The Irish Banks After NAMA Professor Karl Whelan University College Dublin

Problems Still Faced by the Irish Banks The government argues that the NAMA loan transfers will fix our banks and get credit flowing. There are good reasons to believe that this is not the case: 1.The banks remain undercapitalised and this tends to restrict lending. 2.High default risks are likely to restrict lending. 3.The banks have not developed a sustainable new funding model.

Banks and Equity Capital Banks have assets and liabilities. Liabilities: Deposits from customers, Debt securities (bonds they have issued), Short-term borrowings (e.g. from the ECB.) Assets: Loans made to customers, Cash and reserve, Other assets (stocks, bonds, property) Equity capital is Assets minus Liabilities: Banks are to maintain assets far enough above liabilities so those who supply funds to banks can be assured that their money is safe.

Capital Levels After NAMA The G20 has agreed that banks will need to have higher levels of equity capital in the future. Core (common shareholder owned) equity capital will need to be at least 8% of a risk-weighted measure of their assets. JP Morgan believe that, after NAMA, AIB will have a core equity capital ratio of 3.5% and that BOI will have a ratio of 3.9%. If the €7 billion in government preference shares are converted to common equity (meaning we lose out on the eight percent dividend owed on these shares) then these ratios would be 6.2% (AIB) and 7.3% (BOI)---still below what will be required.

More Losses to Come So the banks are starting from a point where they are viewed by markets as not having enough capital. And there are more losses to come: The severity of this recession will trigger big losses on mortgages, business loans, credit cards etc. The bottom line is that our major banks are seriously undercapitalised relative to the size of their balance sheets.

Recapitalisation or Shrinking Credit? Banks that are undercapitalised (low capital relative to its risk-weighted assets) can address this via: – Outside investment in return for an ownership share. – Reducing the bank’s assets by restricting credit. Bank CEO’s generally are reluctant to dilute ownership (Eugene Sheehy would rather have died...) and private investors don’t seem too interested in the Irish banks. The government could recapitalise but they want to restrict their ownership share as much as possible. This combination of banking and political concerns points towards shrinking credit as playing a key role.

High Default Risks Also a Problem Beyond the problem of low capital ratios, it is not realistic to expect large increases in lending to households and SMEs. Property loans are being removed from the banks and replaced with NAMA bonds. But to expect with default rates high because of the extreme recession, this is unlikely to translate into significant increases in loans to SMEs or households : Banks generally tighten credit during recessions for this reason (and this isn’t a typical recession.) And with a less competitive banking market, interest margins for loans that are made will be a good bit higher than before.

A Broken Business Model Irish banks traditionally obtained their funds from local deposits. During the construction boom, they financed most of the expanded lending via borrowing from international wholesale markets. This source of funding has largely dried up. It has mainly been replaced by borrowing from the ECB, which is currently letting banks borrow unlimited amounts once they have eligible collateral. NAMA bonds count as eligible collateral, so the banks will now be able to increase this dependence on the ECB. But the ECB’s unlimited lending policy is likely to come to an end over the next year or so. What then?

NAMA May Not Generate Much Lending People expect the banks to make loans to SMEs and households using the funds NAMA is giving them in exchange for property loans. There are three reasons why this may not happen: – The need to shrink balance sheets because of undercapitalisation. – The riskiness of lending to failing businesses and struggling households. – Can’t tie up money in long-term loans if ECB needs to repaid over the next year or so.

Should We Force Them to Lend? This is an obvious reaction to the conclusions just reached---let’s just force them to lend to businesses. Some problems with this: – New rounds of bad loans (from forced lending) will only worsen the problem of undercapitalisation. – Doesn’t solve the problem of finding a funding source to replace ECB. A better approach will be to take steps to fully recapitalise the Irish banking system, with state money if necessary. Even if the bankers don’t want this because it dilutes current ownership.