Thoughts on the banking crisis : November 17th 2008

This oped was published in the Irish Times shortly after the bank guarantee. It was a first attempt to mobilise academic opinion on the banking issue. It is startling to look at it now and see that we were pegging 2011 as the start of a recovery (maybe)…. how optimistic we were.

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OPINION:As academics who study finance and banking, it is our professional view that Irish banks must be recapitalised if Ireland is to avoid a Japan-style prolonged recession, retarded by zombie banks, write Brian Lucey, Patrick McCabe, Colm Kearney, Aleksandar Sevic, Louis Murray, Elaine Hutson, Valerio Poti, Gregory Connor, Cal Muckleyand Mark Hutchinson

THE EXISTENCE of a healthy well capitalised banking system is a key component of any functioning modern economy. As banks write down the quality of their assets their capital base shrinks. This is the scenario that Irish banks now face.

Banks require adequate capital to make loans, and it is arguable that it is in periods of recession that bank loans play their most essential role. In a recession, even sound companies will require a considerable buffer of bank loans to see them through to stability.

As the recession bottoms out, the role of banks is fundamental to the provision of rapid financial injections to companies that see themselves as well positioned to take advantage of an improvement in business conditions.

Banks that are under capitalised are not, by definition, in a position to grow their loan book and to increase their assets, and as a consequence cannot play their part in assisting the economy to grow. Worse, as they shrink or grow at a slower pace than the potential growth path of the economy in which they operate, they act as an actual drag.

The phenomena of banks too large to fail (in political and national pride terms) but too small to grow, is one that plagued the Japanese economy for over a decade and half. It is well accepted that these so called “zombie” banks retarded the Japanese economy and left it ill positioned to take as much advantage as it might otherwise have done when world economic conditions improved.

The Irish based banks require capital – that is now agreed by all. The only source that seems to be considered, however, is to issue bonds on the international debt markets.

The structure of the bond funding programme as it emerges, appears to be one that is not guaranteed to provide the banks with the capital required.

It will be managed by the regulators to ensure that no bank, regardless of how strong or weak, takes a “disproportional” share of the available funding. This is a fundamental distortion of the asset allocation mechanism of the international capital markets.

Second, it is asserted that the funding will be at an AAA rate of interest, the bank borrowings being backed by the Government guarantee. This is not, however, in any way guaranteed – it is dependent on the markets believing that the Irish state is capable of meeting that guarantee should it be called upon.

It is more probable that the funding cost will be significantly above that at which AAA-rated funds are priced.

Third, capital is, by its nature, long term. The consensus of commentators worldwide is that it will be at least 2010 before we see marked improvement in world economic conditions.

The Irish recession may take until 2011 or later to work through. Therefore banks need capital strengthening with instruments that are at least three to five years in duration.

Yet the funding proposed is to be short term in nature, to attempt to access it at the AAA rated costs. Such short-term capital funding presupposes that the banks will, in 2011, be able to raise capital on their own accord in normal market conditions.

However, that will only be possible if the economy is back on a sustainable track and if the international markets are convinced that the Irish banking system is fundamentally well managed and sustainable. Neither of these are guaranteed.

Finally, it is not clear that sufficient funds to strengthen the bank balance sheets, which may be of the order of EUR 10 billion plus, can in fact be raised.

It is our professional opinion, as academics who study finance and banking, that a preference share-based recapitalisation of Irish banks is more appropriate.

The appropriate and only source for such funds is government, conditional on the true extent of the impairment to the bank’s loan books being ascertained and made public prior to, and as a condition of, investment.

These shares should have warrants or conditions attached to them. This has several advantages. First, it can provide capital to the banks on a longer term and thus leave them well positioned to take up their role in any recovery.

Second, it can provide funding at a guaranteed rate of 6-7 per cent. That is a good prospective return for equity investments over any period, still less for banks that are effectively distressed.

Third, properly structured these can allow the investor, the State, a share in the upside of any banking stock recovery as well as providing a good return.

Fourth, this approach has emerged over the last month as the preferred mode for banking assistance, most recently with the decision by the US to scrap the proposal to purchase toxic assets in favour of using the funds to recapitalise.

Fifth, such an investment ‘would provide a signal to the markets that the regulatory bodies in the State were fully convinced of the long-term quality of the banking system and would better position them for accessing the international markets when and as economic conditions improve.

Brian Lucey is associate professor of finance at Trinity College, Dublin; Patrick McCabe is a senior lecturer in accounting at TCD; Colm Kearney is professor of international business at TCD; Dr Aleksandar Sevic is a lecturer in the school of business at TCD; Louis Murray is professor of funds management in University College Dublin; Dr Elaine Hutson is a lecturer at UCD; Dr Valerio Poti lectures in financial econometrics, securities investments and corporate treasury management at Dublin City University; Prof Gregory Connor lectures in risk management systems at the National University of Ireland (Maynooth); Cal Muckley is a lecturer in finance at UCD; and Dr Mark Hutchinson is director of the Center for Investment Research at University College Cork

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