In this article on Forbes.com, I discuss the possibility of a deal with the ECB on Ireland’s promissory notes in light of last week’s summit statement.
Category Archives: Central Banks
Presentation: Target2 and the Euro Crisis
Yesterday, I gave a presentation on “Target2 and the Euro Crisis” at the Bank of England’s Centre for Central Banking Studies. The slides from my talk are available here as a PowerPoint slideshow and here in PDF. Probably needless to say but the content of the presentations reflects only my own views and its presentation at the Bank of England does not imply their endorsement.
What Is Ireland’s Bank Debt and What Can Be Done About It?
In both the run up to the referendum and its aftermath, there have been widespread references to something called “Ireland’s bank debt” with widespread agreement among all right-thinking folk that “something should be done about it” particularly in light of ongoing discussions about the use of EU funds to recapitalise Spanish banks.
One problem with this discussion, as two recent pieces by John McHale and Seamus Coffey discuss, is that there is a lot of fuzziness in discussions of the bank debt issue with a lack of clarity about what people mean by bank debt and what they expect to be done about. Here I want to clarify the size of the Irish state’s outlays and commitments to the banking sector and consider some of the steps that could be taken to reduce the burden associated with these outlays.
Total Outlays and Commitments
The figure of €64 billion has been widely circulated as the cost of bailing out Ireland’s banks. I’m happy to be corrected but I believe the most recent estimate of the total outlays in terms of cash and promissory note commitments comes from this written answer from Michael Noonan on 18th April. The answer contains a handy table that I reproduce below and it shows the total figure at the slightly-lower €62.8 billion. Of this, €34.7 billion was supplied to the institutions that comprise the IBRC, while the other €28.1 billion was spent recapitalising and acquiring full ownership of AIB/EBS and Irish Life and Permanent and acquiring preference shares and a minority ordinary shareholding in Bank of Ireland.
IBRC was recapitalised with €30.7 billion in promissory notes and €4 billion in exchequer resources. €20.7 billion from the National Pension Reserve Fund was used to acquire preference and ordinary shares in AIB and Bank of Ireland. Additional exchequer resources were used to spend €4.7 billion on AIB and €2.7 billion on ILP.
So the total outlay and commitments to the Irish bank bailout can be broken into three components:
- €30.7 billion in promissory notes of which two installment payments have been made (or one made and one kinda-sorta-maybe made depending on your point of view) with many more to come.
- €20.7 billion from the NPRF has been invested in acquiring ownership stakes in AIB and Bank of Ireland.
- €11.4 billion of additional exchequer resources have been spent on IBRC, AIB and ILP.
It may be stating the obvious but these figures show that the €63 billion figure does not simply refer to a unique “bank debt” waiting to be defaulted on or renegotiated. The €20.7 billion from the NPRF could have been used to finance deficits instead of borrowing money from the sovereign bond markets and the troika. Similarly the €11.4 billion of cash balances used was largely obtained via borrowing. However, there are no particular sovereign bond issues or slices of the borrowings from the troika that are specifically earmarked “bank debt.” The part of the debt that is clearly and unequivocally bank debt, however, is the IBRC.
Let’s look separately at these two areas, the IBRC debt and the rest of the outlays.
AIB, Bank of Ireland and Irish Life and Permanent
The government invested a combined €25.4 billion in acquiring the shareholdings in AIB and Bank of Ireland currently held by the NPRF. The NPRF’s latest set of accounts values these holdings at €9.36 billion. Those accounts don’t break down the valuations between the two banks but these accounts from 2011:Q3 value the holdings at €9.6 billion, of which €7.1 billion is allocated to the ownership of AIB. The book value of equity in AIB at the end of 2011 was €14.6 billion. Given weak operating profits and ongoing loan loss writedowns, the NPRF valuation looks highly optimistic.
The government also own Irish Life and Permanent, which had equity with a book value of €3.5 billion at the end of 2011. Given the bank’s serious ongoing problems, I’d be surprised if it had a market value much above zero.
