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Western EuropeJune 3 2009

A 'bad' solution for a battered economy?

As Ireland reels from its banking woes, a fierce debate is under way as to whether the government's 'bad bank' solution will be enough to open a route to recovery or whether widespread bank nationalisation is a more realistic option. Writer Philippa MaisterIreland's finance minister has divided opinion with his 'bad bank' plan
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A 'bad' solution for a battered economy?

A heated debate is under way in Ireland between supporters of the government's favoured solution to restoring the nation's battered financial system - a 'bad bank' - and those who say nothing short of nationalisation of the biggest banks will work. The survival of the country's economy may depend on finding the right answer.

The global financial crisis has not been kind to Ireland or its banks.

Shareholders of many financial institutions, including its three biggest banks, have been wiped out as bad property loans devalued bank assets and their stock prices plummeted. The government's necessary support of the nation's banking system has weakened the state's own financial outlook. And the nation's political parties have refused to put aside their differences to forge a joint solution to what is the severest emergency in Ireland's recent history. The government's public approval ratings are at historic lows.

In a report in March, Fitch Ratings ranked Ireland second - behind the UK and above the US - in its risk of exposure to the global financial crisis. This is largely because Ireland has one of the world's largest banking sectors relative to gross domestic product (GDP).

Loss factors

Experts agree that Irish banks had little exposure to the US subprime market or to the complex financial instruments that underlay it. The banks' problems stem partly from an excessive exposure to commercial and residential property lending in Ireland and abroad, and partly from excessive risk taking and poor risk management.

The government has already taken steps to bolster the banks. It was praised for acting decisively when, on September 20, 2008, following the crash of Lehman Brothers, it became the first in the EU to announce a guarantee of all deposits in Irish banks.

On December 14, the government proposed pumping additional capital into the banks to keep them afloat. However, a month later it concluded that Anglo Irish Bank would have to be nationalised. A promised €3.5bn recapitalisation of Bank of Ireland has been completed; a similar recapitalisation of Allied Irish Bank (AIB) is still under review. Both will be funded by money from the National Pensions Reserve Fund in return for preferred shares in the two banks.

A new solution

In his April 7 budget speech, Brian Lenihan, Ireland's finance minister, announced that a "bad bank" - politely named the National Asset Management Agency (NAMA) - will be established under the National Treasury Management Agency (NTMA).

The new agency will purchase the banks' most problematic assets - mainly land and development loans and "the largest aggregated associated exposures" - and pay for them via the issue of government bonds.

According to Michael Somers, NTMA's chief executive, the goal would be to take the bad loans off the banks' balance sheets and assign them to the new entity.

Among the many issues being considered, says Mr Somers, is how to structure the bad bank, and how to value the assets. He says much of the development lending has been to a core group of 25 to 30 individuals who have acted essentially as sole traders.

Mr Lenihan asserted the maximum potential book value of the assets to be €80bn to €90bn. However, the state would pay much less than this to reflect their drop in value, and the banks participating would have to assume the losses. He maintained the "bold, radical measure" was needed to restart the flow of credit into the economy.

National debt

Mr Lenihan admitted the resulting bond issue "will result in a very significant increase in the gross national debt". By one estimate, €90bn represents 50% of GDP. But Mr Lenihan insisted it would be a good investment in the medium term - about 10 years - and would be covered by the interest on the loans, which must be repaid, or a levy on the financial sector.

Ireland, and any other country exploring the bad bank option, could do worse than take the advice of Jan Kvarnström, who helped set up and headed a bad bank in Sweden from 1994 to 1997. The bad bank, Securum, absorbed the non-performing assets of Nordbanken, one of the country's largest banks which, as in Ireland, found itself in trouble because of a real estate boom, followed by a bust.

Many things are needed to make a bad bank work, says Mr Kvarnström. The first task is to create a "good" bank - a bank with a solid asset base, a good organisation and a customer focus that has a chance of long-term financial survival. "Each bank by itself has to go through what is its business model to survive, and how much money it will need to succeed," he says.

Toughing it out

Nordbanken survived as the good bank, and anything that did not fit in with its new business model was assigned to the bad bank, Securum. Not all the assets transferred were bad - some were designated as discontinued business, including all Nordbanken's assets outside Sweden.

Also needed is management with the particular skills required to run a bad bank.

"Bad banks usually contain a lot of problems and you can't expect a profit: you have to recover as much value as possible. That's a very different process from a normal bank," says Mr Kvarnström.

Managers, for example, have to be able to look at the underlying asset and what can be done to develop it so it is positioned for divestment when the market comes back. One of the aspects of a bad bank that is likely to prove most controversial is the price at which it agrees to sell its assets. It is essential, Mr Kvarnström says, to have the expertise in house to know whether there is a market for an asset, what the right price is, and the negotiating skills necessary to get that price.

It was initially expected that it would take 15 years to clear Securum's balance sheet. In the end, it only took five years because the economy picked up. Though there was some criticism that assets were sold too quickly and too cheaply, Mr Kvarnström says the bank's decisions were largely validated by a subsequent study.

