by Mike Soden
One might feel comfortable that as long as the branch network remains the same, with the same name over the door, one’s financial system is safe. Safe it may be, but how sympathetic is it to the needs of the local market? When annual budgets were presented to head offices in London, Sydney or Melbourne, with requests for additional credit facilities for agriculture, these requests often were greeted with a steely silence. What had been viewed as a sectoral allocation of resources by the domestic banks of New Zealand was now seen as an international sectoral allocation from a head office perspective. Channelling resources to the preferred sectors in the New Zealand economy was now out of the hands of the traditional decision makers and, in part, a national economic policy was being determined outside the country.
Some twenty years have passed since the New Zealand crisis occurred and the banking system still remains in foreign hands. Having a clearly thought out national plan for the Irish financial services industry would ensure that each decision would be made in the overall context of national recovery rather than on a piecemeal basis, hence preventing foreign ownership. Such a national plan would require strong leadership and the various constituents working together on a consistent basis. The difficulties that arise between the banks as lenders, NAMA, the Regulator and the borrowers are compounded by the lack of clarity being displayed by the leadership of the country. The complexities as to who is to be considered the most important constituent in any given transaction, be it the shareholders, borrowers, lenders, policy holders, regulators or the taxpayer, causes unnecessary confusion. Each piece of the financial jigsaw has its respective position but the need for an overall plan for getting the best deal for the country, in which each constituent has its place, appears to take a secondary position to the bureaucratic process.
A BLUEPRINT FOR SUCCESS – SWEDEN
Closer to home, the handling of the Swedish property bubble of the 1990s is another example that could give us guidance as to how we might manage to extricate ourselves from the mess of our own burst bubble.
The Swedish banking crisis had its origins in the domestic commercial real estate market, as is the case in Ireland today. Rapid increases in lending fuelled the crisis; financial companies that were subsidiaries of the banks were lending to the commercial real estate market, funded by the issuance of commercial paper. A liquidity crisis arose when this source of funding dried up and financial companies reached the edge of insolvency. With a rapid expansion of credit growth in the course of five years, private borrowing grew from 85 per cent to 135 per cent of GDP. If we care to remind ourselves, in a similar time frame, the growth of credit in the Irish private sector grew from 100 per cent to 200 per cent.34
One of the major failures in terms of credit decisions in Sweden was that banks lent to customers, projects and geographical areas of which they did not have sufficient knowledge (sounds very familiar). A further mistake in the lending habits of the banks was that they accepted, knowingly or otherwise, high risk concentrations, not just in terms of individual companies but also in economic sectors, primarily real estate, and within particular geographical areas.
It was uncovered after the fact that the supervisory authority had not adjusted to the changing market conditions. It continued its traditional formal supervision, ensuring that reports and permits, etc. were formally correct rather than supervising the actual risks. This lack of good practice was experienced some seventeen years ago in Sweden and all we can say today is ‘Déjà vu’. Lacking relevant crisis experience, the authorities in Sweden did not perceive that the 1980s could pave the way to a new financial crisis.
The first signs of a potential crisis were observed in autumn 1990. In early 1991, one of Sweden’s middle-sized banks, Forsta Sparbanken, disclosed severe credit losses in real estate lending and its capital ratio fell below 8 per cent, threatening its survival.35 The Treasury gave a credit guarantee to the bank in order to improve the bank’s ability to raise funds in the market. There was no sign at this time of the systemic nature of this crisis being recognised by the authorities. This background sounds familiar in the context of events relating to Anglo Irish Bank in September 2008. However, the global financial crisis forced our decision makers to recognise the potential catastrophe of a liquidity crisis in one bank having a potential contagion effect on the whole Irish banking system.
Later in 1991, one of the larger Swedish banks, Nordbanken, disclosed large credit losses that took its capital ratio below 8 per cent.36 The Government now gave a new guarantee and in return took a majority shareholding. In 1992, Nordbanken and Forsta Sparbanken found themselves in trouble again as credit losses in the commercial property sector were revealed. Behind the scenes, the Government decided to merge a number of the smaller savings banks under an umbrella organisation (the current Swede Bank). At the same time, the Government bought out the remaining shareholders since it believed it would be easier to restructure the company with sole ownership. When it became clear that the credit losses were bigger than expected at Nordbanken, the Government decided to create a new company, Securum (a ‘bad bank’), whose sole purpose was to take control of the distressed debt. Some 25 per cent of Nordbanken’s outstanding stock of credit was transferred to Securum. The comparison between Securum and NAMA is obvious.
On 9 September 1992, Gotha Bank, a major bank, went bankrupt. Real estate prices in the previous six months had continued plummeting, and the provisions and write-offs at the bank were enormous. Sweden was now in recession, and over the three-year period in question GDP fell by 6 per cent. While the country is twice the size of Ireland in population terms, we must remember that in 2009 our GDP fell by 11.3 per cent.