So the Irish government has invested €28.1 billion in bank shares that are likely worth less than €9 billion now. This calculation omits €2.0 billion received from Bank of Ireland in preference share dividends, the repurchase of warrants and the sale of ordinary shares to Wilbur Ross’s consortium. Still, you’re looking at a loss in the region of €17 billion, which is over 10 percent of GDP.
This raises the question of what could happen with these investments if ESM was to be given the power to recapitalise banks (a big if). Personally, I would be shocked if such a decision did not come with guidelines for ESM to recapitalise banks in a manner consistent with not losing money. For example, insolvent banks may have to be restored to a “zero capital” point by creditor write-downs or national government funding before ESM gets involved in recapitalizing banks.
Even if ESM was allowed get involved in directly recapitalising banks in this manner, that does not mean it will be allowed to simply acquire shares in banks that are already recapitalised. And even if it was, it is wildly optimistic to believe that the EU would sanction acquiring these shares for the €28.1 billion we spent on them rather than what they are currently worth.
All told, I think we should welcome the prospect of ESM acquiring AIB and ILP as well as our shares in Bank of Ireland. We could use the funds obtained (perhaps €9 billion if my guess above is correct) to reduce debt and perhaps implement some well-judged capital programmes. We should also welcome ESM playing a role in any future recapitalisation of these institutions as this would eliminate this source the uncertainty from considerations of the Irish public finances. But Irish citizens will almost certainly still be left with the large loss on their “investment” in these institutions.
The IBRC
Despite putting €35 billion in to recapitalise the IBRC, the institution only has equity capital of €3 billion. The €31 billion in promissory notes thus account for almost all of the loss the taxpayer is incurring due to the IBRC. As is now pretty well known (see details here) the payments on the promissory notes will be used to repay ELA loans from the Central Bank of Ireland and that these loan repayments will retire the money issued when the ELA loans were created.
Many people would like the Central Bank to simply write off these loans but the Eurosystem’s rules do not allow this. An alternative is to delay the repayment of the ELA. However, Eurosystem rules allow the ECB to block any renegotiation of the terms of the ELA loans and, despite months of negotiations, it seems pretty clear that the ECB are not in any way minded to allow a rescheduling of IBRC’s ELA repayments. If lobbying from Ireland had been likely to produce a rescheduling, then it would have occurred in late March of this year. Instead, IBRC were required to meet their scheduled ELA repayment in full and on time.
Perhaps the most realistic option for replacing the promissory notes is to use Ireland’s potential access to the European Stabilisation Mechanism (ESM) to refinance the IBRC. For example, ESM could issue thirty-year notes to financial markets and loan the funds raised to the Irish government over the same term. In turn, the Irish government could give these funds to IBRC as a replacement for the promissory note. IBRC could then pay off all of its ELA debts and be quickly wound down.
I read Seamus’s contribution as arguing against an ESM deal and John’s contribution as neutral. I’m happy to say that, in the absence of any deal with the ECB on restructuring the promissory notes, I am willing to endorse an ESM deal as an obtainable second best.
What can be said in favour or against such an approach? Against this approach is the fact that the interest rate on such a loan, likely to be around 3 percent, is higher than the effective current cost of ELA, which is the ECB main refinancing rate (1 percent at the time of writing). Another complication is that the size of such a loan from ESM would be large: €28.1 billion would be required to pay off the remaining ELA and the IBRC’s one-year loan from Bank of Ireland. The existing European debt issuance agencies such as EFSF and EFSM have not yet placed a thirty-year bond of anywhere close to this size and this may make it difficult to achieve the desired low interest rate.
Those caveats noted, the benefits to this arrangement seem to far outweigh the costs. An ESM loan locks in a low interest rate for a long period and may provide lower cost financing than the ELA arrangement once the ECB’s main refinancing rate moves upwards again. More importantly, a thirty-year ESM loan would require only an annual interest payment for 29 years followed by a payoff of the principal in year 30.