Pros and cons

The Irish Banking Federation (IBF), which represents domestic and international banks and financial services institutions in Ireland, says it welcomes the creation of NAMA.

However, many of Ireland's leading economists strongly disagree.

Brian Lucey, a professor of finance at Trinity College Dublin, was one of 20 economists who issued a formal statement contending that nationalisation is "the inevitable consequence of a required recapitalisation of the banks done on terms that are fair to the taxpayer".

Mr Lucey says he and his co-signatories believe the only way out is to go for a nationalisation of the country's banking system, or at least the part that is systemically important. He argues this would make it easier to see what can be salvaged and to shift assets from one structure to another. Changing from a deposit guarantee to nationalisation would also create a firewall to protect the public interest. "Right now, the state has a large amount of risk, but is not getting a commensurate return," he says.

Indeed, a joint analysis by three Irish stockbroking firms calculated the potential government liability created by these guarantees at 250% of GDP. The official proposal for NAMA prepared by a consultant says that the government had assumed additional contingent liabilities of €440bn with the deposit guarantees.

Mr Lucey says nationalisation would also enable the public to share in any upside, and reduce the underlying cost to the taxpayer. When the nationalised institution got back on its feet, the government could convert its ordinary shares of the institution into preferred stock and the bank could be returned to private ownership.

Banks, however, are firmly opposed to nationalisation. Pat Farrell, the IBF's chief executive, says it is not in the interest of Ireland, Inc. He contends that commercial banks have a better track record.

Certainly, Mr Lenihan has made it clear that further nationalisation is a possibility, insisting the state will only inject fresh capital into a bank in exchange for ordinary shares.

He noted the state already owns a 25% stake in Bank of Ireland as the price of recapitalisation, and may acquire a similar stake in AIB.

Nationalisation and a bad bank are not necessarily mutually exclusive, according to Ronald Greenspan, a senior managing director with FTI Consulting in Los Angeles, who has had discussions with the Irish government in an advisory role for his firm. It is a matter of who is in operational control.

The central issue, he says, is recapitalisation - whether of the 'good banks' that survive when their troubled assets have been spun off into a bad bank, or of nationalised banks. In either case, the capital will have to come from the government.

"The private sector is not going to come in to pay for prior mistakes," says Mr Greenspan. "Once there is capital and asset stability, it is likely the private sector will invest additional money, but you won't get them to fill a hole."

Private sector scouts

Scenting opportunity, some foreign private equity groups have busied themselves sniffing out potential acquisitions, often with Irish partners.

One much mentioned is Mallabraca Investment Funds, a new group reportedly made up of Irish, Middle Eastern and US investors, including JC Flowers & Co, The Carlyle Group and Sandler O'Neill. Mr Greenspan declined to confirm or deny reports that his firm is advising the group.

NTMA's Mr Somers says his agency has met with several private equity groups scouting bank targets in Ireland. Bank of Ireland has also confirmed receiving "unsolicited approaches from a number of parties" but refused further details.

Mr Somers is cautious about such investment, and unions have expressly opposed it, fearing that in their quest for a quick buck buyers will squeeze costs and eliminate jobs before flipping a bank.

While nationalisation, a bad bank or a private equity buyout may help the banks' balance sheets and ability to survive, an even more fundamental challenge is to restore confidence in their integrity.

The Irish have long regarded occasional ethical lapses of their leaders with a tolerant if cynical eye. Tolerance finally reached its limit this year, however, with revelations about undisclosed loans of millions of euros by some banks to their own directors, year-end fund shifts to make bank balance sheets look better at Anglo Irish Bank, and a separate €27m pension fund and €1m bonus to benefit the former chairman of Irish Nationwide Building Society.

Poor regulation

"The big problem in Ireland has been the lack of effective regulation," Mr Lucey reflects. "There has been no proper regulatory structure or proper implementation of regulation."

Ireland has also relied on a principles-based regulatory regime, which opponents say has given banks too much leeway.

The clean-up has already begun. Some senior executives of the major banks have been replaced. The government has installed its nominees on bank boards. Mr Lenihan has asked all banks covered by the government's guarantee to limit executive pay to €500,000. Banks are revisiting their corporate governance models.

The role of the central bank is to be reformed, making it the centre of financial supervision and financial stability oversight. Sir Andrew Large, former deputy governor of the Bank of England, has been called in to advise on the selection of a new head of financial regulation in the new structure.

Cultivating business

Restoring Ireland's reputation cannot come too soon for Dublin's International Financial Services Centre, recently ranked 10th in the City of London's Global Financial Centres Index. Ireland was cited as a cost-efficient location for banking operations and an attractive destination for investment and corporate tax residence.

Mr Farrell contends that Ireland is far from alone in having to deal with problem behaviour, citing high-profile cases in the US and elsewhere. He says the Financial Services Centre's high ranking demonstrates that Ireland still has a strong reputation for financial services.

"Clearly there has been an acknowledgement that we didn't get things right. People are genuinely hurt. There have been casualties of the sharp economic downturn and access to credit is more constrained. We are sorry that that should be so and we acknowledge that we have made mistakes," he says.

The real challenge will be to fix them.

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