Recapitalising the Banks : November 28 2008

Another oped for the Irish Times, from a similar group warning that unless we moved rapidly we would end up with credit crunches and zombie banks….

 

Only adequate recapitalisation of the banks is likely to stop them inflicting further pain on an already slowing economy, write Brian Lucey, Gregory Connor, Valerio Poti, Mark Hutchinson, Niall O’Sullivan, Patrick McCabeandCal Muckley

THE DEBATE on bank recapitalisation appears to have moved on in recent weeks. At first, bankers denied the need for it, now, there is a denial that it will be useful. The gist of the argument against recapitalisation is that it will not make credit more available. The argument is that companies, and the economy, will have to accept an indefinite credit famine from Irish banks. The main thrust of the argument is that lower lending will be determined by the need for lower loan-to-deposit ratios, so that increasing bank capital will not help.

Aiming for lower loan-to-deposit ratios is a sensible proposition, given the deterioration of the loan assets of the banks, itself a direct result of the over-rapid increase in housing and construction related loans.

It is true that the loan-to-deposit ratios of Irish institutions are uncomfortably high. According to a UBS survey of bank balance sheets published in April, Ireland’s average loan-to-deposit ratio is 163.1 per cent. The country’s largest mortgage lender, Irish Life Permanent (ILP), records a ratio of 277.4 per cent, one of the highest of any western financial institution.

The typical US commercial bank has a lower ratio, about 100 to 110 per cent. The average ratio in the euro zone was at last count an even healthier 86.6 per cent. So, there is a problem with Irish banks’ loan-deposit ratios and Irish banks are probably best advised to reduce them.

Banks are reluctant to accept new capital and thereby dilute the claims of existing shareholders. The banks’ preferred strategy is to rapidly reduce loans to Irish business to lower the loan-to-deposit ratio, and not accept any new capital injections. From a macro-economic perspective, we need to recapitalise banks, allowing for an orderly and minimally disruptive process so that banks can slowly decrease outstanding loans rather than engaging in a panic reduction.

Consider a simplified bank balance sheet, with loans that represent the sole asset, financed by debt (deposits and inter-bank borrowing) and equity. Assets and liabilities must balance, but the composition of the liability side of the balance sheet matters. Deposits represent relatively stable funding, whereas inter-bank borrowings can be very volatile. This is why prudent bank management would rather increase deposits and/or decrease loans. Equity is arguably the most stable form of funding, because the capital is tied up in a bank indefinitely. Deposits and equity capital therefore share a common desirable trait in that they represent stable sources of funding. Adequately capitalised banks will likely move to reduce the loan-deposit ratio more gradually, inflicting less pain on an already badly slowing economy.

There is also another consideration which reinforces the conclusion that recapitalisation would help reduce the recessionary effects of the banks’ efforts to reduce their loan-to-deposit ratios. This argument rests on the notion of the “money multiplier”. For every euro of extra capital injected into the banking system, the amount of deposits in the economy increases by a multiple, due to the chain of depositing and lending. A recapitalisation would inject more capital into the Irish banking system as a result of this multiplier effect. It is important, however, to note that if banks were to re-export the capital injection via lending outside the economy, the beneficial effect would be much reduced. Thus some element of contingency and oversight is required. The oversight would be a requirement that banks which receive the capital be encouraged to invest in loans to the domestic economy.

The Government could seek adequate remuneration for the risk it takes in buying bank shares. For example, if it was to buy preference shares, it could demand a dividend likely to be in excess of 10 per cent per annum (the figure for similar transactions in the UK is about 12 per cent) and the option to convert into ordinary equity so the taxpayer benefits from any recovery in bank share prices. Contrast that with the high teen returns that are required typically from private equity funds, an increased return that can only come from rationalisation of banks and from increased profit margins at the expense of an already deflating economy.

As the Japanese and Swedish experiences show, if this is done well, it could turn the economy around and end up as a good deal for the taxpayer. The Japanese economy recovered from the decade-long depression that followed the burst of the property bubble in the 1980s only after the Japanese government recapitalised troubled banks by subscribing substantial amounts of preference shares. This injection of equity capital started in 1998 and picked up momentum in 1999, when the Japanese government recapitalised over 30 banks.

The recapitalisation of troubled banks lifted Japan out of the long depression and turned out to be a profitable investment. A number of banks turned around early and bought back the shares faster than anticipated, at a large profit for the Japanese government.

More importantly, the injection of capital allowed banks to clean up their balance sheet. This was essential to restore confidence, while avoiding the credit squeeze that would have occurred if the clean-up exercise had taken place in the absence of recapitalisation.

In the Swedish case, the banks were recapitalised with government monies and again the government was able to eventually recoup a very large amount of the monies invested.

A foreign private equity component to the bank capital injection has the advantage of bringing fresh managerial expertise. However, too much foreign capital in the mix would mean handing over control of strategic assets. Given the current illiquidity of Irish business, it seems reasonable to think that the only domestic investor with sufficient financial resources is the Irish Government.

This does not need to be a Christmas present for bank managers and shareholders. Both management and shareholders failed in their duties. Managers have presided over a loss of wealth unprecedented in the modern economy. Shareholders failed in their duty to monitor and control management. Neither side should get away with this dereliction of duty. Nor should the recapitalisation be a bad bargain for the taxpayer. Structured in the right manner it should represent a good long-term investment.

Brian Lucey is associate professor of finance at TCD; Prof Gregory Connor lectures in risk management systems at NUI Maynooth; Dr Valerio Poti lectures in corporate treasury management at DCU; Dr Mark Hutchinson and Dr Niall O’Sullivan are co-directors of the Centre for Investment Research at UCC; Patrick McCabe is a senior lecturer in accounting at TCD; and Dr Cal Muckley is a lecturer in finance at UCD

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