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How the Irish can prevent a bank crisis from becoming sovereign default

Ireland was the first country to offer a blanket guarantee to it’s banks’ depositors. I welcomed this move as a necessary step to restore confidence. However, there are two problems associated with it.

  1. As Willem Buiter has pointed out, this move was a “beggar thy neighbour” policy which initially sucked deposits out of British institutions. British savers flocked to government-protected Irish institutions in the UK which courted the British savers with higher interest rates — the government had effectively subsidized the banks. Eventually, Europe as a whole got onside, and sweeping deposit guarantees were offered all around.
  2. The government must be able to credibly back up its guarantee. And this where Ireland looks a lot like Iceland. The country has an outsized financial sector which could not possibly be guaranteed by the Irish government. Moreover, Ireland is a member of the Eurozone — meaning it can’t print its own money. The UK, which borrows in Sterling can at least print money to finance any guarantees. The Irish are constrained — and, therefore, vulnerable.

It remains to be seen whether there is a sub-current of panic about the fragile Irish banking system that could lead it to Iceland’s fate. In fact, commentators like Wolfgang Munchau have argued that the single currency is a boon to the likes of Ireland because it prevents currency attacks like the one Iceland suffered, leading to its downfall.

However, a run on Irish banks is what would ultimately bring the Irish down. After all, it is the Government bank guarantee which creates the vulnerability. The Irish Government needs to make some contingency planning because an Icelandic fate is not out of the question. It need not worry about a currency run, but a bank run is still possible.

There are two ways to skin a cat.

-Is Ireland the next Iceland?, November 2008

I like to look back into the CW archives to see what I was saying a year or two ago and whether my commentary works with the passage of time. Let’s be critical here: what I was pointing out in November 2008 was that I missed the boat on how crucial the bank guarantees were. My initial reaction to them was largely positive. Here’s what I wrote in September 2008 when they made the guarantees:

Along with American and British banks, Irish banks have been under heavy attack due to the turmoil in the financial services sector. The government has finally had enough and stepped in with a blanket guarantee for six institutions of both deposits and bank debts.

This is a move that is identical to what the Swedes did during their banking crisis and I see this as a necessary position from which to start true banking reform and recapitalization.

The goal is to stop the loss of confidence in banks as deposit institutions and as bank counterparties first. Then, one can move on quickly to the comprehensive solution of merging, liquidating and recapitalizing.

-Ireland guarantees bank deposits at six banks, September 2008

I was wrong about the guarantee. Buiter’s comments clued me in to the fact that I had it wrong initially because Ireland suffered the Icelandic problem of banks that were too big to bail. The Swedes were more fortunate in the early 1990s because the relative size of their banking sector was smaller.

Ireland should have forced this issue when it had the chance. In January 2009, I gave this advice:

My take on events is that a number of countries within the Eurozone will face banking crises, starting with Ireland.  At that point, leaving the Eurozone will make no sense because the damage has already been done.

Evans-Pritchard’s calculus is more to the point: Ireland must threaten to leave now if it wants to maximize any EU help it expects to receive, before the scope of other EU banking crises become apparent.  Weakness in the financial sector has infected all of the Eurozone members. I have mentioned that Austria has a weak banking system (see posts here and here). But, there is even growing evidence that Germany too has a fragile banking system.  To be clear: this is an ‘every nation for itself’ strategy pitting Eurozone members against each other, where those nations savvy enough to request help sooner are likely to benefit at the expense of others. The question is whether the Germans would go along with this.  If they do not, tensions will rise and that will change the calculus for Portugal, Italy, Ireland, Greece, and Spain. I don’t have a view on this as yet because the situation is still evolving.  However, I lean toward believing the Eurozone will remain intact even while individual nations or banking systems collapse.

As events occur in Eurozone banking, I will keep you abreast on developments

-The Eurozone and the spectre of banking collapse

So, if we fast-forward to today, we can see it’s still all about the banks in Ireland. This deposit debt guarantee issue is still the critical one. The Irish Independent is talking about total nationalisation of AIB because of the ‘bank run’ hitting Ireland.  And it is a bank run; AIB cannot access credit markets without a government guarantee. Either Ireland lets some banks fail or it steps in and nationalises them.

Allied Irish Banks will soon be fully nationalised as the cost of insuring bonds in the bank soared to record levels, traders predicted yesterday.

Speculation mounted to fever pitch as the cost of insuring €10m of AIB’s subordinated bonds for five years rose to almost €8m. The cost of insuring €10m of senior debt for five years was half that.

Credit-default swaps, which are used as a measure of risk, spiked before the collapse of Lehman Brothers in the US and Northern Rock in the UK.

