“Now we potentially have the worst of all worlds..”

In the Sunday Business Post, David McWilliams spots another potential problem with the Republic of Ireland’s bank guarantee scheme, “by placing the weaker banks in the state on a par with the stronger ones”, and he invokes Gresham’s Law – named after Sir Thomas Gresham (1519-1579) founder of the Royal Exchange. By way of an aside, interesting to note that Gresham’s Law, “bad money drives out good”, could actually be called Copernicus’ Law.. but then it did take the administrative genius of Sir Isaac Newton to address the problem of the debased coinage of the time. And Gresham College [established 1597] provided the first meeting place of Those [Royal Society] Guys, on 28 November 1660, as well as, from September 1664, the lodgings of Robert Hooke as the soon-to-be Gresham Professor of Geometry, one of his many roles, where he gave free public lectures and lived until his death in 1703. Three weeks after Hooke’s death the trustees of Gresham College notified the Royal Society to hand over the keys and remove themselves and their belongings.. And, IIRC, Robert Hooke actually proposed decimalisation as part of his solution to the debased coinage.. ANYway, from the Sunday Business Post article.

A conspiracy theorist might suggest that the weaker banks have pulled a stroke over the bigger ones – AIB and Bank of Ireland – using the Department of Finance in the process. Surely not? Could this happen in our clear-thinking country? Could our Department of Finance favour one bank over another? Never!

More likely, the scheme was drawn up with political considerations in mind – with the government under pressure from the opposition not to be seen to put taxpayers’ money at risk. For the economy in general, the worst aspect of penalising all the banks for the sins of one is that it smells and looks like the discredited Japanese model. It means that we have tied the whole banking system up in knots. This can only slow down any recovery of the banks.

It would have been far better to have followed the Swedish or Swiss approach, by sticking to the three-phased programme, weeding out the guilty while recapitalising the system using government preference shares. Now we potentially have the worst of all worlds. The moral of the story is that, when you try to satisfy the left- and the right-wing, you end up with a dog’s dinner. This is hardly the best platform for recovery.

  • 6countyprod

    Nothing to do with the thread, Pete, but take a look at this!

  • willis

    You could have told me to put on shades!

  • willis

    Any how

    The great thing about your posts Pete, is that you know where they come from before you scroll down.

    Erudition writ large.

  • paul mckenna

    “The great thing about your posts Pete, is that you know where they come from before you scroll down.

    Erudition writ large.”

    Think you spelled self-indulgent incorrectly in your otherwise brilliant post. It doesn’t begin with an ‘e’. Oops, I wrote brilliant, I meant to say embarrassing…

  • Pete Baker


    If we could focus on the actual topic, rather than the aside..


    Everyone’s a critic..

    Well, not everyone.

    Thanks, willis.

    Let’s just hope we don’t need an Isaac Newton to address this problem..

    Although a polymath like Copernicus might be useful..

  • borderline

    why debate a topic when pete baker explains it all in the intro?

  • Dave

    It’s good that McWilliams is beginning to slowly backpedal from his earlier position of giddy cheerleading for the intervention of the government in the free market, realising – belatedly – that government intervention serves to make a bad situation worse, not better.

    It is, however, far better that the banks should agree to assume responsibility for each other’s debts in default than that the taxpayer should be the first port of call for creditors. Clause 2.6 gives the taxpayer a layer of protection that they would not otherwise have. McWilliams is correct to argue that this should play havoc with a bank’s balance sheet but it is by no means apparent that it will. It depends on what adjusted accounting procedure that the Regulator uses to absorb the liability if made actual and what models it uses to absorb the contingent liabilities. For example, does the bank assume that all other banks will fail and thereby account for all debts as contingent liabilities? How could it ever know what the liabilities of other banks are unless the Regulator devised the model? If all banks assumed such a model, then the level of debt among them would be multiplied by the number of banks participating in the scheme, giving an artificially high level of debt which would result into an automatic declaration of insolvency of each bank.

    The Regulator has declared that all Irish banks are solvent, so the State guarantee of deposits was designed to address temporary liquidity problems that resulted from the perception among international lenders that Irish banks were insolvent due to high levels of property-related loans outstanding (62% of all lending b Irish banks in 2007 was property-related) and that, ergo, it was best practice not to lend money to these banks until the concerns were resolved. This was good practice by the international lenders. Biffo did a marvellous job of creating the impression among the international community that the Irish banking system was in clear and present danger of imminent collapse. If it was difficult for Irish banks to get loans prior to ham-fisted intervention, it would have been bloody impossible after the oaf’s intervention – thereby forcing the opposition parties to agree to the State guarantee. The fact that the international banks only restored liquidity to Irish banks after the guarantee shows that good business practice among banks is quickly abandoned when the State intervenes to assume the risks of private business.

    And that’s the practical problem with this State guarantee. A private business can only be deemed to behave recklessly if it exposes its shareholders to an unacceptable level of risk. Because the State assumes responsibility for the risk, the bank can never act recklessly. As in the case of the American GSEs (Fannie May and Freddie Mac), when a government gives an implicit guarantee to private business that it will assume responsibility for all risks, then those private businesses literally have nothing to loss – they have a risk-free model of acquiring wealth and, naturally, they take full advantage of it. In the Irish case, the guarantee is explicit, so the level of ‘recklessness’ (again, it is now impossible for a bank to be reckless) will increase accordingly unless the Regulator becomes a de facto partner in the management of the business – and having bureaucrats running businesses in highly complex and competitive industries never works.

    If the banks required short-term liquidity, then they should have approached the Irish Central Bank for a loan. Of course, the Irish government would have to request permission from the EU for that option because they have transferred sovereignty over Irish monetary policy to that organisation’s European Central Bank. It is hard to fathom why they didn’t go that route since the route they took also required the permission of the EU (they didn’t get it so they acted ‘illegally’). At any rate, it shows the folly of transferring sovereign powers to third parties, thereby hamstringing the ability of the government to act in the national interest as and when required.

    There are many ways a bank can raise capital (it can issues shares, sell assets, etc). The perception problem could have been resolved by a pro-active Regulator contacting the lenders and stating that the bank was solvent and demonstrating that his auditing and monitoring procedures were sufficient. If any fail was insolvent, then it should have been allow to fail. All that happens is that it declares bankruptcy and its shares are then sold to new owners to raise the capital that the bank needs to restore liquidity. The only risk here is to the shareholders of the ‘troubled’ banks. So why were they protected and the taxpayer (and other shareholders of solvent banks) protected?

  • Dave

    Typo: “So why were they protected and the taxpayer (and other shareholders of solvent banks) [b]not[/b] protected?”

  • Dave

    “The fact that the international banks only restored liquidity to Irish banks after the guarantee shows that good business practice among banks is quickly abandoned when the State intervenes to assume the risks of private business.”

    Just to make this less obscure: The international lenders were wary of lending money to other private businesses where they had reservations about their solvency. This is responsible lending. Clearly, money should not be lent to a business that may go bankrupt. However, the intervention of the State had the outcome of persuading the international lenders to engage in irresponsible lending. The international lenders were persuaded to disregard their new-found anxiety about only lend money solvent customers and to lend money to other private businesses irrespective of issues pertaining to solvency. As far as those international lenders are concerned, they now don’t care about the creditworthiness of the customer because the State has assumed the risk, guaranteeing repayment of the loan irrespective of the ability of the customer to repay. In other words, the lenders adopt irresponsible lending practices because they can transfer the risk in the business transaction to third parties. This is a classic example of what happens when government underwrites the risk of private business. Of course, now that Irish banks are all lined up by Clause 2.6 as a chain of dominoes…