to the economy.

*Seamus Coffey is professor of banking at University College Cork

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