The problem with Irish banks : is it solvency or liquidity or both? Why does the Minister for Finance say “we would need some sort of external assistance to address the problems in the banking sector”

Solvency or liquidity? It’s almost as if we’re back in September 2008 and that fateful meeting on Upper Merrion Street where the Minister for Finance, Brian Lenihan, was persuaded that the banks were confronting a liquidity crisis but that they were essentially solvent. Remember that liquidity refers to having cash on hand, so if you pop out for a sandwich at lunch today and forget your wallet, you could explain to the café that you have a liquidity problem but you’ll pay them at the end of the day. Liquidity means that you do have assets worth more than your liabilities – it’s just that you can’t lay your hands on the cash you need right away. Giving a loan to someone who has a liquidity problem is less risky than in the next scenario because if you need collect your loan the person has assets worth more than their liabilities.

As it turns out, the banks back in September 2008 had an insolvency problem (as well as a liquidity problem). Insolvency means your assets are worth less than your liabilities. Oddly enough you can be insolvent but still be liquid – so you go for your sandwich today and you pay for it without any problem but unfortunately you own a house that is in negative equity, so if you had to settle your mortgage today you would be bankrupt. But on the face of it the banks were solvent back in September 2008, their assets which included loans they had advanced to property developers were worth far more than their liabilities which included deposits from customers and money they owe to the bondholders. However that assessment was wrong – although the value of the deposits and bondholders was shown correctly in the banks’ accounts, tragically the value of the loans to developers were vastly overvalued and as we now know are worth less than 50c in the euro.

So the banks were insolvent back then and since September 2008, we (the citizenry of the State) have committed to pumping €46-52bn into the banks. We were told by our new-ish Financial Regulator and by our Minister for Finance, both as recently as 30^th September, 2010 – 45 days ago –  that “today’s announcement brings full clarity to the costs and methods of recapitalising the banks”. As for the source of the funding of the €46bn – €11bn was to come from our pension reserve, €4bn in cash was borrowed in 2009 and pumped into Anglo and the remainder, €31bn, was to be pumped into the banks as promissory notes which would then be borrowed by the State over the next 15 years. That was the position on 30^th September, 2010 – 45 days ago. It seemed sorted. What has changed?

(1) Have further losses been identified at the banks? If I understood Peter Mathews (independent Irish banking consultant that like a Cassandra has been shouting from the rooftops for the past two years that losses in Irish banks are far greater than officially recognized) correctly last night during his appearance on RTE’s Prime Time TV programme, he is now saying that losses in Irish banks (I guess he is talking about the six under the State guarantee – AIB, Anglo, BoI, EBS, Irish Life and Permanent and INBS) will be €91bn (€66bn for commercial losses and €25bn for losses on residential mortgages). I understand Trinity College Dublin professor, Constantin Gurdgiev to have been estimating losses at €70bn and last week economist Morgan Kelly seemed to be predicting losses of €70bn in Anglo, AIB and BoI alone (excluding INBS and EBS). The government/official forecast however appears to be around €50bn – I say “appears” because it is not always the case that like is being compared with like (some provisioning already exists for loans and some State funding might be recoupable and some profits might be made from discounting bondholder redemptions and from continuing operations). But the official line is in the €50bn zone and that is substantially different to these other three. Under normal conditions if you were to set the opinion of individuals outside the banks against the opinion of an army of bankers, accountants, auditors, financial regulation and central bank personnel you would expect the official line to be the better estimate except that during the past two years these individuals above have tended to be more accurate in their predictions which were substantially at odds with the official predictions. Are they right this time?

(2) If the problem is a liquidity problem, then why does the ECB not continue in its role of lender of last resort? It seems that, apart from the ECB, no-one wants to lend to Irish banks at reasonable rates at the moment and if I understood Pat Rabitte on the same Prime Time programme last night, he asserts that the Irish banks are paying (a bargain) 1.5% to the ECB for the present emergency assistance. And if rates demanded on the open market for lending to Irish banks is so elevated as to be impractical, then isn’t that a true “emergency” and shouldn’t the ECB be providing unlimited assistance? We signed up to the euro a decade ago and with that exchanged a large part of our autonomy with domestic monetary policy in return for (a) price stability and (b) a stonking great central bank in Frankfurt with €1tn reserves. As much as we would now like to abandon the euro and re-introduce our former currency, the Punt, that notion is dismissed for economic and political reasons. So we have this currency yoke around our necks and instead of inflating/devaluing or minting/printing our way to recovery we continue to struggle with a currency more befitting German and French needs. Fine, we accept that reality but why are we being deprived of one of the euro’s great advantages – the strength of the reserves in the ECB? If Irish banks need another €100bn of liquidity then why isn’t that forthcoming from the lender of last resort?

So what is the problem? Does the ECB believe that the losses in the banks have been understated and that more capital (solvency) is needed? Does the ECB believe that the statements given just 45 days ago are inaccurate? I must say that if this is the case, Ireland has the right to feel short-changed by the stress tests undertaken earlier this year and which were published at the end of July 2010 in respect of the two main “Irish” banks – Allied Irish Banks and Bank of Ireland. In addition we have a new-ish €340,000 a year Financial Regulator that conducted what he terms a Prudential Capital Assessment Review and concluded just 45 days ago that given the €46-52bn of funding announced by the government, that our banks would meet (nay, exceed) international capital requirements. Our formidable Central Bank governor, Patrick Honohan also added his name to the estimates just 45 days ago. So unless the Financial Regulator, Central Bank Governor and EU Stress tests were all wrong then why is this not a liquidity problem which properly falls within the reserve of the ECB to resolve.

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