This article follows on from Why Ireland’s 2008 Blanket Bank Guarantee Decision Was Taken: Part 1.
It is five years since the Irish government announced on the 30th of September 2008 that Ireland was going to provide an unlimited bank guarantee to six covered financial institutions. It’s important to remind ourselves of the context of that event. On the 15th of September 2008 Lehman Brothers collapsed and the subsequent credit crunch ensured that the international banking system was soon struggling to obtain interbank credit. Soon significant problems at European banks came to a head. Towards the end of September France, the Netherlands and Belgium injected €11.2bn into Fortis, Belgium’s biggest bank and then, a couple of days later on the fateful 29th of Sept, the Netherlands was forced to take over Fortis’ Netherland operation at a cost of €16.8bn. By the 6th of October the German government had authorised a €50 billion rescue package in its second, and this time ‘successful’ attempt to rescue Hypo Real Estate Holdings. The first attempt was a week previously, again on the 29th of September.
The problems for Irish banks trying to access liquidity in the interbank market were not unique, but Ireland’s solution to resolve it differed considerably to that of every other country in the EU. In the weeks prior to the full guarantee the Irish government had already taken the decision to guarantee deposits up to €100,000. Up to that point deposit guarantees in the majority of European countries was just €20,000 with only Italy providing a deposit guarantee of 100,000. As a result of the Irish extension 97% of all customer deposits in the Irish banking system were fully guaranteed (Carswell, IT Oct 2008, see image below). Yet this wasn’t enough to stem the banking crisis and the loss of liquidity. At this time Anglo Irish Bank that was losing significant deposits of between €50 million and €200 million each, amounting to losses of €1 billion a day, causing Anglo to breach its regulatory liquidity ratio. Most of these deposits were borrowed from the short term money markets.
As a result of the credit crunch liquidity was an issue for AIB and Bank of Ireland too but Anglo was in full melt down, as it was unable to roll-over its foreign borrowings and had effectively run out of collateral to refinance at the ECB.
By Friday the 26th of September Anglo formally requested a loan from the Central Bank of Ireland for €1.7 billion to keep it going until the end of the month and on the same day Irish Life Permanent gave it €3.45 billion in cash deposits to cover it for the following four days. Over the weekend of the 27th and 28th, however, it became clear that Anglo was no longer in a position to make repayments and in the early morning of September the 30th a decision was made to provide an unlimited guarantee covering old and new debt.
The purpose of the guarantee was in the circumstance of the crisis simply to allow the banks to raise ‘hard-to-get short-term funding’ and to get it at an affordable, that is a ‘cheap’ rate.
But Irish banks had got themselves into a situation where they had been exposed to this potential liquidity pitfall for some time, a problem compounded by the fact that they obtained a considerable portion of their short term funding from a variety of often complex and exotic sources. As Simon Carswell mentions, this included inter-bank deposits, covered bonds and dated subordinated debt. A 2007 IMF working paper on the venerability of Irish banks to contagion within the financial markets points out that the three Irish banks, which make up the vast majority of the domestic retail banking market, had one of the highest loan-to-deposit ratios for industrialised countries. When the ratio, expressed as a percentage, is too high it’s an indication that the bank might not have enough liquidity to cover any unforeseen fund requirements. The high ratio is also an indication of what exactly the banks were up to.
“…increased reliance on wholesale funding in recent years, including interbank borrowing and capital market issues, is another potential source of international interdependencies. The average loan-to-deposit ratio for Ireland exceeds 150 percent, one of the highest for industrial countries. All of the major Irish banks are dependent for funds on the interbank and securities markets—AIB and BoI fund about 40 percent of lending in the market, while the market funding requirement for the Anglo IB is at about 35 percent. The overwhelming bulk of both nonresident interbank borrowing (83 percent) and debt securities issued and held by nonresidents (83 percent) in 2004 were vis-à-vis non-Euro area residents.”
The paper also points out that Irish banks were able to issue covered bonds, which as Carswell’s article points out, were also covered by the guarantee:
“Irish banks are also able to issue covered bonds—BoI has transferred the bulk of its domestic residential mortgage assets to a designated mortgage credit institution, which has a banking license to issue mortgage covered securities—these are used both for hedging interest risk and for generating additional funding. Almost 60 percent of these securities were held by other Euro Area members, while 25 percent was held in USD by other countries.”
Answering a question in the Dail on the inclusion of dated subordinated debt in the guarantee Brian Lenihan said:
“Given the highly volatile state of international financial markets in September/October 2008, it was essential that the commitment provided by the Irish Government to stand behind our banking system was entirely credible, clear and consistent. In those circumstances, there were significant risks in an approach which sought to discriminate between different types of bank liabilities. Such an approach could have resulted in the financial markets concluding that the guarantee was not acceptable or indeed credible.”
Because of the way Irish banks were structured a credible, clear and consistent guarantee provided to obtain short term funding at a time of crisis was only ‘acceptable or indeed credible’ if it agreed to guarantee the Shadow Banking System. The banks knew this. Whether or not government knew it is beside the point. What is more important is that they were willing to accept the banks view that it was absolutely necessary.
Those who provide this short term funding are sophisticated investors. They are not old folk putting their life savings on deposit. Rather those who provided deposits in Irish banks are also banks, hedge funds and insurers who are not only are aware of the risks, but actively hedge those risks and sell them on as insurance against potential losses. Patrick Honohan in his report on the banking crisis points out that covered bonds and ‘dated subordinated debt’ are part of the banks ‘capital’ and as such are there to provide a cushion against losses. This is the capital that is first called upon to deal with bank losses. Guaranteeing it makes no sense in banking terms:
“The scope of the Irish guarantee was exceptionally broad. Not only did it cover all deposits, including corporate and even interbank deposits, as well as certain asset backed bonds (covered bonds) and senior debt it also included, as noted already, certain subordinated debt. The inclusion of existing long-term bonds and some subordinated debt (which, as part of the capital structure of a bank is intended to act as a buffer against losses) was not necessary in order to protect the immediate liquidity position. These investments were in effect locked-in. Their inclusion complicated eventual loss allocation and resolution options. Arguments voiced in favour of this decision, namely, that many holders of these instruments were also holders of Irish bonds and that a guarantee in respect of them would help banks raise new bonds are open to question: after all, extending a Government guarantee to non-Government bonds has the effect of stressing the sovereign to the disadvantage of existing holders of Government bonds; besides, new bonds could have been guaranteed separately. The argument for simplicity also is weakened significantly by the fact that an actual dividing line between covered and non-covered liabilities was drawn at as least an equally arbitrary point; moreover, such instruments were held only by sophisticated investors.”
In an earlier report on the banking crisis (ERSI 2009) Honohan writes:
“No public indication has been given that the authorities gave serious consideration to less systemically scene-shifting – and less costly – solutions.
For example, they might have provided specific state guarantees for new borrowings or injections of preference or ordinary shares – approaches that were widely adopted across Europe and the US in the following weeks.”
Indeed they might have, but they didn’t. And we are still trying to figure out why.
Read Part 3 here.
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