The Moral Hazard of the Banks' Bail Out

Six Irish banks are being bailed out by the State because of their systemic importance. This is supposed to mean that the consequences of their failure would have an adverse, far-reaching impact on the economy and the financial welfare of the country. Taxpayers are naturally concerned that if large scale public resources are committed that these are used to create repair a problem not to make those who caused the problem richer and this can arise in many ways including the valuation of assets and liabilities and through the derring-do of executive and non-executive leadership.

The resources required in Ireland to bail out banks are enormous in the context of our resources – potentially 50% of Gross Domestic Product. If Ireland were to experience a 10% drop in GDP this year, which could happen, the recession we speak of would become a depression. Foreign lenders are becoming ever more cautious. Tax revenue has collapsed from €47 billion in 2007 to a potential €34 billion in 2009. Taxes and levies have been raised several times in the past 12 months and Government spending has been curtailed. These initiatives are designed to impress lenders and the rating agencies' but it will aggravate the downturn. The guarantees and the direct investment provided to the banks could even strain the long-term solvency of the country and this puts further strain on the country.

There are many uncertainties in relation to the bank bailout and one of these is the consequence of moral hazard. Moral hazard arises when banks make choices in the light of Government support that would not make were this not available. A glaring example relates to the disclosure of losses arising from impaired loans. Last week AIB announced that it has increased the amount being set aside to cover impaired loans from €106 million to €1.8 billion. Irish Nationwide Building Society has announced a loan loss impairment charge of €464 million, increased from €48.8 million in 2007. The loan loss impairment charge was €17.6 million in 2006; €27.2 million in 2005 and €6.5 million in 2004.

Following the publication of a 9-bullet point press release last Friday, the Taoiseach has announced that this institution is to join the bailout fraternity. Irish Nationwide announced a loss of €243 million after this very large loan loss impairment charge. The common understanding of a building society is that of providing house loans to members from the proceeds of members' savings. The risks involved would be fairly widely dispersed and thus moderate.

Irish Nationwide had residential mortgages of €2.547 billion in 2007, down from €2.599 billion in 2006. 98% of these were in Ireland and 28% related to houses in Dublin. But Irish Nationwide also had commercial mortgages amounting to €9.785 billion of which only 37% were in respect of Irish properties (16% in the Dublin area). 53% of the commercial mortgages were in Britain (34% in London). The total loan book in 2007 was €12.332 billion. This has was reduced to €10.474 billion in 2008.

Ireland had become very dependent on tax revenue derived from construction such as capital gains tax, stamp duty and corporation tax. But the drop in tax revenue from these sources has been dramatic reflecting the burst bubble of the construction sector. Capital gains tax has dropped by 54%; stamp duty by 48% and corporation tax by 20%.

The reserves of the Society in 2008 were stated to be €1.2 billion, a reduction from €1.51 billion in 2007. However, the 2007 figure included a property revaluation reserve, of which €67 million, but the property values of 2007 no longer prevail.

Irish Nationwide makes a point each year of commenting on its cost-income ratio which in 2007 was 17%, “which continues to be the lowest of any Irish financial institution”. A wonderful accomplishment when directors’ emoluments amount to €3.49 million – 78 times the average annual pay of the 400 staff of the Society (€44,500).

If 50% of Irish Nationwide's loan book concerns transactions outside this country, to what extent is it of systemic importance to Ireland? How valuable is the Irish Nationwide franchise? A strong franchise is derived from a strong competitive creates pricing power and a status that can make it a sought after acquisition target. Why did Irish Nationwide never cede its mutual status and become an acquisition candidate? Does its reluctance offer any insight into the real quality of its business and prospects? Are its problems fundamentally different in character to other covered institutions?

The moral of all of this generally is that taxpayers need to be extremely vigilant as to whether Government intervention repairs the banks and building societies, or merely affords an opportunity to those who control them to enrich themselves through ‘adjustments’ that would never see the light of day if Brian Lenihan was not standing by with buckets of your hard-earned money! The issue concerns what is called ex post accountability - whereby problems are resolved after uncertainty has been resolved, or thought to be resolved. But as we are living in a country where the Finance Minister indicates that serving politicians are to forego political pensions, while serving in elected office and less than two weeks later his boss indiciates that this measure will only apply to the politicians of tomorrow, doesn't inspire confidence that this Government has the savvy to really understand the implications and vulnerabilities of its bail out initiative.