The Irish deal with the European Central Bank (ECB) and other European central banks to relieve the huge Irish debt burden resulting from the bank bailout four years ago has arrived even faster than predicted here. This is good news. The Irish government can now avoid the €3.1 billion promissory note payment due at the end of March and save some much needed cash. Moreover, the agreement illustrates the political flexibility of the euro area in designing financial support for a member trying to get out from under the tough terms of its rescue by the International Monetary Fund (IMF).
What the Deal Entails
Under the ECB agreement, which took 18 months of negotiations to reach, Ireland will be able to swap €31 billion ($42 billion) of high-interest promissory notes in exchange for long-term government debt that will be easier to pay off. (The notes had been used to bail out Anglo Irish Bank and other institutions in 2010.) The deal demonstrates that euro area governments and institutions have more flexibility—and more options—to secure their financial and political goals than previously thought. Hence the common currency is far more robust than often assumed. With this accord, the Irish government has more time to return fully to financial markets and potentially gain access to a precautionary ECB Enhanced Conditions Credit Line (ECCL), all of which should help pave the way for Ireland to exit its IMF program on time—just before German elections in September. Another advantage of the early Irish deal is that it enables European authorities to deal with Cyprus, Portugal, and the establishment of a new banking supervision and resolution authority.
The technical details of the promissory note swap are worth examining because they reflect several positive developments . The promissory notes issued by Ireland in 2009 were short-maturity (fully repaid by 2025) and high yielding (7 to 8 percent). They were issued to the Irish Banking Resolution Corporation (IBRC) to secure liquidity from the Irish Central Bank and the ECB to bail out several Irish banks, notably the Anglo-Irish Bank. The new €25 billion in lower yielding (around 3 percent) long-term debt, with an average maturity of 34 years, will save the Irish government an estimated €20 billion in financing costs, or 11 to 12 percent of 2012 GDP. "In effect, we have replaced a short-term, high interest rate overdraft that had to be paid down quickly through more expensive borrowings, with long-term, cheap, interest-only loans," Prime Minister Enda Kenny said correctly. The Irish Ministry of Finance noted that the swap "will have significant benefits from a market perspective as it ensures the liability to repay is beyond most credit investors' time horizon." Put another way, over 34 years even, the ECB's low 2 percent inflation target will eat a great deal of the actual costs of this new Irish debt!
The arrangement also illustrates the benefits of dealing with euro area government creditors, which are more flexible and patient than a rules-bound organization like the IMF—which could never have agreed to a transaction like this. In effect, Ireland has obtained help from others in Europe to stretch out its debt and make it payable far into the future—a future so far away that some of its government liabilities might be less costly because they will have been turned into eurobonds when the amortization begins.
A Hopefully Precedent-Setting Liquidation
Another important aspect of the Irish deal relates to the liquidation of the IBRC, and its legacy banks, Anglo-Irish Bank and Irish National Building Society.1 The words "liquidation" and "bankrupt euro area bank" in the same sentence represent welcome news of progress in the euro area's handing of its banking crisis. In Ireland, the IBRC Act was passed literally overnight by the Irish parliament. It provided, among other things, a "stay of all legal creditor actions against IBRC," facilitating its liquidation. A better example of the fast-moving changes to the euro area bank liquidation legal framework is hard to imagine! And even if the Irish government's actions in the IBRC case are challenged on constitutional grounds, the political willingness to proceed to liquidation of large banks—and the ECB's acceptance of such steps—is welcome testament to the euro area progress on these matters.
The liquidation of the IBRC was important because the process protected the ECB and the Irish central bank from losses on their previous loans to the ailing banks (in return for dubious collateral). Equally important, the process will have forced further losses on other creditors and, in theory, even depositors (above a certain threshold). Such an approach vaguely mirrors what the Federal Deposit Insurance Corporation (FDIC) does in the United States—kill off banks rather than let them stagger zombie-like and impose a drag on the entire economy. It would have been impossible to have any kind of deal for Ireland without protecting the ECB and the Irish Central Bank's status as senior creditors. The euro area, which is now writing the legislation to establish its new banking resolution mechanisms, should take note.
The Irish government in its transaction description lists several appreciable elements of the IBRC liquidation laying out how the remaining losses in IBRC will be distributed :
- A small amount of customer deposits remain within IBRC with a significant number of these depositors having connected loans with IBRC. The status of the contractual position of these deposits will be considered by the Special Liquidators.
