Rebuilding Europe’s banks: Irish lessons

To get a measure of how much Ireland has done right since the middle of 2010, there are many places one can look: bond yields that once tracked Greece are now at 8% compared with Greece’s 28% and GDP was up 1.6% on the first quarter of 2011 in the second quarter. Ireland is also the country that in 2010 faced the wrath of every eurocrat and politician, when it refused to increase its corporate tax rates, even though it was receiving an €85 billion bailout from the EU and the IMF. At the time, the country was pilloried, especially by French president Nicolas Sarkozy. But one year on, the decision has been vindicated. Sarkozy went so far as to praise Ireland at the Brussels summit last month, saying: "Ireland was a country that was standing on the brink of the precipice when the 2008 crisis hit us, and yet Ireland today is a country that is almost out of troubled waters, almost out of the crisis."

What has the country done that is so different from other eurozone periphery countries and what lessons can be learnt? As important as its stance on corporate tax rates has been what it has done to the banking sector. As the sovereign debt crisis in Europe spirals into a full-blown credit crunch and banking crisis, the way that Ireland has dealt with its banks is now an object lesson for the rest of the continent. Bold, quick, painful and decisive, the moves were everything that the current European solutions are not. They stand in sharp contrast.

"I’d say they would be looking very closely at what we have done," said Michael Torpey, a banking official at the Irish finance ministry, at a briefing with journalists in November. "If I was sitting in another country, I would be saying ‘let’s see what lessons we can learn’."

The scale of the problem facing Europe’s banks is clear. According to the deal struck between European heads of state in early November, European banks will have to raise €106 billion in new capital between now and the middle of 2012. Many are asking how this will be done. The Irish, in a process of recapitalization that began two years ago, have shown the way.

At the outset it is important to point out the differences between the Irish situation and that in other countries. Irish banks went bust because of bad lending policies to a bubble real estate sector. The government had to guarantee all bank depositors to prevent a mass run on the banks. It then had to step in and recapitalize them. Five out of the big six banks are now in government hands.

Contrast this with Greece. There the banks have been brought down by their exposure to Greek sovereign debt. In Greece the sovereign impaired the banks; in Ireland the banks impaired the sovereign. This has strong implications for how both countries are seeking to heal themselves.

Some other countries in Europe now look more like Ireland than Greece. Spain, for instance, has low levels of sovereign debt and the banks are as exposed as the Irish banks were to a hollowed-out real estate sector. It is no surprise that the incoming government of Mariano Rajoy is considering many of steps that the Irish have taken.

Even so, the specifics of Ireland’s banking collapse have dictated the specific measures taken to rebuild the sector. And these specifics might not be suitable for other countries. "Each market needs its own solution and one size does not fit all," says Ben Davey, head of FIG IBD, EMEA, at Barclays Capital in London.

Yet the way Ireland has implemented its measures is as important as the measures themselves. And where Ireland stands apart from other countries is in having accepted that it had a problem. "If I was sitting in one of the other countries, one of the questions you would ask is what is the scale of capital raising?" said Torpey at the press briefing. "If there are countries which have problems that are as deep, then they have to be prepared to look at solutions that are as severe." When it comes to severity, one word can make even the boldest Irish banker blanch. Nama, the acronym for the National Asset Management Agency, is a textbook example of a bad-bank solution to a banking crisis. Modelled on the bad bank set up in Sweden in the wake of that country’s banking crisis of the early 1990s, Nama quickly established itself as a brutally effective way of slimming down the banking sector. Established in 2009, the agency has plans to sell up to €71 billion of loans by 2019.

Nama is not universally liked. Understandably, the banks and their advisers have been scarred by their experience of dealing with the agency. They have been forced to sell assets at very low prices, crystallizing big losses that in turn have forced them to raise new capital. As the only source of new capital, the government has had to come in and take over all but one of the nation’s banks. Thus Nama – by insisting on brutally low prices – effectively sealed the fate of the whole sector. It is understandable that it is not loved by the country’s bankers.

"Nama has been excessively punitive," says the head of European FIG at an investment bank in London who has been working on deals to help recapitalize some of Ireland’s banks. Speaking off the record because of the sensitivity of the issue, he claims that Nama has made the situation in Ireland worse, not better. By forcing the sales at low prices, Nama crystallized immediate losses for the banks. It also reduced the value of all assets in the country, essentially devaluing the entire property and real estate sector. These losses were taken from the bank’s balance sheets and transferred to the sovereign, via the balance sheet of Nama. This therefore reduced the ability of the sovereign to fund itself and led to a spike in sovereign bond yields in 2010. This in turn necessitated the EU/IMF bailout. "It was a classic negative feedback loop," says the banker.

Others, however, defend Nama, saying it was necessary to get the process going. "While crystallizing losses for the banks on transfer, Nama started the process of restructuring and allowed the banks to take material portfolios off their balance sheets," says Davey.

Nevertheless, the government did realize that further measures would be needed if the country were to escape the downward spiral. At the end of 2010, the Irish central bank and finance ministry – under the guidance of the EU and IMF – changed tack. They oversaw a thorough asset due diligence stress testing of all the banks, in a process undertaken by global fixed income asset manager BlackRock. The central bank then asked Barclays Capital to help it design a deleveraging plan to right size the banking system, while at the same time, trying to work out what the banking system of the future should look like.

