Stumbling towards default

The stress tests have revealed that the banking crisis is worse than envisaged under the EU/IMF bailout. And the EU isn’t helping us, writes Ray Kinsella

THE publication of the results of the stress test and the proposals for restructuring of the banks announced by the Government is unlikely to draw a line under Ireland’s ongoing banking crisis.

This is no responsibility of the new Government, who have sought with some degree of courage and conviction to convince EU partners to accept their responsibilities in resolving the banking crisis.

The response by the EU, and some individual member countries, has to date been deeply discouraging. A further increase in the already unsustainable burden of indebtedness arising from the outcome of the stress tests may impel Ireland towards a default which could precipitate the emergence of a ‘twin track’ eurozone.

The results of the stress tests indicate an additional capital injection of €24 billion. This will take the total committed so far to almost €70bn. This is, by several orders of magnitude, more than either the Government or the ‘troika’ of EU/ECB/IMF envisaged just three months ago.

What is also in prospect is the loss of between 5,000-10,000 jobs in the banking sector. But the real issue is the impact of the increased level of indebtedness and whether even this will be enough to rescue the banking system in a manner that will allow it to rebuild.

This is, in part, because the crisis is not just about the banking system: it is about a banking crisis that has simultaneously generated a sovereign debt crisis, each of which is now feeding off the other.

But it is also because capital, and the recapitalisation of banks, is not the core issue confronting Ireland right now. In theory, a banking system could get by with a minimal amount of capital to support its loan book: it cannot, however, function without sustainable sources of funding.

Of course, recapitalisation and access to such sustainable sources of funding, are inter-related. But funding for a stressed-out banking system with increasing level of impairment is the immediate challenge. In this context, Ireland’s banks remain almost wholly dependent on the ECB and the Central Bank to an extent that is wholly unsustainable.

What determines the amount of capital that banks need is the ‘mind of the markets’. And what counts here is policy credibility and confidence. The terms of the EU/IMF bailout are not credible. There is no confidence.

This is reflected in the fact that the costs of insuring against default of Irish debt — which should have fallen sharply in the wake of the EU/IMF bailout — remains at elevated levels. There may be some slight encouragement to be gained from a slight narrowing of ‘spreads’ over German bond rates in the immediate aftermath of the stress test results.

A key issue is therefore whether, or not, the costs of insuring against default now begin to decline. This would denote an increased level of confidence on the part of the markets that what is proposed in the present ‘bailout’, including the €24bn set-aside for recapitalising the banks is credible.

The results of the stress test were intended to give a greater degree of certainty regarding the estimation of loan losses and future impairments — especially in the mortgage markets. The results show the situation is significantly worse than was assumed when the EU/IMF package was put together less than six months ago and it was envisaged that anywhere between €10bn and €15bn of a total of up to €35bn might be necessary.

Just to take one example. In September last year the results of a previous set of stress tests indicated that Irish Life & Permanent was ‘well capitalised’ and that even in an extreme case the amount of additional capital required, would be less than €150 million. Yesterday’s results indicate that IL&P will need €4 bn capital.

Two points are important in this example. Firstly, the banking crisis continues to worsen. Secondly, one of the key factors driving this deterioration are the loan losses arising from increased losses on mortgage lending.

These are ‘tail losses’ — their distribution extends out into the future. They are being driven by a rise in unemployment and an increase in the number of houses in negative equity and therefore increase losses to the banks on their mortgage businesses, requiring additional level of capital.

What all of this indicates is just how inextricably bound-up are, on the one hand, a resumption of economic growth and, on the other hand, stabilisation of the banking system. You can’t have one without the other — providing yet more capital for banks that are operating in an emaciated economic environment makes no sense. Economic recovery — which would reduce the riskiness of bank lending, is the priority. The EU/IMF programme is undermining, rather than facilitating, economic recovery.

In the space of three short years, policy has been pushed back from attempting to fend of nationalisation across the board to one where the whole banking system is dependent — directly or indirectly — on the state. What this indicates is the reactive nature of policy and the extent to which official forecasts, the assumptions built into successive ‘plans’ and ‘strategies’, including the terms of the bailout, are continually playing catch-up with deteriorating market expectations.

THE chronic capital deficit revealed by the stress tests and the continued funding crisis, are not simply about Ireland and Irish banks. Banks, analysts, and capital markets will scrutinise results of these stress tests. The key issue is whether, or not, the markets’ response to the results and to the restructuring proposals set-out by the Government, are seen as credible. If they are not, the crisis within the eurozone will be ratcheted upwards as the knock-on effects impact on other EU peripheral countries, and in particular Portugal, which appears to be on a trajectory very similar to Ireland.

In effect, the epicentre of the crisis — and the place to which the markets look for a resolution of the crisis — centre on the EU. And this is the problem. The recent EU Summit, and the eurozone meetings which preceded it, confirmed that Ireland’s partner countries, for their own internal political reasons, are unwilling to work with Ireland to resolve a crisis for which the EU — its institutions and its banks — are at least partially responsible. This makes no sense, even from their own narrow self-interest.

The IMF Staff Report which underpins the IMF portion of the bailout, is emphatic that a default would generate a financial infection — of ‘contagion’ — that would threaten EU banks and the wider eurozone.

There is no evidence of EU solidarity, or a sense of shared responsibility. All that is on offer is a prescriptive and punitive regime. If there were any doubts at all on this, then a brief glance at a recent ECB Opinion on ‘Economic Governance in Europe’, and which has found its way into the ‘Pact for the Eurozone;’ should be sufficient to dispel all doubt. It is a very scary document, one wholly at variance with the spirit of the union, and which clearly indicates the cul de sac down which Ireland is being driven.

The case has been made in these pages over recent years that:

- Ireland’s recession-inducing budgetary policies were wholly misconceived.

- The Stability and Growth Pact imposing on Ireland a requirement that it reduce its current deficit from a recapitalisation-swollen deficit of almost 33% this year, to 3% by 2014 [a target set-out in the national development plan on which the bailout is based] is misconceived and counter-productive.

- The terms of the EU/IMF intervention to deal with the consequences of this approach exacerbate, rather than help resolve Ireland’s structural problems. Including an appropriate down-sizing of the banking system.

- A ‘default’ event by Ireland over the course of the bailout programme is almost inevitable. In this context, the significant increase in the amount of the bailout programme set-aside for recapitalising the banks, compared with that originally envisaged just a few months ago, is telling us that this crisis is deepening.

An important aspect of the stress test results relates to the restructuring of the banking system itself. In this context a requirement that IL&P divest itself of its profitable life and pensions business just as it moves into de facto state control, makes little sense.

This is similar to the requirement that AIB, as it passed into public ownership over the course of the last year, divest itself of its profitable overseas subsidiaries which, had they been retained, would have provided a platform for the rehabilitation of the banking sector and mitigated losses to the Exchequer.

In the wake of the stress test results, it is difficult to see how, as matters stand, Ireland’s inter-related banking and sovereign debt crisis can be resolved within the eurozone as it is presently constituted.

In the absence of decisive assistance from our European partners, Ireland is stumbling towards a default event. Indeed, it is already happening.

A ‘twin track’ Europe with Ireland in the outer track is now a very real prospect. The costs and consequences of such an event have already been modelled by authoritative analysts. Irish policy needs to adapt to this prospective reality.

- Professor Ray Kinsella is on the faculty of the Michael Smurfit Graduate School of Business

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