Banks could prove too costly for the state in 2010

Capital, liquidity and rising bad debts will pose serious this obstacles to Irish banking this year, writes Bill Hobbs

2010 could well be the year when Irish banks may finally prove too costly to save by the State using its own resources.

NAMA, which has yet to establish the true underlying value of builder and developer loans, continues to worry many observers. Some maintain Government has reached the limit of its ability to rescue banking on its own. They point to the emergence of a second wave of bad debts that could, despite NAMA, swamp bank balance sheets.

For now Government is maintaining NAMA will get credit flowing again. Indeed politicians may claim what little lending is done by Irish banks in 2010 will have resulted from the NAMA intervention. But this is not necessarily the case. Banks will prudently lend what little they can as they continue to struggle to survive. Capital, liquidity and rising bad debts remain quite serious issues challenging the entire domestic banking system in 2010. NAMA may well solve for the worst of property loan assets but bank funding and capital adequacy remains extremely problematic.

Nearly 16 months after the fateful night of the 29th September 2008, when the state guaranteed its banking system, banking stability has only been partly assured. The banking system is only surviving due to this unprecedented state guarantee and subsequent infusion of ECB funds. Both these extraordinary supports cannot continue indefinitely. In particular ECB forbearance in funding Irish banks will come to an end this year.

Undercapitalised, over lent and overly reliant on wholesale market funding, banks have yet to realise the full cost of the imploding credit bubble. In adjusting their highly leveraged business model, banking credit might well decline to late 90’s levels as banks reduce their reliance on wholesale funding and shrink their balance sheets. The key is whether or not remaining credit creation capacity will be enough to fund domestic consumer and business borrowing needs. If banking is unable to operate efficiently then credit starvation will seriously inhibit economic growth.

But bankers will not find it easy to convert loans to cash to pay off those that have lent them money. €110bn remains owing in family home and investment property mortgages – much of which was borrowed between 2003 and 2008 at peak property prices. And the bad news for banks and Government is that mortgage defaults are escalating – both home and investment property loans.

Socialising the mortgage trap of a generation of Irish borrowers is a serious challenge to the Irish state. With worsening household financial vulnerability due to declining real incomes and increasing joblessness, mortgage default rates will continue to rise in 2010. And selling off repossessed property, the text book banking response, is not available for economic and social reasons. Allied to this is the problem of unsecured consumer debt and small business loans also showing rising default levels.

Meanwhile NAMA’s due diligence on builder and developer loans may establish a far lower base line forcing Government to effectively nationalise the two main banks. But what happens when defaults on other loans emerge? Can banks weather another round of debt write downs? Many believe that, even after the state injects capital post-NAMA, the main banks may well require further injections of tax payer’s funds.

What form of banking will evolve? In the first instance banks will revert to a traditional model of funding their lending largely from retail deposits. The era of cheap abundant short term availability of wholesale funding is over. Banks will not be permitted to leverage up on funding and will be required to build larger capital buffers. Reducing leverage and building higher capital reserves will force them to shrink their balance sheets dramatically. Secondly they will adopt traditional prudent lending criteria to exorcise behaviours developed through their over-optimistic engagement in property lending.

It’s almost certain that banks will develop an aversion to property lending lasting well into the foreseeable future. Such risk adverse behaviour, some say, could result in property prices eventually stabilising at about 40% of peak prices. While apparently a worse case scenario it is based on the compelling logic that Irish banks and borrowers will fundamentally change their behaviours in both creating and using bank credit and will never again speculate optimistically in investing in bricks and mortar.

The banking crisis starkly illustrates the risks inherent in a small regional banking marketplace. And there is little evidence that national or foreign control matters as both types of banking has suffered. Market share remains significantly concentrated within locally controlled banks. Bank of Ireland and AIB have dominated Irish banking for decades even allowing for the incursion of foreign banks in the recent past. If, as it is likely, the domestic banking system will enter a period of near total state ownership then how it will be controlled and reconfigured needs to be addressed.

Apart from the dominant Irish joint stock bank or shareholder model other forms of banking exist that are worthy of consideration. The inherent financial stability of co-operative banking has proven resilient during the global credit crisis due to its prudent levels of capital and longer term orientation. Many consider co-operative banking systems to be resurgent as regulators begin to truly understand how their unique organisational form helped to underpin financial stability and keep credit flowing elsewhere when commercial banking had all but collapsed.

How will the State govern and restructure a banking sector it almost wholly owns? A national banking commission charged with the oversight of state controlled banking system may be required to remove risks of undue political and sectoral interference in commercial banking. It should be possible to design a system in which individual banks operate within defined public interest parameters and compete with each other in the marketplace. It might also address what ownership form of banking is required by this State into the future. It may be possible to allow for both co-operative banking and joint stock banking forms which may go some way to ensuring local control of consumer and small business banking needs into the future.

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