Resolving Europe’s Banking Crisis

I’m giving a presentation tomorrow afternoon at the annual Dublin Economics Workshop conference in Limerick. (For those of you who don’t know these things, the Dublin Economics Workshop’s annual conference has always been held outside of Dublin ….)

The presentation is titled “Resolving Europe’s Banking Crisis” and provides facts and figures on Europe’s credit crunch, explanations for the sources of this problem and scenarios for the upcoming European banking stress tests.

Ireland’s Blanket Guarantee Supporters: Still Wrong After All These Years

Five years ago, Ireland’s government guaranteed almost all of the debts of six privately-owned banks.  The subsequent bailout of these banks has cost the Irish public over €60 billion with about half of this due to the now-notorious Anglo Irish Bank.

The Cause Of all Our Problems - Anglo Irish Bank

(Photo credit: infomatique)

One might have hoped that those who took the guarantee decision would now express regret. However, politicians from Fianna Fail and the Green Party, the parties then in government, still defend the decision. In continuing this defense, these politicians will undoubtedly now cite the recent article in the Irish Times by former IMF economist Donal Donovan, which claims that the guarantee was the “least worst” (in other words “best”) option available to the government.

Economics can be a tricky business and sometimes the true merits of policies run counter to peoples’ gut feelings. However, if you had thought that a decision to guarantee almost every euro owed by the Irish banks was a reckless one that maximised the subsequent cost to the public, it turns out you’re absolutely right and in this case the contrarian economist is wrong. Donovan’s arguments in favour of the particular guarantee offered by the Irish government ignore widely-understood best practice in crisis management and are based on a flawed understanding of legal issues.

Ireland’s banks were in crisis in September 2008 and there were strong arguments for some form of government intervention to preserve financial stability. Indeed, in the months after the collapse of Lehman Brothers, most European governments offered guarantees of various forms to their banks.

However, with the exception of Denmark, these governments offered guarantees that were far more limited in form than the Irish one.  Specifically, schemes were put in place in the UK, Germany, France, Italy and elsewhere that guaranteed only new bond issues. (See this ECB report for a detailed description). This approach dealt with the problem at hand (banks having difficulties in getting funding) without making the public responsible for the full stock of debt that had been accumulated by their banks.

Most likely, other European governments were aware of the dangers of blanket guarantees. Research from the World Bank and the IMF had repeatedly demonstrated that guarantees of this type resulted in a substantial increase in the costs of banking crises.

While the “new debt only” approach to guarantees was adopted throughout the rest of Europe, it is dismissed out of hand by Donal Donovan who argues that the need to provide guarantees for new funding when existing debt subsequently fell due would have led to the government guaranteeing the same amount of money.   This ignores the reality that the Irish banks had plenty of “locked-in” long-term funding that could not have be pulled at short notice.  For example, as of September 2008, Anglo had €38 billion in liabilities with a maturity over three months (see its annual report).

Even after passing the guarantee, the Irish government knew within three months that Anglo was a rogue institution. So a “new funding only” guarantee would have allowed the government to apply well-understood resolution tools for closing Anglo. Retail deposits (which accounted for less than twenty percent of Anglo’s liabilities) could have been moved on to a new institution and the remaining “bad bank” could have been put into liquidation with unguaranteed creditors taking losses on their investments.

Those who argue that such a resolution would not have been possible should remember that both events have now occurred. Anglo’s deposits were moved to AIB in 2011 and the rest of the bank was put into liquidation this year.  Unfortunately, these actions were taken long after public money had been used to fill almost all the hole in Anglo’s balance sheet. I don’t wish to argue that an earlier application of these resolution tools would have been costless for the Irish public but they would have substantially reduced the burden on the public while maintaining financial stability.

Donovan’s article repeats an argument often rolled out by the last government to defend the form of the guarantee, which is that Irish law would not have allowed for a selective guarantee that covered some liabilities but not senior bonds.

This argument is based on a flawed understanding of debt contracts and the legal basis for guarantees. Contractual clauses for senior bonds that state that they rank equally with other liabilities are only operable in a liquidation. Independent of the outcome of any liquidation, governments are free to provide additional insurance to whichever creditors they choose. If Donovan’s argument was correct, then deposit insurance would be illegal because governments could not single out this class of creditors for special protection. In reality, no such prohibition exists.

The fact that the ECB used their influence in 2010 to convince the Irish government to continue repaying unguaranteed debt is cited by Donovan as a further argument that the blanket guarantee was unavoidable. However, these discussions took place after the Irish government had taken on all of Anglo’s debts which over time became debts to the ECB.  This gave the ECB enormous power over the Irish government in 2010. A limited guarantee in 2008 followed by a quick resolution and liquidation of Anglo would have kept the Irish government out of this precarious situation in the first place.

The final excuse offered for the blanket guarantee – that the government believed the banks had a liquidity problem but not a solvency problem – also lacks merit.

A liquidity problem did not require the guaranteeing of locked-in debts and, in any case, the evidence that the banks were heading towards a serious solvency problem was all around us by September 2008.  Brian Lenihan had already admitted the construction sector had come to a shuddering halt and warnings from economists and journalists such as Morgan Kelly, Alan Ahearne and Richard Curran should have given pause for thought before placing the debts of the banks on the public’s shoulders.

People are perhaps understandably tired at this point of again debating the merits of what happened five years ago. However, the additional debt piled on the public by the guarantee will make a big difference to ordinary Irish people’s lives in the coming years, forcing more fiscal adjustment than would be necessary if there was a lower level of debt.   And Ireland’s issues with problem banks are not necessarily a thing of the past.  A country that won’t learn from its mistakes will be condemned to make them again.

Fianna Fail may well be back in government in Ireland in a couple of years and their continued defence of the blanket guarantee policy increases the chances that such a guarantee could be put in place again.  Donal Donovan’s arguments, however well-meant they may be, do not provide reasonable justification for an approach to banking problems that is unsound, unfair and unnecessarily expensive for the public.