Why FG's "solution" won't work.

Extract from Richard Bruton’s Irish Times opinion piece in last Friday’s Irish Times. It concerns their approach to the banking system in the NAMA-less solution they are proposing.

“In the event that the banks cannot pass such a stress test by the end of the guarantee period, Fine Gael’s proposal is to split each failed bank into two, leaving the assets with the most uncertain values (the developer loans) in legacy asset management companies owned largely by the shareholders and other classes of risk investors. Deposits, other short-term liabilities, personal loans, mortgages and business overdrafts, the branch networks and the vast majority of the staff would all move safely and seamlessly into a new, going concern “clean bank”, initially owned and guaranteed by the taxpayer.”

This extract illustrates one of the main challenges for FG – a complete absence of understanding as to how the situation is likely to evolve, and a naïve belief that if you write something down it makes it happen.

It was good to hear Richard Bruton finally admit, at yesterday’s committee meeting, that he hadn’t understood the difference between Senior and Subordinated bonds. (Joan Burton also demonstrated a need to read up on Derivatives).

A key plank in the FG solution is the setting up of a “National Recovery Bank”
Let’s assume that this “bank” can raise the necessary €20bn, as outlined in the FG proposal.
How long will it take to get it up and running?
How long to organise
- Fundraising
- Personnel
- Distribution Channels
- Accounting/Bookkeeping/IT/Loan processing Systems/Processes

At best it will take several months to get off the ground, and probably a couple of years before it could be fully operational.

In the interim, for the 2nd leg of FGs banking proposal, the two main banks servicing the Irish economy, AIB & BOI, are told that post-Sept 2010 there will be no extension of guarantees for their fund-raising activities.

What will they do?
- immediately withdraw from any new lending exposures
- commence a major pro-active de-leveraging of their balance sheets, cancelling/ calling in overdrafts
- engage in huge cost-cutting activities e.g. laying off staff, closing any marginal branches
Their sole focus will be in survival, at any cost, beyond Sept 2010 as Zombie banks, in the hope that they can, over time, work out their property loans and return to profitability.

In the process, they will also reduce the economy to a Zombie state – FGs National Recovery Bank won’t be up and running in time to make up the slack, and all the foreign-owned banks are firmly in retrenchment mode.

This aspect of the FG plan, supposedly focused on National Recovery, is mind-boggling in its naïve stupidity.

I have no difficulty with the proposal to leave the bad assets with the banks and letting the shareholders/bondholders take their chances with “long-term economic value” of the underlying security they hold.
But there’s also a need for a functioning banking system over the next 2-3 years while we, hopefully, work our way out of the current recession.
However, that involves allowing the Banks the prospect of trading through the period, so here’s the alternative proposal:

- The current blanket guarantee of all bank liabilities is allowed to expire next year and is not extended. This removes the comfort from the subordinated bondholders.
- The Govt extends the guarantee for ordinary depositors and senior debt providers.
- The Govt provides ongoing guarantees, but only for specific fund-raisings by the main banks on a case by case basis.

This approach gives the Govt considerable leverage in ensuring that the banks support the economy while, at the same time, trying to repair their balance sheets.

If additional capital is required by AIB and/or BOI post-Sept 2010, then the Govt can underwrite rights issues and, in the event that private investment is not forthcoming, will become a major, perhaps majority, shareholder in those banks.

The critical consideration is to maintain a functioning banking system through the cycle, not Zombify it a.s.a.p. as would inevitably happen with the current FG proposal.