- The joint safeguards of the Deposit Guarantee Scheme (DGS) and Eligible Liabilities Guarantee (ELG) Scheme remain in place for all eligible deposits (up to €100,000 for an individual and €200,000 for a joint account in IBRC are protected by the DGS and eligible deposits beyond this limit are guaranteed under the ELG Scheme.
- DGS costs are not a cost for the Minister for Finance and will be paid from a Deposit Protection Account maintained by the Central Bank of Ireland.
- It is not anticipated that any payments will need to be made under the Derivatives Guarantee—however, it is not possible to be certain of this outcome.
- Claims are expected under the Eligible Liabilities Guarantee (ELG) scheme. This could cost the State €0.9 billion to €1.1 billion in 2013 based on best estimates.
- There may be a further cost if the Minister is required to make up any potential difference between the consideration paid by NAMA (National Asset Management Agency) for IBRC's assets and the valuation placed on those assets by the Special Liquidators.
- If the value of the assets sold is not sufficient to compensate NAMA for the bonds it has issued the Minister will be required to reimburse NAMA for the shortfall.
- If the value of the assets is greater than the net outstanding borrowings under the Facility Deed, the Special Liquidators will retain the surplus assets for the benefit of unsecured creditors.
- Any remaining assets after the unwinding of all secured liabilities will be available for the benefit of the pool of unsecured creditors (including the Minister due to payments under guarantees, unguaranteed bondholders, suppliers, and sundry liabilities).
- Whether unsecured creditors receive anything depends on the value ascribed to the assets in the valuation process.
- It is not expected that any assets will be available to repay subordinated liability holders.
In essence, Ireland overnight created a legal precedent for imposing losses on all unsecured bank creditors, including depositors exceeding the statutory individual €100,000/joint €200,000 limit and deemed not to "worthy of political protection" through the Eligible Liabilities Guarantee (ELG). At the center of this arrangement is the ELG, which was set up in 2009 to protect Irish bank deposits above the statutory threshold. The ELG also guaranteed eligible debt securities up to five years issued by participating Irish banks, which fund it with a substantial fee. (For this reason, the healthier Irish banks want the fee abolished.) The ELG legislation was recently extended to June 2013 .
As a result of these provisions, the actual number of IBRC depositors facing losses may not be that great. But the importance of the precedent is that in the euro area today—overnight—any depositor above the DGS threshold and not specifically identified in other legislation can face losses. This is not quite what the FDIC does, and it is not settled European law yet, but the direction is promising!
The Complex Ties Between Ireland and the ESCB
As confusing as it might be, the distinction between the ECB and the European System of Central Banks (ESCB) is important, as well as politically useful for the euro area. The ECB (based in Frankfurt) is the top player of the ESCB, which includes each national central bank in the euro area. The existence of a supra-national central bank on top of domestic central banks helps policymakers navigate the treacherous minefield of tensions over national sovereignty in Europe. When it is politically expedient, the ECB's policy actions can be portrayed as a domestic issue between the national central bank and its government. In addition, the distinction affects the treatment of the balance sheets of different parts of ESCB assistance to member state governments.
Early in the European crisis, the Securities Market Program (SMP) of the ECB enabled it to buy distressed bonds of financial ailing peripheral governments like Greece, Portugal, Italy, Ireland, and Spain. These purchases were placed on the consolidated ECB balance sheet and thus underwritten by all 17 member state governments. They amounted to a de facto fiscal transfer in another name, just like the ECB's large-scale liquidity assistance to euro area banks. (This liquidity assistance created large cross-border TARGET2 imbalances on the balance sheets of individual national euro area central banks, though the imbalances are meaningless in a functioning currency union.)
When the ECB felt it could no longer provide financial assistance to euro area governments, for political or financial risk reasons, the ESCB has been there to provide Emergency/Exceptional Liquidity Assistance (ELA) help to banks in individual member states. The assistance would take the form of a liquidity provision by the national central bank to its domestic banks, against collateral of poorer quality than the ECB would accept. This arrangement allowed the ECB (representing other euro area governments) to calibrate the balance between centralized fiscal transfers and domestically provided assistance.
Since 2010, the Central Bank of Ireland (CBI) has prevented an outright collapse of the Irish banking system. Now, the ESCB's ability to accept weak collateral to keep banks afloat—and avoid the fiscal costs of their collapse—means that its ELA program has become the functional equivalent of monetary financing to a national government by the national central bank. The program has thus effectively become a lender of last resort for each nation's domestic banking sector and sovereign government. The entire complex stratagem allows the ECB in Frankfurt to claim that it never engages in such monetary financing, and that it remains within the legal boundaries of the EU Treaty, as German authorities want.