This deferral of principal payments would significantly reduce Ireland’s cash financing requirements over the next decade. It would also provide a substantial reduction in the net present value of the burden of this debt when calculated using realistic discount rates reflecting Ireland’s likely cost of funding.
For example, in this paper, I calculated that the IBRC’s ELA would be paid off by 2022 if Ireland sticks to its current schedule of paying off €3.1 billion a year in promissory notes. Using a 7 percent discount rate, this stream of planned promissory note payments plus the IBRC’s loan repayment to Bank of Ireland in 2013 have a combined net present value almost twice as large as the stream of payments associated with paying 3 percent interest on a €28.1 billion loan for 29 years and then repaying the principal in year 30. (Calculations in this spreadsheet. Since the promissory note example incorporatse €3.1 billion for repaying the IBRC’s one-year loan from Bank of Ireland next year while the ESM example has that money being borrowed from ESM).
Given the seriousness of the current problems with the public finances, one can hardly say that such a restructuring would guarantee sustainability but it would represent a significant improvement over current arrangements.
As a final thought, I’d note that each of the realistic options for lowering the burden of the bank debt, whether they involve purchases of equity stakes in live banks or refinancing the debts of dead banks, involved access to the ESM. Those who advocated voting No to facilitate a “deal on bank debt” were advocating cutting off access to ESM. I’m still in the dark as to how those who adopted this position believed Ireland was going to renegotiate a bank debt deal after voting No.
ECB and Bankia: Liquidity Solvency Confusion in the Eurotower
My earlier post about the FT’s story on ECB “rejecting” the plan to recapitalise Bankia by providing them with €19bn of sovereign bonds was critical of both the substance of any such ECB intervention, if it existed. It was also critical of the reporting of the story by the FT on the grounds that it confused solvency and liquidity issues, something I try hard to explain to my undergraduate students.
Now it appears that the confusion of solvency and liquidity isn’t confined to the FT reporters but includes ECB officials as well.
The ECB this morning tweeted a denial of sorts of the FT story:
Contrary to media reports published today, the European Central Bank (ECB) has not been consulted and has not expressed a position on plans by the Spanish authorities to recapitalise a major Spanish bank. The ECB stands ready to give advice on the development of such plans.
I say “denial of sorts” because the “blunt rejection” of the plan from the ECB reported by the FT may have occurred in an unofficial way e.g. the ECB explaining what there response to the plan would be if it they were to be officially consulted on it. This allows room for a statement that ECB hasn’t been consulted.
Then an emailed statement was sent out. Then, things get more interesting. A second email statement was sent out. Here it is. If you’re too lazy to click, here’s the full text.
Contrary to media reports published today, the European Central Bank (ECB) has not been consulted and has not expressed a position on plans by the Spanish authorities to recapitalise a major Spanish bank. The ECB stands ready to give advice on the development of such plans.
It should be noted, however, that the funds needed to ensure banks’ compliance with capital requirements, can not be provided by the Eurosystem.
Now why should this be noted? Does the ECB official who wrote this paragraph actually believe that the Spanish plan involves providing funds from the Eurosystem to meet capital requirements? If so, they need to go back to Money and Banking 101.
Bank capital is the gap between assets and liabilities.Taking on a loan increases both assets and liabilities and so has no effect on capital. The Bankia proposal only affects capital because the provision of new government bonds to the bank raises its assets without raising its liabilities. Whether it then pledges these bonds to the ECB in return for a loan affects the bank’s liquidity but has no influence on its capital\solvency ratios.
Next up, the ECB issues a statement saying this additional sentence had been “published erroneously”. Well perhaps, but it didn’t write itself.
Since it seems highly unlikely that the ECB press office makes up these statements on its own, one can only assume that the sentence was written by a senior official. Moreover, this senior official apparently believed, at some point today, that it was necessary to make a point about Bankia’s capital requirements that was based on a complete misunderstanding of how the Spanish plan affects the bank’s capital ratios.
And these are the people we’re relying on to save the world! Now I’m scared.
The ECB and Bankia
The FT is reporting (news article here, commentary here) that the ECB has “rejected” the Spanish government’s plan to recapitalise Bankia by providing them with €19bn of sovereign bonds.