Davey was one of those who led this work. He believes that the way that the Irish authorities have responded has significantly helped the banking sector recover. Firstly the level of transparency, through disclosure, was voluminous. The Financial measures programme report was over 90 pages long and published for all the market to see. The stress tests were extremely rigorous, including stressing the whole life of the assets under review, not just in the short term. This gave the whole process credibility, in an environment where information is crucial. This approach is potentially a key lesson that could be usefully adopted elsewhere in Europe.

Davey points to the fact that in the three months before the report was published, Irish 10-year government bond spreads traded at about 250bp below Greece and around 200bp above Portugal. On publication of the report and the deleveraging plan, Ireland immediately decoupled from both and sovereign spreads began tightening, while the others widened. As a result of this, the theoretical saving to the country of openly admitting its losses was a 20% differential in the cost of borrowing, or tens of billions of euros.

"There is no doubt that the Irish banking system will have benefitted significantly from taking such action this year," says Davey. "There is now a coherent and integrated deleveraging plan across the whole banking sector. This has secured value for the banks, for their stakeholders and for the system as a whole." At the time the report was published, the naysayers were adamant that it was the wrong time to start such a process. With hindsight, though, it can be seen that it was exactly the right time. As Europe’s troubles have gone from bad to worse, the early mover advantage for Ireland has been an important contributor to its success.

For banks in other countries in Europe, which are desperate not to have to offload assets or even their equity at what they perceive to be fire-sale prices, the lesson is clear: the market is not at the bottom, and things can, and probably will, get even worse.

For the past six months, Ireland’s banks have been recapitalizing through three broad strategies: LMEs, or liability management exercises (a fancy term for imposing losses on bond holders), raising fresh equity and where possible debt, and divesting assets from the balance sheet.

Of these, the LMEs have been the most controversial but might be the most influential in a Europe-wide recapitalization programme. From April to July, the two largest banks that are still active in the market, Allied Irish Banks (AIB) and Bank of Ireland (BOI), both completed exercises, although they were slightly different. In the case of AIB, which went first, it invoked a legislative tool called a subordinated liabilities order (SLO), which was created by the government in the Credit Institutions (Stabilization) Act of 2010. This blunt legal tool allowed the authorities to force junior bondholders to take extreme losses on their AIB debt. The final losses were in the region of 90% for most bondholders, although the government agreed out-of-court settlements with two US funds that held out against the deal, Aurelius Capital and Abadi. It is unclear what haircut they took.

The fact that the government, through the Ministry of Finance, imposed a High Court order and went to court to force the issue had a salutary effect on the other LME in the pipeline, that for Bank of Ireland. In that case the bondholders accepted the exchange offer voluntarily: at the end of June, some 75% of eligible holders accepted the offer and of those 95% chose to accept the exchange in the form of shares. This debt-for-equity swap added some €1.98 billion of core tier 1 capital to Bank of Ireland’s beleaguered balance sheet. In the case of AIB, it added €1.6 billion to its core tier 1 capital.

Since 2009, Bank of Ireland has raised its capital by €4.5 billion through LMEs alone, with the Irish banking sector as a whole generating some €15 billion. With a GDP of roughly €200 billion, this equates to 7.5% of GDP. This is a vast sum and seen in the wider European context could mean hundreds of billions of euros of losses for European bank bondholders. But it is clearly the inspiration for the private-sector involvement (PSI) portion of the Greek bailout this summer, in which the bondholders agreed to a relatively generous 50% haircut.

Again the Irish experience of going hard and going early is important, as the bondholders are still – just – in a position to take these losses. However it also primes them up for the next stage of the process, divestments.

Much has been written about how much capital is now available for the European bank asset sale process. US banks, hedge funds and private equity firms are all primed to pick up valuable assets from motivated distressed sellers. According to some estimates there is as much as $200 billion of dry powder waiting to pounce on these sales. For instance, Perry Capital, a large US hedge fund, recently closed down its Asian operations to focus on finding bargains in US and European credit markets. Investors will be motivated by the example of Bank of Ireland, which in October announced it had raised some €4.54 billion in little over three months from a planned €10 billion deleveraging process that was expected to take until the end of 2013.

The final piece of the puzzle has been equity investment. This has involved five out of six of the largest banks falling into government hands. However, Bank of Ireland escaped this fate because of the last-minute interest in the bank by a group of US investors comprising WL Ross, Capital Research, Fidelity and Kennedy Wilson, an investor group that a few months later would buy the bank’s UK commercial property portfolio.

It was a huge vote of confidence in not only the bank but in the sector as a whole and established a market-clearing floor to the overall process.

Much still needs to be done. Indeed most of the deleveraging so far, by both Nama and by the banks, has been of the overseas assets. The great sell-off of Irish property has not even begun. But most commentators say that the willingness with which the Irish have embraced the process, and undertaken the harsh steps it has engendered, bodes well for the future. And this has huge lessons for the rest of Europe.

Like having children, there is never an optimal time to engage in an asset-sale process but the best times are clearly never, or today. It is a lesson that other European banks will probably have to accept. More than anything it will take a change in attitude from the continent to realize the difficulties they are in. For all the pain they have been through, and all the pain they have caused others, Irish bankers are way ahead of their European cousins in one important attribute: acceptance. And that might be the most important asset they have at the moment.

see also:

Bank of Ireland shows the way to delever
Anglo Irish Bank : What’s in a name?