At the time of Gotha Bank going bankrupt the Swedish Government issued a guarantee that no counterparties to the bank would suffer losses. This meant that the Government guaranteed all forms of bank debts, not just deposits. The Government ensured that the shareholders should bear the cost and not be included in any guarantees. Two weeks later the Government expanded the guarantee to be a general guarantee for all Swedish banks. The big question was what the limits to the guarantee should be. The answer: an unlimited guarantee in order to create the best conditions possible to rebuild confidence in the financial system.
By early 1993, the Swedish Government decided to create a new agency – the Bank Support Agency. The guiding principles of this agency were:
• All banks were eligible for support.
• Support in the form of equity was more preferable than debt, as the taxpayer would benefit from the improvements in the stock price when the bank recovered.
• The Government (strongly socialist) had the express wish not to take over banks as it had no interest in socialising the industry. Only as a last resort would banks be nationalised, and if it happened it would be a temporary solution.
• All participating banks had to disclose all known and expected losses and collateral values.
• A tricky conundrum was how the Bank Support Agency should value debt and collateral. If the value was set too low, the banks would go bust. But if the value was set too high, taxpayers would risk making a bad deal. The guiding principle was to make conservative assessments rather than the opposite (perhaps NAMA could have taken a lesson here).
• The Bank Support Agency also had to determine which of the banks were worth saving from a long-term perspective.
• A law was passed that saw the creation of a board of independent judges who were deemed to have the inalienable right to decide what the fair value of the existing shareholders’ equity should be. The decision could not be appealed.
All of the foregoing has a great similarity with NAMA.
So, why was the management of the Swedish banking crisis deemed a success? The Swedish Government sought and received backing from the main opposition party for the above strategies. The achievement of political consensus was probably the most important factor that aided the quick recovery in Sweden. The two entities that were formed as the g
ood and bad banks, which were expected to last for a fifteen-year period from their creation, were done liquidating their assets after four years and they ceased to exist thereafter. This was achieved because of the speed and independence of their NAMA-equivalent vehicles in operation. They created a market and participated actively in it with the purchase and sale of assets that led to the rebuilding of confidence in the country. This confidence originated within the country but was valued externally by the international investment community.
While the crises are similar in many ways, the dimension of the Irish crisis is unfortunately far greater than Sweden’s ever was. However, there are number of simple lessons to be gleaned from the Swedish crisis that have application to our own situation today. First, confidence needs to be restored rapidly. This was achieved in Sweden’s financial sector and was reflected in the real economy. A prolonged lack of confidence would have delayed recovery by years. While a severe crisis can wipe out confidence, this confidence can be restored through transparency in the reporting of the extent of the losses and the magnitude of the bad loans. The Swedes divulged all aspects of the losses publicly, everyone grasped the enormity of the national problem and consequently there was a cohesive response to the Government’s proposed solution. Second, it was acknowledged that someone had to take responsibility for the losses. It is important to realise that, once the crisis had occurred, the losses could not be hidden and were dealt with in a straightforward fashion. Party politics was separated from commercial realities and an acceptable framework was set up to accommodate all parties. The shareholders were not rescued. People in general had to take major cuts in living standards. Fairness, real or perceived, was served through astute and cohesive decision making.
CHAPTER 8
The Model Is Broken –
A New Financial Services Landscape
At this time there is a full-blown exercise underway to rehabilitate the financial system in the country. As those responsible for this huge undertaking try to harmonise our system to an unclear European plan, we face a dilemma due to lack of vision or lack of clarity of vision.
The Government has clearly determined that, if possible, the banking system in Ireland should stay free of total nationalisation, meaning 100 per cent ownership by the state. There are two distinct reasons for this. First, experience suggests that government-run banks are less likely to be a success. This is evidenced by the lack of socialised banking throughout the developed world. The second reason is that the temptation for politicians to spend their way into office would be too easily accommodated through government-owned institutions. It is easy to put forward a case that suggests that 100 per cent state ownership might not be a bad alternative as private ownership has brought the country to its knees. A conclusion might be that anything other than private ownership could do no worse. My belief is that we should do everything to ensure that private ownership is retained in this sector for the good of the country and democracy.
Government support packages to financial institutions are influenced by a process that has been developed by the European Commission (EC). The EC oversees whether state assistance is in line with the principles of the Common Market and whether institutions require restructuring. A broad outline of the European process and how it might apply to the Irish Government bank guarantee and the recapitalisation of the banks follows.
After the Government provides assistance to an institution, the member state notifies the EC of the nature and dimension of the support. It is implied that there would be some verbal communication between the Government and the EC in advance of the announcement. The EC then determines if the support is compatible with the principles of the Common Market. As part of the EC’s assessment, it examines the exit plan of the institution in terms of the support, and consideration is given to the imposition of penalties to compensate for market distortions. The institution that has received the support is required to provide a continual update on the restructuring, which may include such things as the sale of subsidiaries, withdrawal from certain businesses and likely reduction in foreign branch networks. During this period of restructuring, it is unlikely that the institution receiving the support would be permitted to acquire new businesses.