As the arch villain Keyzer Soze noted in the movie, The Usual Suspects, "The greatest trick the Devil ever pulled was convincing the world he didn't exist." In that spirit, Mario Draghi, president of the ECB, could say at his most recent press conference that he took no decision on Ireland, instead explaining: "But on Ireland, let me say this: There was not a decision to take. The Governing Council unanimously took note of the Irish operation and I am going to refer you to the Irish government and the Irish central bank for the details of this operation, which was designed and undertaken by the Irish government and the Irish central bank. I can only say today that we took note of this. We all took note of this."
This is deliberate diplomatic sidestepping. The ELA provision by a national central bank is in fact overseen by the ECB Governing Council, which has the power to block it. No Irish assistance would have happened without approval from the ECB and the governing board. But one must expect plausible deniability from an unelected but powerful technocratic authority, which must hide its real powers to remain legitimate.
The real designers of the Irish transaction are in Frankfurt, not Dublin. In effect, the ECB has signaled that, well before it becomes the chief bank regulator in Europe, it already possesses the power to block the liquidation of a bank until the ECB and the ESCB are protected from financial losses caused by ELA assistance. This super-senior status for ELA in bank liquidations is evidently the ECB and ESCB's political prize for being flexible in interpreting what has amounted to monetary financing in the euro area.
In principle, however, any euro area bank liquidation of course puts the ECB and the ESCB at risk of financial loss, because the central bank takes over ownership of the collateral provided by a collapsed bank. The ECB itself relies on imposed losses, or haircuts, of up to 70 percent on such collateral to protect itself against this risk. But as noted earlier, the risk management policies of national central banks when providing ELA are unclear. No one can know the value of such collateral until long after a crisis, when the liquidated bank's assets are sold off.
How the IBRC Avoids Problems
None of these problems arise in the liquidation of IBRC. The Irish transaction is deliberately complex , taking up four organizational maps in the Irish government presentation of it.2 It works this way. The Central Bank of Ireland (CBI) becomes the legal owner of the IBRC collateral, i.e., both the original high yielding promissory notes issued by the Irish government in 2010 to IBRC and used as collateral with the ECB, and the other IBRC collateral used to secure assistance from the Irish central bank. The Irish government promissory notes on the CBI balance sheet are swapped out in return for longer-dated Irish government bonds. Meanwhile the Irish government's National Asset Management Agency (NAMA), through a special purpose vehicle, is instructed to acquire the other parts of the IBRC collateral, previously pledged to the CBI in return for the national emergency liquidity assistance (ELA). NAMA will purchase these assets from the CBI at par and hence take on the entire financial risk of the underlying assets, providing the CBI with government-guaranteed NAMA bonds. As outlined by the Irish Finance Minister Michael Noonan on February 6, this is specifically designed to protect the CBI from any losses. Minister Noonan noted to the Irish parliament: "It is intended that the net debt owed by IBRC to the Central Bank and its associated floating charge security will be purchased by NAMA, using NAMA bonds, in a way that ensures that there is no capital loss for the Central Bank [my emphasis]. The Ministerial Guarantee underpinning the net debt owed to the Central Bank will also be transferred to NAMA." The NAMA special purpose vehicle will try to sell the underlying assets, with the Irish government pledging to make up any shortfall.
In the end, with IBRC liquidated, there is no need for further ECB or ELA provision of liquidity. The CBI's balance sheet will strengthen as a result of the conversion of IBRC collateral into long-dated Irish government bonds and government-guaranteed NAMA bonds. Appropriately, the losers will be other unsecured creditors of the IBRC and—if asset sales disappoint—the Irish taxpayers, who may have to honor the commitment to NAMA.
Popular concern persists over the perception that this transaction still amounts to monetary financing by the CBI (and thus ESCB). After all, these two entities take possession of €25 billion of Irish government bonds and the government-guaranteed NAMA bonds. To counter that concern, the Irish government specifies : "The Central Bank of Ireland will sell the [government] bonds but only where such a sale is not disruptive to financial stability. They have however undertaken that minimum of bonds will be sold in accordance with the following schedule: to end 2014 (€0.5 billion), 2015–18 (€0.5 billion p.a.), 2019–23 (€1 billion p.a.), 2024 and after (€2 billion p.a.)." Slightly simplified, one could argue facetiously that the CBI's activities will at least be sterilized in the next decade, as the CBI sells its government bond portfolio to private investors!