In reading these stories, it is important to keep in mind Whelan Law’s of Financial Reporting: No concept is more mis-represented in financial reporting than bank capital.
I work hard to explain to my undergraduate students that bank capital is the gap between assets and liabilities and that’s it’s not a bank’s stock of cash or reserves or liquid assets. (e.g. here and here for my teaching notes and here for a video of Stanford’s Anat Admati and others discussing bank capital). By exam time, I’ve usually succeeded in pursuading about 60% of my students that this is the case. I think the other 40% go on to become financial journalists.
The FT comment story states
The floating of Madrid’s plan to recapitalise Bankia using ECB liquidity was seen by some observers as a high-stakes bet to put extra pressure on eurozone policy makers
By putting the onus on the ECB to turn Spanish government debt into cash through its repurchase, or repo, facility, Brussels and Berlin would get the message that Madrid means business.
There are several layers of nonsense here. First, banks are recapitalised by increasing the gap between their assets and their liabilities. The Spanish government bonds are the new assets that are recapitalising Bankia. It is possible that Bankia also has liquidity problems and needs to swap these government bonds with the ECB for cash. But this does not mean that the “ECB liquidity is recapitalising” the bank.
Second, the “onus\Madrid means businesses” sentence seems to ignore the fact that all Eurozone government debt is considered eligible collateral for ECB operations. The “high-stakes bet” is nothing of the sort. It simply asks the ECB to keep to its usual policies.
The news story tell us
The ECB told Madrid that a proper capital injection was needed for Bankia and its plans were in danger of breaching an EU ban on “monetary financing,” or central bank funding of governments, according to two European officials.
Again, the nonsense quotient is particularly high. First, there is nothing “improper” about the proposed Bankia capital injection. If the government gave Bankia €19 billion in cash and the bank then purchased government bonds with this case, the outcome would be the same: Is that a “proper” recap while the proposed one isn’t?
Second, it should be remembered that the ECB is already providing enormous amounts of liquidity against Eurozone government bonds as collateral, including government-backed bonds placed directly with banks such as the Irish NAMA bonds. If this isn’t “almost monetary financing” then why is lending money to Bankia?
So what is going on here? First, let’s note what is not going on. The ECB is not the Spanish bank regulator and it does not set EU’s rules for regulatory capital nor does it oversee government aid to banks (both of these are done by the European Commission job). So the ECB has no legal role that allows it to “reject” the proposed Bankia recap.
The “rejection” must instead mean that the ECB will refuse to sanction the provision of liquidity to Bankia under the proposed recapitalisation. There are two routes through which it could do this.
The first is through the ECB’s “risk-control framework” which allows it to cut off credit to individual banks or refuse to extend credit against certain collateral, if it feels it is taking too much risk. This framework was one of the tools the ECB used (and continues to use) when threatening to cut off credit to the Irish banks. Indeed, I discussed the framework here in a post written the month before the ECB shoved Ireland into an EU-IMF bailout. From the perspective of the Bankia deal, the key elements are
the Eurosystem may suspend or exclude counterparties’ access to monetary policy instruments on the grounds of prudence …
the Eurosystem may also reject assets, limit the use of assets or apply supplementary haircuts to assets submitted as collateral in Eurosystem credit operations by specific counterparties …
The Eurosystem may exclude certain assets from use in its monetary policy operations. Such exclusion may also be applied to specific counterparties, in particular if the credit quality of the counterparties appears to exhibit a high correlation with the credit quality of the collateral submitted by the counterparty.
The last point is particularly relevant to Bankia.
A second route through which the ECB could reject the provision of capital is through preventing the Banco de Espana providing it with Emergency Liquidity Assistance (lots of material on ELA here.) I don’t know whether Bankia is receiving or may need to receive ELA but this is a separate track through which the ECB Governing Council could place Bankia in severe trouble if they choose to.
