In coordinated statements made on 30 March by the National Asset Management Agency (NAMA), the Irish Financial Regulator and the Finance Minister, the Irish authorities set in motion their plan to clean up their banking sector once and for all. The plan consists of three parts: NAMA, Ireland’s bad bank, will buy €81bn of bad loans from five of Ireland’s most troubled institutions, freeing up their balance sheets; the banks will be recapitalised as dictated by the Regulator, which has set new capital targets and performed stress tests on the institutions in question to ensure that, in theory, the banks will need no further bail-out; and the Eligible Liabilities Guarantee (ELG) will be extended.

Let us begin with NAMA. It has set out the terms on which it will buy the first €16bn tranche of bad loans (see table below), which revealed the shocking nature of these banks’ lending decisions. Instead of an average discount of around 30%, which had been the previous guidance (see previous blog), the average discount came in at 47%. Of course, it is to be hoped that this first batch represents the worst loans on each bank’s books and that the discount on subsequent transfers will be significantly lower. This will become clear over the course of the next year; the transfer of the full €81bn of bad loans will be completed no later than end-February 2011. But such bad news delivered out of the blue is far from encouraging – while CDS spreads have not yet reacted significantly, investors will be watching developments closely.

Details of first batch of loans acquired  by NAMA

Source: NAMA

The most immediate effect of the higher haircuts has been an increase in each affected institution’s capital shortfall, which is now greater than previously foreseen. The Financial Regulator has conducted stress tests on the five affected lenders based on new rules, which stipulate that all institutions must have a minimum core Tier 1 capital ratio of 8%, of which 7% must be equity. Furthermore, no bank’s core ratio may fall below 4% in a severely stressed scenario. The results of the tests are set out below:

• AIB must raise €7.4bn of equity to meet the 7% target (as well as €4.9bn less any equity capital generated – excluding the conversion of government prefs to meet the base case target of 8% core Tier 1);

• Bank of Ireland must raise €2.7bn of equity (of which €0.25bn must be new core Tier 1);

• EBS must raise €875mn of core Tier 1 to meet the 8% requirement (as well as €120mn of contingent capital to meet the 4% stressed target);

• Anglo Irish Bank, which was nationalised in 2009, needs €8.3bn immediately and may require another €10bn to cover future losses;

• Irish Nationwide has a capital shortfall of €2.6bn.

The two largest banks, AIB and Bank of Ireland, have thirty days to lay out plans to raise sufficient capital by the end of the year. The government is willing to convert some or all of its pref holdings in each bank into common equity if necessary. It seems confident that Bank of Ireland will be able to plug its capital hole at no extra cost to the taxpayer. With AIB, the situation is much more uncertain. It has UK, Polish and US interests it can sell, but it is not clear what price these assets would fetch. It seems likely that the government will have to provide the bank with further funds, and it is perfectly possible that it will end up with a majority stake (several commentators expect AIB to be 70% state-owned by the end of the year). Turning to the others, the government has effectively nationalised the two building societies by buying €100mn of Special Investment Shares in each, giving it “full economic ownership”. EBS, like AIB and Bank of Ireland, will attempt to cast around for private capital before accepting government money if necessary. But Irish Nationwide and Anglo Irish’s combined €10.9bn capital shortfall will be filled in by the government immediately by means of a promissory note, which allows the banks to book the capital gain straight away while giving the cash-strapped government ten to fifteen years to hand over the funds. And it is likely that the government will have to plough further capital into the banking sector as sufficient private funds are unlikely to emerge. If this happens, promissory notes will again be the method of payment.

As well as offering capital support, the government is proposing to extend the ELG beyond September 2010 to allow the banks to rebalance their funding profiles. As the original blanket guarantee offered on all bank liabilities in the wake of Lehman Brothers’ collapse expires on 29 September, banks were forced to seek ever shorter-term funding. The ELG was designed to offer them access to longer-term funding by guaranteeing individual securities out to five years, as was done elsewhere in Europe. Its extension would be a sound move. Bank of Ireland’s latest results show that only 32% of its wholesale funding had a maturity greater than one year, leaving it with €41bn to refinance within the next twelve months. It is not unreasonable to suppose that other institutions find themselves in similar positions. Rebalancing their liability structure must be a priority, particularly as the new Basel III rules due by end-2010 are expected to stipulate greater liquidity on both sides of the balance sheet. It will take time to do this. Extending the ELG is therefore eminently sensible.

All this, of course, ties the fortunes of the Irish banking sector even more closely to those of the sovereign. Despite the high cost of bailing out its banking sector, and the massive damage the deep recession has wreaked on the Irish public finances, investors have so far given the Irish government the benefit of the doubt. In part, this reflects the government’s early adoption of painful fiscal measures – including tax rises, wage cuts and pension changes – to get its borrowing under control. But while these measures have helped limit the extent of the fiscal deterioration, the fiscal deficit is still expected to be more than 11% of GDP this year, broadly unchanged from 2009. Furthermore, this latest wave of bank recapitalisations could also push gross government debt up towards 100% of GDP – a dramatic turnaround from the 25% level of just three years ago.

The Irish deficit is only expected to begin falling significantly from 2012. And the planned reduction relies, as many others in the euro area do, on a marked rebound in GDP growth. The Irish government thinks that, after shrinking a further 1.3% this year, GDP will grow by 3.3% in 2011, and then by more than 4% in each of the following three years – so that, by 2014, the deficit will just crawl in below the EU’s 3% limit. The relatively flexible Irish economy probably has more chance of delivering this strong turnaround in growth than some of the other euro area periphery countries. But nonetheless, if growth is weaker than expected, the Irish government will have to take further painful fiscal measures in order to meet its deficit targets – which could, in turn, put downward pressure on growth. And although investors have been patient so far, any hint that the government’s fiscal plans are going awry could drive up Irish spreads. This should be kept in context – Ireland is not Greece, by any means. But the continued bad news from the Irish banking sector is a reminder that the government still faces massive challenges to put the banking sector, the public finances and the economy as a whole back on a sustainable footing.

Nick Smallwood, Credit Analyst & Colin Ellis, European Economist

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