Government bank bluff called
With share prices down to penny-stock levels and overseas banks reluctant to lend it is now clear the government must do much more to rescue the Irish financial system and get the banks lending again
9 March 2009
By the end of last month the combined value of the three remaining Stock Exchange-traded Irish banks, AIB, Bank of Ireland and IL&P, had fallen to under €1bn. That’s less than 2% of the €57bn peak value of the Irish banks, including the now-nationalised Anglo Irish, at the end of February 2007. This represents by far the greatest destruction of shareholder value in Irish economic history.
Of greatest concern is the continuing fall in the AIB and Bank of Ireland share prices. Last month the government announced plans to pump €3.5bn into each, however, by the end of February AIB had a market value of just €460m while that of Bank of Ireland had fallen to a mere €280m.
In other words, when the effect of the recapitalisation is stripped out the markets are valuing both of the major Irish banks at less than zero. Recapitalisation has failed.
Even if it had succeeded in strictly financial terms, the structure adopted by the government to get our banks lending once again is fatally flawed. Indeed, the arrangements announced by the government last month threaten to turn the current credit squeeze into a loan famine.
As the crisis has intensified the bank bosses have brilliantly exploited the government’s desire to keep the cost of any recapitalisation to a minimum to protect the interests of the shareholders. So, instead of taking straight equity the government is putting the money into AIB and Bank of Ireland as repayable preference shares.
The advantage of preference shares from the government’s point of view is that, with the banks unlikely to pay their ordinary shareholders a dividend for years to come, it would receive an 8% interest rate.
While the government also received warrants giving it the right to purchase up to 25% of the shares in either AIB or Bank of Ireland at the market price on the day it subscribed for its preference shares, the big winners from the recapitalisation were undoubtedly the existing bank shareholders.
If the government had insisted on ordinary shares instead, it would have ended up with an 88.3% stake in AIB and 92.6% of Bank of Ireland. This would have all but wiped out the existing shareholders.
Not alone does the recapitalisation scheme short-change the taxpayer it also threatens to have catastrophic economic consequences. As mounting bad debts eat up what capital they have left the banks are cutting back on lending – bank lending fell by 2.2% in the month of December alone.
Under the current scheme the banks can redeem the preference shares at par, i.e. 100%, within five years. If, however, either of the banks wait more than five years they will have to pay 125% to redeem the preference shares.
This means that the recapitalisation scheme creates an enormous incentive for both AIB and Bank of Ireland to redeem the preference shares just before the fifth anniversary of their issue. So, when the interest which must be paid on the preference shares is added, AIB and Bank of Ireland must find E9.8bn between them over the next five years.
AIB and Bank of Ireland will hoard capital even more aggressively than before. Most banks lend about 15 times their capital. This need to find almost €10bn of capital over the next five years will drain almost €150bn of lending capacity, close to 40% of all lending, out of the banking system. At a time when bank lending is already shrinking rapidly this is mad, utterly mad.
Furthermore, the collapse in bank share prices signals the fact that foreign shareholders have sold up and walked away. Even more disturbing is the fact that overseas banks and other depositors are following suit. But what about the deposit guarantee?
Ever since the government put the Irish taxpayer on the hook for over half-a-trillion euro last September the unspoken truth has been that the deposit guarantee is little more than a gigantic bluff. With the total liabilities of the Irish-owned banks estimated at €575bn, more than three-and-a-half times the value of our annual economic output, the government has never had the resources to honour the guarantee.
Now that bluff is being called. Unless the ECB bails out the Irish banking system soon, things are going to get an awful lot worse before they get better.