So there you have it. If the story is true, then the ECB has taken it upon itself to decide how Spanish banks are to meet their regulatory capital requirements and how the Spanish government must fund these requirements. All in the name of “risk control”. It will be interesting to see how controlled these risks will be once Spain is pushed into an EU bailout. Perhaps the ECB are interested in finding out.
Another Week, Another Target 2 Article
Another week, another academic hyperventilating about the crucial importance of Target2. This week’s entry is from Michael Burda of Humboldt University. It summarises the situation with Target2 balances as follows:
Bundesbank surpluses with the ECB have swelled to well over €700 billion, or about 30% of German GDP. Germany has now become a hostage to the monetary union, since a unilateral exit would imply a new central bank with negative equity.
However, there’s no follow-up explanation for what this means. Apparently “a new central bank with negative equity” is something so unthinkable that it means that Germany has no choice but to be a “hostage” to monetary union.
My assessment, as argued in this article is that the Bundesbank losing its Target2 credit would be no more than a minor inconvenience to Germany. We now live in a world of fiat currencies. The man that accepted that euro for your cup of coffee this morning didn’t do so because he believes the central bank has “positive equity”. He did so because it’s the legal tender of the land.
The post-EMU Bundesbank (it wouldn’t be a new central bank) won’t have to worry about its equity position because it won’t have the same kind of solvency concerns that you and I have because it has the power to print money. (See this recent Bill Mitchell blog post “The ECB cannot go broke – get over it”).
Another disappointing aspect of Burda’s article is that while there is a single mention of “capital flight”, the use of language in the article predominantly links Target2 balances with the traditional trade balances associated with David Hume specie-flow theory. I’m sure Burda knows this but it is worth reminding people again that the ever-growing Bundesbank Target2 balance relates far more to capital flight from the periphery than current account balances. Here’s a graph of current account deficits as a percent of GDP, including the EU Commission’s forecasts for 2012.
And here’s a nice graph from an FT blog post by Gavyn Davies from a few weeks ago. Note that current account imbalances are getting smaller while the Target2 balances are getting bigger. Capital flight, not trade imbalances, is what’s driving the Target2 balances.
Vox-EU Article on Target2 & Some Thoughts on Central Bank Balance Sheets
I have written a new article on Target2 for Vox-EU titled “TARGET2: Not why Germans should fear a euro breakup.”
It is interesting to see how the debate about Target2 has changed over time. This is the third article I’ve written for Vox on this subject. The first two (here and here) largely dealt with serious inaccuracies that were being aired prominently, such as claims that the Target2 system was crowding out credit in Germany or that the Budesbank was being forced to sell securities to fund loans to the periphery. While new false claims about Target2 have since emerged (e.g. CESIfo’s claim that German commercial banks are having to alter the asset side of their balance sheet because of Target2) these particular stories appear to have been put to rest.
More recently, as the Euro crisis has escalated, the focus of discussions on Target2 has switched to the question of what would happen to the balances if there was a complete Euro breakup and those central banks with Target2 liabilities refused to honour their debts. This is a legitimate question and it is the one I address in today’s article.
My conclusion is that there will be no need to fiscally recapitalise the Bundesbank should its Target2 credit turn out to be worthless because the new-DM will, like the Euro, be a fiat currency and such currencies do not obtain their value from being backed one-for-one by hard assets held by the issuing central bank.
This conclusion will, I’m fairly sure, attract a lot of criticism, particular from the Northern European parts of the internets. However, I think much of the scare-mongering about Target2 reflects a general confusion about the nature of central bank balance sheets within a fiat currency system.
Consider, for instance, the constant stream of business press reports featuring various commentators worrying about the balance sheet of the ECB. As I’ve noted before, much of the commentary on the potential credit losses focuses on the wrong figures by discussing the ECB’s capital when, in fact, loss-sharing on monetary policy operations is shared across the full Eurosystem, which has nearly half a trillion euros in capital and revaluation reserves to absorb losses.
