Bank Funding – The Irish Situation

30 Mar 2011

IIEA

The Central Bank of Ireland is due to announce the result of stress tests on the Irish banking system, undertaken as a condition of the EU-IMF support package for Ireland, on 31 March 2011.

The European Central Bank may also be preparing to introduce a new facility for banks under restructuring that would have important consequences.

Ahead of these crucial decisions, this infographic and accompanying post by Prof. Karl Whelan explain the currently critical funding situation of the Irish banks.

 

Zoom in to view here

Zoom in to view here

 

The Evolving Balance Sheet of the Irish Banks

Prof. Karl Whelan

Tomorrow’s stress tests announcements will be a major landmark in the Irish banking crisis, with attendant implications for the broader European debt crisis. It is clear that the Central Bank of Ireland, in consultation with a large team of international advisers, has undertaken a very detailed examination of the Irish loan books and it is to be hoped that the stress test reports will bring far greater clarity to the question of the underlying losses suffered by the Irish banks.

However, even if we could draw a line under the question of loan losses at the Irish banks, we are still a long way from having a normal and fully-functioning banking system. The infographic above helps to illustrate some of the problems facing the Irish banking system.

Traditionally, banking was a relatively simple business. Banks took in deposits from customers and then used these funds to make loans to customers. Up until 2003 the six domestic Irish banks (AIB, Bank of Ireland, Irish Life and Permanent, EBS, Anglo and Irish Nationwide) behaved according to this simple model.

After 2003, however, the banks expanded their loan books much faster than their deposit books. They did this by borrowing large amounts of money from the international bond market: the graphic shows (bottom right) that international bond borrowings reached almost €100 billion by 2007.

But since 2007 international bond markets have lost faith in the Irish banks as evidence mounted of large losses on property development loans. Bonds matured and the banks failed to source new funds on the markets to pay them off. With the Irish banks unable to recall the funds they had loaned out to firms and households, they had to turn to the European Central Bank to come up with the money to pay off bondholders.

By late 2010, international confidence in the Irish banks had reached new lows. Downgrades from ratings agencies led to large corporate depositors pulling funds from the system. So even though the banks were reducing their stock of outstanding loans by restricting credit, the 'funding gap' between loans and deposits jumped to new record levels.

Another problem was that ECB loans must be backed by high quality collateral and the banks were running out of this collateral. For this reason, since September of last year, the banks have had to turn to the Central Bank of Ireland, which has been allowed by the ECB Governing Council to make 'exceptional liquidity assistance' (ELA) loans to the Irish banks. The ECB allowed this on the condition that the Irish government guarantee that the loans be paid back. These ELA loans stood at about €70 billion at the end of February (the data used in the charts above only go up to end January 2011). They have proven controversial.

The reliance of the Irish banks on emergency central bank funding is now at critical levels. The €150 billion or so that is owed to central banks comfortably exceeds the projected value of this year’s Irish GNP. In other words, if every person in Ireland handed over their income this year to the banks, it would still not be enough to allow them to pay off the money they owe central banks.

What happens now with this funding? A best case scenario would see the post- stress test banks moving back into the bond market and using the funds borrowed there to pay off central banks. However, even if this were to happen, it seems unlikely that anything like the amount of funds required to pay off the central banks could be raised in the coming years.

The financial press are now reporting that the ECB may be willing to extend its loans to the Irish banks to a multi-year facility but that such a facility would carry a higher interest rate than the rate the banks are currently borrowing, that it may be willing to take over the Irish Central Bank’s ELA loans (thus accepting lower quality collateral than it is usually willing to), that the latter move may still be subject to some form of agreement to share any losses with the Irish state and, finally, that the banks will have to formulate 'deleveraging' plans to sell off loan books to raise funds to pay back its central bank funding. Any such moves will present their own challenges.

Exactly how these issues are resolved may have far more influence on the future of the Irish economy than other points that have received far more attention, such as the interest rate on the EU’s portion of Ireland’s EU-IMF loan package.  One can only hope that the next few weeks bring some greater clarity on these matters and that their resolution doesn’t place further stress on the Irish state.

The Central Bank of Ireland will announce the results of the stress tests at 4.30pm GMT tomorrow, Thursday 31 March. The new Taoiseach and Minister of Finance will then present their plans for dealing with the banks.

 

This content forms part of the E View project, which is part-funded by DG Communication of the European Parliament. 

 

 

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