"It looks like the Government will end up owning more of the bank than had been expected," said Harpreet Parhar, a credit strategist at Credit Agricole in London.

"Investors are nervous that under the concept of burden sharing, the Government may try to force through substantial haircuts on Allied Irish subordinated bonds. One only has to look at what happened with Anglo Irish Bank for precedent."

Swaps on the bank’s subordinated debt now resemble contracts on Anglo Irish Bank just before it was taken over by the State after it collapsed in 2009.

Now, one could argue it is the Irish government’s hints that it would cut subordinated debt holders loose which  has dealt the bailout plan a blow. Had they stuck to their plan to make everyone whole, none of this would have happened, some say. There is truth in that argument. But I think a whole confluence of events is combining to bring this to a head including the escalating costs for the Anglo bailout and the failure of austerity to trim the Irish budget deficit. I see the Greek blow-up and bail out as the true trigger event here – the potential Creditanstalt of our great financial crisis.

As an aside, I should note that RBS is getting hit here as well because they have a lot of Irish exposure as do most of the large British banks. You can see the exposure to the euro zone periphery from this chart from June. Clearly this is about more than Ireland, but also about confidence in the European banking system, cross-border credit exposure and contagion to others in the euro zone periphery.

As I said last year:

There is zero chance the Irish are going to be able you make a fiscal adjustment of 10% of GDP in 3 years in a weak economic environment. And we know where this type of policy leads by looking at Latvia.  So, now it seems government officials are finally coming clean and admitting, much as Latvia has done, that the only way out of this fiscal crisis is a bailout plain and simple.

And here I was just talking about the primary fiscal deficit. If you add in the concern over the Irish banking system, there is no chance the Irish can convince markets they are going to make the grade. You have a case that should have already headed to the IMF and the EFSF like Greece. When I made the same remark on Tuesday, one commenter suggested this was a bit of stating the obvious. But it’s not. You still have people in the Irish political elite like John Bruton saying the Irish can get by on export growth.

Is this a case of denial? After all, Ireland was supposed to be the one that made it as they were willing to face the music and were not profligate like the Greeks. I think, yes, there is a lot of denial and foot dragging here. In my view, the die is cast. What should concern Ireland and Europe is the talk of sovereign default and the potential for contagion. If Ireland is to save itself and prevent contagion, it will have to let bondholders take the hits instead of Irish taxpayers.

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About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

10 Comments

  1. jimh009 says:

    Edward,

    Isn’t’ the real major problem for Ireland is that they guaranteed both the deposits AND the debts? Wouldn’t have Ireland been better off guaranteeing the deposits (and perhaps only Irish deposits) but not the debts – and then essentially winding down the banks? The amount of debt Ireland guaranteed (much of which has turned “toxic”) and took on its books is pretty staggering in relation to its GDP. Ultimately, what isn’t sustainable eventually is proven so – thus I have to wonder if endless bailouts by the ECB at 8% interest is really going to accomplish anything but further kick the can a short distance down the road.

    Granted, it’s probably too late to “go back.” But it seems the Irish situation is so unsustainable in the longer term that, eventually, a default seems almost inevitable – regardless of how many bailouts are provided. I can’t help but think that the Irish government will, sooner or later, be forced to say to heck with the bondholders and the ECB and remove their guarantee from the banks. That “force” will arise either from a radical change in government due to a very upset population or simply running out of money and having to finally “face the music.”

    • right, it is the Irish debt guarantees which are the real problem. Because the Irish banks are so large relative to the government, the debt cannot be credibly guaranteed by the Irish sovereign – one that does not have a printing press I might add.

      As I said, it’s cutting the sub debt loose NOW that is critical. Afterwards, they should call for the IMF and get the sovereign bailout they need. If the Irish state is able to get rid of the debt guarantees and get the money to tide them through, we know the Irish are willing to make the cuts.

    • I caught an instance where I said deposit guarantee instead of debt guarantee above and have amended it accordingly.

      • DavidLazarusUK says:

        I don’t think that Ireland threatening to leave will be much of a threat. If the heads of the central banks have not deluded themselves that all is well they will realise that there is a lot of toxic debt still hidden on the banks books of all EU nations, and the crisis is a long way from being over.

        With Ireland guaranteeing the Irish banks debts, meaning that the poor Irish taxpayer will need bailing out very soon, unless they drop the guarantee. I doubt that they can survive until next summer even with the funds secured till next year. Even sticking to the guarantee would have been exposed eventually as a deception, and they would still have had a bank crisis.

        Ireland needs to nationalise the banks but without guaranteeing its liabilities, better still would have been to allow the banks to collapse then nationalise the remains, though they dived in and sacrificed billions of euros to save political face. Too late now.