The foregoing process has had an influence on the restructuring of the banks in Ireland. It has to be repeated that the idea of looking at the restructuring plans of individual banks in the absence of a national banking plan is tempting failure. The creativity and vision of the Department of Finance has been tested during these turbulent times and, unfortunately, I believe they were found wanting in this regard. If the sole outcome of the planning of individual banks is the deferral of state ownership of the banks then this will be disastrous. Our banks, if slow to recover, will become the target of takeovers by European banks if they are viewed as viable partners and are priced cheaply. The EC assesses whether an institution that is in receipt of state aid has a long-term future and, if not, what the time frame is for its closure. This is surely the situation for Anglo Irish Bank as justification for its survival spreads thinner.
Anglo is the living embodiment of the cause of the crisis. It is difficult from most people’s perspective to recognise that those who were in charge – directors and senior executives – have departed and have been replaced by a superior calibre of very experienced international bankers. But the effigy of the crisis is Anglo and the desire to burn this effigy runs very deep. To satisfy the emotional outburst of the electorate in its search for retribution, some plan has to be devised that enables Anglo to be absorbed into another entity or to have it as part of another strategy that would see it run down in a short period of time. Both of these suggestions would have a potential contagion effect on the Irish banking system and, in turn, on the sovereign rating of the country for international debt raisings.
Any precipitous actions on the future of Anglo could have, and are likely to have, dire consequences for the country’s ability to borrow. Currently, the state raises funds in an orderly fashion in its own name while the banks now require hundreds of billions to be borrowed, with the guarantee of the state to keep their books in balance. The international markets view the various debtraising activities of the banks and the state as being separate and independent for the moment. International investors have internal categories of ratings and portfolio concentration guidelines that restrict them from investing excessively in one borrower. For the moment, the market recognises the difficulties the country faces but respects the difficult decisions that have been made to turn the economy around. If all the entities in Ireland that borrow on the international markets had to be recognised as a single borrower, there would possibly be a lack of capacity in the market to satisfy the total borrowing requirements of the country.
The management of Anglo, the Government and the Regulator have all concluded that the liquidation of Anglo at this time would be prohibitively expensive. The combined losses and funding requirements might well exceed €75 billion,37 which would have grave systemic consequences.
The plan put forward by the new executive of Anglo to separate the activities into a good bank–bad bank structure is a replica of the previous success story in Sweden in the early 1990s. There is a greater likelihood that this approach will provide the least expensive solution for the country over time, for several reasons. The single most positive outcome of this option is the creation of a new well-managed, strongly capitalised Irish financial institution that provides much needed liquidity and competition for the SME sector.
The six Irish banks are being viewed from the perspective of what needs to be done to them so they can return to their glory days: recapitalisation, the establishment of stable boards and executive management, the maintenance of risk profiles that are consistent with SME lenders, and the creation of effective governance regimes with an active regulator presiding over them. The banks lost most of their money on poor judgment in property lending, which did not recognise the mass of weaknesses in the market
. The caution that will now be observed in bank lending practices will be frustrating for the credit-thirsty SME sector. By April 2010 there was a 34 per cent increase in the number of companies placed in liquidation, receivership or examinership compared with the same period the previous year.38 Are we going to experience one of the worst years for business failures on record? At this stage it would be a fair bet.
Lest we forget, the markets are very critical of institutions that have poor prospects for growth, and substantial growth at that. In addition, the banks will want to get out from under the government guarantee as soon as possible. In order for the banks to get an improvement on their credit ratings they are going to have to produce clean balance sheets, excellent profits, growth prospects in their respective markets and no surprises in their loan portfolios. This vision of the future for the banks has to be achieved within Ireland.
The growth of the two major banks, AIB and Bank of Ireland, offshore during the 1980s and 1990s was in response to their shareholders’ demands for increased growth. The banks were forced abroad due to the lack of investment opportunities in Ireland during that period. Safe havens were sought for the investment of the surplus capital of the banks that could not be invested productively at home. This expansion into the UK, the US and, later on, Poland might today be considered a blessing in disguise. The value of these offshore investments grew and, when divested, will provide a much needed capital injection into the respective banks. The sale of the offshore assets will in no way replace the massive capital shortfall created over these past two years but it will contribute to a reduction of the banks’ capital deficit. However, if the major offshore assets are sold to enable the banks to strengthen their capital ratios, some of their most profitable activities will be gone. What they may gain from the sale of the assets in terms of strengthening their structure will be offset by the loss of profits for the future, as they would be making themselves less attractive propositions for domestic or foreign investors.
