02/03/2011: Village Magazine - March edition article

Here is an unedited version of my column in the current edition of the Village magazine

Top legislative/policy priorities for the new Government should focus on addressing the four crises we face – the banking sector renewal, the debt crisis, the need to dramatically reform our economy and the long-term reform of our political and governance systems. The inter-connected nature of these crises implies that some of the reforms undertaken in one of the areas, such as, for example, fiscal adjustments, will have a positive long term effect in other areas, e.g. in stimulating private sector economic growth.

Given the constraints of the space, let me deal here first with the decisions that should take priority for the new Government over 2011 in the areas of banking and finance.

EU/IMF ‘bailout’ package: the new Government will be forced, willingly or not, to renegotiate the terms of the original agreement. Given the level of debt carried by this economy courtesy of the previous Government commitments, the question of the need for such a revision of the ‘deal’ is no longer a valid one. Instead, the real question we face is what path to a ‘default’ or debt restructuring do we take and resolving this issue should be the top of our Government agenda.

Overall, there are three possible scenarios that the new Government can face in this respect.

The first one – the scenario of exogenously imposed resolution – implies that the impetus for altering the terms of the original November 2010 agreement can come from the EU itself under the auspices of the broader EFSF reforms. Under this scenario, expected eagerly by many pro-status quo or ‘do nothing’ advocates, the EU is likely to marginally reduce the cost of the EFSF funding to, say 5% from the current 5.83% and potentially extend the duration of the loans (up to 20-30 years), while creating a ‘flexibility fund’ which will make additional funding available to Ireland post-2013, but at higher rates of interest incorporating any future increases in the ECB core policy rate. In exchange for such a ‘rescue from previous rescue’ package, Ireland will be asked to accept the need for enhanced fiscal coordination– re: tax harmonization.

The second path is of structured and orderly ‘default’ involving banks debts. Under such a scenario, Irish Government should first prepare significant buffers for dealing with the funding failure in the currently insolvent banks. Since not all of our Government-guaranteed banks are insolvent, this means that the damage limitation is relatively better contained than the current full exposure scenario. In fact, an orderly restructuring will require replacing the blanket Guarantee with the one that covers fully only the deposits held in the Irish banks. This will significantly reduce taxpayers’ future exposure to the banking sector.

At the moment, the entire banking system in Ireland holds €168.3bn in deposits. However, not all of these are held in the 6 covered banks. In addition, of the above deposits, €10.5bn is held under the termed contracts with maturity in excess of 2 years. Roughly, only ca €100bn of domestic deposits are held by the Irish banks and is subject to a withdrawal demand within the next 2 years. This means that to underwrite these deposits, the Government will need a funding buffer of ca €30-50bn over the next 2 years (providing a 30-50% cover). This buffer can be provided by a combination of new currency issuance by the CBofI, NPRF funds and a stand by facility from the IMF not exceeding €5-15bn. A far cry from what the Government, alongside the EU and IMF, are planning to burn already.

Of course, the scenario means that we will need to effectively radically reduce our banks exposure to their largest lender – the ECB. This can be done by restructuring the share of Irish banks debt held by the ECB and the CBofI into a combination of a 10 year loan at a fixed interest rate of 0.5% and a haircut of, say, 40%, in effect reducing the risk of future rollovers, while cutting the overall burden of repayment and the cost of financing. Along with it, the EU/IMF should also agree to a restructuring of the €67.5bn loan extended under the November 2010 agreement into, for example, a €35bn perpetual loan at 3% pa interest rate and a €30bn loan extended for 10 years at 1.5-2% pa interest. The key in both deals should be to achieve not only a reduction in the cost of financing the quasi-Governmental (banks) and Government debt, but also cutting the overall level of gross debt assumed.

The worst-case scenario would arise if the markets were to force Ireland into a disorderly default. In this case, the markets will execute a massive sell-off of Irish Government debt preceded by a complete collapse of the secondary markets in banks debts. This will leave the ECB with some €185 billion worth of Irish banks debts that will have virtually no real market value and an unknown (but sizeable) volume of Irish Government debt which will be selling at a 20-30% discount on the face value. Both, the sovereign bonds and the banks debt markets will cease. Overnight and demand deposits will be frozen and the country will find itself in the situation where the Central Bank will have to monetize the very same costs of the orderly restructuring scenario, plus the disruptive costs of a bank run at the same time. Instead of holding the buffers of cash and committed funds it might not have to draw down in full, the ECB system will end up in a situation where all cash will have to be delivered as soon as technically possible.

It is clear that a prudent Government action should be from day one to prepare for the second, less disruptive scenario.

Following the entry into the resolution process of the banks debts, the Government should swiftly address the banks balancesheets problems. Here, the actions should follow the Swedish model and start with the abandonment of the misguided Nama-based approach. The Government should order the six banks to supply – by the end of June – a full accounting of the loans they hold, with clear indication as to the riskiness of these loans with respect of the probability of their repayment, the quality of the underlying collateral and titles. By the end of August 2011, the Government should complete detailed evaluation of this information by an independent panel of economic, property, lending and finance experts. Parallel to this, the Government should set an exact target for banks bondholders writedowns to offset at least in part loans losses in the banks. All bonds repayments and interest payouts for banks debts due for 2011 should be suspended. The balance on the expected losses net of the funds recoverable from bondholders should be financed by the purchase of the direct equity in the banks by the Government at a price for banks shares at the time of the publication of the assessment exercise. The time-frame for such closing of the balancesheet gaps should be set for no later than November 2011.

Nama loans that belonged to the banks should be valued as banks’ own in the above exercise and following the completion of the valuations, Nama should be shut and loans transferred back to the banks for management.

Subsequent deep reforms of the banks strategies and operations should be scheduled for the first quarter 2012.

Parallel to this, the Government should submit to the Dail no later than June 2011 a full draft bill dealing with reforms of our personal bankruptcy codes. These reforms should at the very least:

Make past and future loans for the purchase of personal residence non-recourse against the person of the borrower and his/her future income and assets;
Reduce the period of bankruptcy restrictions to just 2 years and complete removal of the bankruptcy history from credit history after 5 years of continued financial probity performance; Replace a blanket ban on companies directorships for individuals in bankruptcy with a restriction on their holding such directorships subject to satisfactory financial probity conduct during the bankruptcy period;
Restrict applicability of the Loan-to-Value ratio covenants in forcing the liquidation of the existent loans where the borrower continues to pay at least 75% of the interest on the mortgage.

The new bankruptcy laws should come into force as soon as possible and prior to that, the Government should impose a requirement that no state-guaranteed institution can bring new bankruptcy proceedings against homeowners.

Lastly, the Government should act swiftly to put in place an independent expert panel consisting of independent economists, financial analysts and banking experts that will function as a check on the Government decisions in the area of banking and financial services reforms. The panel should be required to provide quarterly reports and testimonies to the Dail which will be made public. The panel will have the powers to propose specific measures to the Government, to request and receive any information from the banks and financial services provider (subject to upholding the required confidentiality clauses) and question any bank official. The panel remit will only cover those institutions in which the Government holds at least a 35% stake and those that are covered by the State guarantee.

Of course, the above measures will help addressing a large share of our debt problem, effectively reducing the Government and banks’ debts, while alleviating the burden of personal debt for mortgage holders. However, other changes will have to take place in the areas of economic, fiscal and political reforms. These proposals will be outlined in a follow up article, so stay tuned.