IRISH RESCUE IS EXPENSIVE STICKING PLASTER / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( VERY HIGHLY RECOMMENDED READING )

Irish rescue is expensive sticking plaster

By Gerald Holtham

Published: November 22 2010 11:05

There are only two ways out of the Irish crisis. The first is what is likely to happen: following Ireland’s finance minister agreeing to apply for a bail-out loan on Sunday, European states will pick up the tab for bailing out Irish banks, and leave the mess elsewhere for another day. But this is unfair to European taxpayers, conducive to moral hazard, and highly unlikely to solve the underlying problem.


The other, better option is to address the problem of European Union banks as a whole.

To do this a ruthless mark-to-market analysis of the balance sheets of all European banks is now needed – the only way to find out how much their assets are actually worth – followed by a continental rescue plan.


Europe’s politicians do not want to consider this. As they imposed a bail-out on Ireland, the poor Irish protested that they are not like Greece. And they weren’t: their government did not follow a profligate fiscal policy; indeed, in recent years it has been draconian.


But Ireland is like Iceland. Their banks participated in unwise real estate speculations, and their system is now insolvent. The Irish state knew it had to bail-out its banks, but their balance sheets were large in relation to gross domestic product – exactly the Icelandic dilemma.


The Irish know that if their banks fail, their liabilities will fall on other European banks, especially in Germany and Britain. Some of those are fragile themselves. A chain reaction and panic in money and bond markets could easily ensue. In other words, another Lehman Brothers.


German politicians and taxpayers are right to be alarmed. They do not wish to have to make good all the holes in the balance sheets of all Europe’s banks. And so they reason the ultimate solution is that some of the pain should be borne by investors too. It is a reasonable position, but one which caused market perturbations when aired by Angela Merkel, and she had to retract.


The problem is that if you force investors to shoulder some of the losses you cannot move one country at a time. A deal for Irish banks that left bank bondholders with a loss would result in flight from the securities of other European financial institutions.


Instead, a Europe-wide solution is needed. This process would see a new Europe-wide stress test. A European bail-out fund would supply a proportion of the shortfall needed in each bank, in return for equity in the financial institution concerned, diluting equity holders. The remaining shortfall would be met by debt restructuring at the expense of creditors.


With the whole deal worked out and announced as a package, uncertainty would be minimised. It would be too late for investors to flee and there would be nowhere in Europe to flee to. The European Central Bank can provide liquidity to maintain the situation while the deal is being worked out. Contagion could spread to other banks outside the EU, so countries such as Switzerland and Norway should be offered the option of participating.


Working out both the valuations and the proper proportions of bail-out and debt restructuring would be politically testing. Large net contributors to a bail-out fund, along with countries with sound banks, would also want fewer subsidies than others. It is also unclear if the enlarged EU could pull off such a feat of technical analysis and political co-ordination in a reasonable time.


So many will conclude that the EU is simply not up to it, and they may well be right. But the alternative is what we now have: an inordinately expensive sticking plaster, over a wound that is not healing.


The writer is managing partner at Cadwyn Capital LLP, and a visiting professor at Cardiff Business School


Copyright The Financial Times Limited 2010.