Even when these articles focus on the right figures, they usually greatly exaggerate the potential problems associated with the ECB’s potential “solvency.” Articles like this one, for instance, seem to be premised on the idea that the value of the euro as a currency depends on the Eurosystem having assets that “back” the currency: One euro more in assets than liabilities and the Eurosystem is fine, one euro less and disaster supposedly awaits.
The truth is that the euro is a fiat currency and its value as a medium of exchange does not stem from the public’s faith in the value of the assets held by the central bank. Commentary that hypothesises existential problems for the euro stemming from perceived issues with the Eurosystem’s balance sheet are simply based on false analogies between private sector and central bank balance sheets.
I’d like to be able to point to lots of other useful work on this topic but, unfortuantely, these issues are rarely discussed in mainstream economics textbooks or journals. Here though is a nice recent presentation by Columbia’s Ricardo Reis that touches on some important points in relation to central bank balance sheets. Hopefully Ricardo will produce a full paper on this soon.
Monetary Dialogue Briefing Papers: April 2012
I’m off to Brussels in the morning to present my latest briefing paper to the Economic and Monetary Affairs committee of the European Parliament. You can see the full list of briefing papers here. There are four papers (including one by me) on macroeconomic imbalances and four on non-standard monetary policy measures. I’m afraid the plastering of the word DRAFT on the pages of each of the papers is a recent piece of technological regress but I always find these papers really interesting.
No Mr. Noonan, NAMA Does Not Borrow From the ECB
One of the great myths about the Irish economy that has circulated in recent years is the idea that the National Asset Management Agency (NAMA) has borrowed money from the European Central Bank. I tried on various occasions in the past to observe that this is not the case without having any impact. However, I had hoped that the people running Ireland understood how NAMA works. Apparently this was too much to hope for.
Here‘s Minister for Finance, Michael Noonan, in the Dail yesterday (H/T NAMA Wine Lake):
The money which we accessed for bridging finance from NAMA was money which is due to be repaid to the ECB for the loans it gave to NAMA to acquire the impaired assets in the bank. Again, it is ECB money that is providing the bridge. What will happen is that when the circle is completed and the shareholders give their consent, which is my expectation, the NAMA funds will be restored and NAMA will do what it intended to do last month, namely, it will repay another portion of what it owes to the ECB.
Just for the record (and I know now for sure I’m wasting my time) NAMA has issued bonds to the Irish banks in return for property assets. It can redeem those bonds as it acquires cash for the property assets. The bonds can be used by these banks as ECB-eligible collateral. However, NAMA is not a bank. NAMA is not ECB-eligible counterparty. NAMA has never borrowed, and will never borrow, from the ECB.
CESIfo Embarrasses Itself Again
CESIfo Group, the research Institute of which Hans-Werner Sinn is president, has developed a fondness for issuing anonymous press releases that claim to “explain” Target2 balances to the general public. Today, their new press release claims:
Target credit levels in the Eurosystem are rising ever more steeply … Who are the losers from this process? The savers in those remaining European countries that still have sound economies. Without their knowledge or consent, the marketable securities owned by their savings banks, commercial banks and life insurance companies that usually cover their savings have been transformed into mere claims against their central banks, which in turn have acquired claims against the ECB system and indirectly against the central banks of Spain and Italy.
Let’s leave aside for a minute the fact that those coloured pieces of paper in your wallet are “mere claims against central banks”. The idea that the assets of savings banks, commercial banks and life insurance companies have been altered by changes in Target2 balances is utterly false.
Target2 balances can only be accumulated (whether as a credit or a debit) by Eurosystem central banks. Take a look at any annual report of a German savings bank, commercial bank or life insurance company. You will not find that their marketable securities have been replaced by Target2 credits because this never happened and can never happen.
The anonymous person who wrote this press release has no clue what Target2 is or how it works. Its appearance should be a cause of great embarrassment to the CESIfo group and they should issue an apology and a retraction.
Anyone who has had the misfortune to read this press release and is now confused about what Target2 balances are should consult this short guide to the subject written by two Bundesbank economists and published (but then ignored) by CESIfo. Two other articles by me rebutting various CESIfo-inspired arguments can be found here and here.