Taxpayer to suffer as cost of bank credit rises

As the banking sector shrinks through mergers and acquisitions in the years ahead, the Government must ensure sufficiently strong controls of financial institutions to prevent excessive profit-taking at the expense of customers, writes Bill Hobbs

The socialisation of bank debt is an inevitable consequence of a credit crisis. Tax payers always pay up as there is no one else who can. The citizen’s burden will be crystallised in the difference between what the banks should be paid for their loans what they will be paid and the return eventually achieved by NAMA in the years to come as it unwinds from one of the largest property portfolios ever assembled. Meanwhile the cost of bank credit is set to rise and may require state intervention to inhibit banker’s excessive profit taking behaviour.

In previous documented credit crisis the cost of bank credit has risen and remained stubbornly high long after the crisis itself has abated. Ireland’s experience could well be acute as it has experienced one of the most dramatic credit crunch led economic reversals ever.

Yet to be defined are two important issues; public policy in relation to land and property and policy in relation to the structuration of the Irish banking system. The first requires informed debate as NAMA has the capacity to influence the property market for years to come and contains an inherent conflict. Maximising tax payer’s return from its asset portfolio could cause another bout of property speculation. The second must deal with designing and crafting a new banking system to ensure it can generate the credit required to fund economic recovery.

For now banks are exclusively focussed on rebuilding their shattered balance sheets. They will be forced to increase the price of credit and services to generate the profits required to pay for loan losses and build the higher levels of capital now required. For example mortgage holders with PermanentTSB will now pay more for credit and cannot switch to a cheaper provider. It’s only a beginning as others will follow suit and raise the cost of both loans and services. The era of low margin credit and cheap services is over as banks adjust both their cost and income profile. Banks will also focus on cutting costs as they dramatically reduce operating capacity build up during the boom years. Many bank employees are set to join Ireland’s growing jobless population as their employers roll out their cost control programmes.

Meanwhile consumer and business choice – competition- has evaporated as customers become captive of their existing banking relationship. Such disempowerment of competition could be amplified as banking power will become more concentrated through what is another inevitable consequence of the crisis – banking consolidation.

The problem for consumers and the majority of Irish businesses is they have no access to credit other than through Irish banks. Irish businesses, which in the absence of deep and wide market for capital, are entirely reliant on bank credit to fund their business capital requirements. Ireland has not developed alternative sources of capital for its indigenous small to medium sized business enterprises. Thus both citizens and businesses are captive of their banks travails and cannot switch to alternative providers.

While NAMA will hope to address land and property development debt the second round of bad debts to hit the banking system has yet to be revealed. Banker’s imprudent lending behaviour that fuelled the property bubble was equally applied to their business and consumer lending. Both consumer and business debt default rates are rising and banks have not as yet divulged the likely scale of losses they will have to contend with. Ominously and inevitably domestic credit growth has stagnated and the back wash of bad debts will now swamp banks balance sheets.

Yet to emerge from the banking crisis is a blueprint for a new Irish banking system. The price paid by NAMA could trigger the nationalisation of AIB unless international investors are convinced the bank proposes a viable investment proposition. Bank of Ireland is similarly but less acutely exposed to a similar fate. But what of the second tier banks, PermanentTSB, EBS, INBS and the state bank Anglo Irish? All four are considered to have no future as independent banks. Ireland’s clutch of once competitive, foreign owned banks have been placed into a state of cryonic suspension as their owners focus on their own national marketplaces.

The probability, given the worsening deflationary environment, is that international investors will shy away from investing in Irish banks for some time to come and it will be left to Government to both drive and finance the establishment of a viable banking system capable of funding domestic credit need.

NAMA legislation will empower the Finance Minister to enforce consolidation of Irish banks of systemic importance to the economy. The future could see two dominant banking groups AIB and Bank of Ireland, together with what some call a “super-mutual” consolidated combination of PermanentTSB, EBS and INBS. But any super-mutual would be far too small a bank to balance the combined market power of the big two. Another scenario could see PermanentTSB bolted onto to one bank with a combined EBS/INBS bolted on to the other.

The outcome will probably result in the creation of an oligopolistic banking system with two banks dominating the marketplace. Competition considerations may be overridden in the national interest to both stabilise and craft a banking system that works. In which case there is a distinct danger of adverse profit taking behaviour as revitalised banks flex their power. In the absence of competition they will have an unfettered temptation to ratchet up margins.

Robust and effective oversight mechanisms should be in place to ensure that banks do not engage in excessive profit taking behaviour. Keeping a close on how banks are costing and pricing credit will be important. While direct price controls are notoriously difficult to implement, the state and its citizens must be assured that banks are behaving correctly. Arguably it’s in the public interest that Irish banks unfettered dominance in the provision of credit is checked by powerful and effective oversight and controls where required.