What the Precedent Should Tell Us About Cyprus
In the end, both the ECB and national central banks in the ESCB (through ELA) remain super-senior creditors in euro area bank windups. The ESCB will never take direct losses from a euro area banking sector collapse. Euro area taxpayers should be happy with this development, because ceteris paribus more financial losses will be pushed on to other private bank creditors in the euro area. To see why the IBRC precedent could be encouraging for the euro area, think of Cyprus. This is another troubled island economy with an excessively large banking system now in deep trouble and in need of an IMF-type bailout.
As discussed earlier on RealTime, the Cyprus bailout is politically tricky and cannot happen without meaningful consolidation of the Cypriot banking system. Emergency liquidity assistance by the Cypriot Central Bank to the island's banks has totaled €9 billion to €10 billion since mid-2012, or about 50 percent of national GDP. Politically, Plan A in the euro area is to try to square the Cypriot circle by securing bilateral financial support from Russia, which holds a large amount of Cypriot debt. But Plan B for Cyprus, if Russia does not cooperate, might look like the deal between Ireland and the IBRC.
As in Ireland, part of the banking system in Cyprus is relatively healthier, while another part is big, rotten, and addicted to emergency liquidity assistance from the central bank. PIMCO is currently evaluating the financial requirements of the entire Cypriot banking system. For hypothetical illustrative purposes, let's focus on the two Cypriot banks that participated in the 2012 EBA capital exercise in which both failed: the Bank of Cyprus and the Cyprus Popular Bank. Table 1 shows the two banks' latest available balance sheet liabilities, as of September 30.
|Table 1 Bank balance sheet liabilities, September 30, 2012 (thousands of euros)|
|Bank of Cyprus||Cyprus Popular Bank|
|Obligations to central banks and other banks||4,129,538||10,158,428|
|Source: Bank financial statements.|
Both are overwhelmingly customer deposit financed, though Cyprus Popular Bank owes more than €10 billion to central banks and other banks. Because few other private banks are likely to lend to these two banks, most of their combined €14 billion in obligations to "central banks and other banks" will be owed to the ECB and the Cypriot Central Bank through the ELA. Thus euro area governments and the IMF can forget about taking haircuts on any of this capital. In any future restructuring of these banks, only customer deposits are available to absorb losses to a financially meaningful extent, because of the limited debt securities and other liabilities issued by the two banks. This situation could leave the euro area with the unenviable choice of having to impose losses on bank depositors or restructure Cyprus's sovereign debt.
Another round of sovereign debt restructuring for Cyprus is not going to happen. But the IBRC transaction suggests how a bank depositor loss might be imposed in an orderly fashion. The Cypriot parliament would copy the Irish example and enact a new bank liquidation framework for its crisis-stricken banks. Such a move would leave out the healthier parts of the Cypriot banking system. The crisis-stricken parts of the system would be expeditiously liquidated, reducing the size of the Cypriot banking system. The ECB and the Cypriot Central Bank would be fully protected (potentially by getting Cypriot government bonds in return for their collateral as in Ireland). At the same time, the few existing bondholders in crisis-stricken Cypriot banks would take losses, but losses would in theory be imposed on depositors above the euro area €100,000 DGS threshold.
But just as the ELG law in Ireland expanded the number of protected depositors and other creditors in the IBRC, Cyprus could specify which additional crisis-ridden bank depositors above the €100,000 threshold would be protected. To avoid systemic contagion, most genuinely domestic Cypriot deposits (i.e., not Russian), including Cypriot bank deposits in Greece and elsewhere in the euro area, would be protected. Why risk another bank run in Greece or anywhere else?
Indeed, the only deposits above the threshold that would not likely be included in the protection afforded by this Plan B would be those traceable to Russia or other murky origins. These would be the deposits hit by losses with limited risk of fomenting bank runs elsewhere following a rescue of the Cypriot system by the IMF, the European Union, and the ECB. Since a Plan B such as this one has been proven to work in Ireland, President Vladimir Putin of Russia might be persuaded to fall back on Plan A or seek to convince the Cypriot government to accept alternative revenue-based ways to secure their longer-term debt sustainability.
The new euro group president, Jeroen Dijsselbloem, was unwilling to rule out such a Plan B at his recent press conference. Instead, the euro group would "only discuss the details" in March! This certainly suggests that he and the other euro area leaders are willing to keep the pressure up while Moscow makes up its mind.