In my blog last week on the future for the Irish banks, I looked at a few different things what could happen to the industry in the coming months. In this blog, I’m going to look at another ‘way out’ for the Irish. A “bad bank” scheme is where a bank splits off all of its non-performing assets / bad debts into a “bad bank”, which is then usually managed by the government. It was successfully introduced into Sweden in the early 1990’s and has been adopted by Switzerland in this crisis.

Sweden’s “Bad Bank” Scheme
Financial deregulation in the 1980’s fed a frenzy of real estate lending by Swedish banks. With no regulatory oversight they didn’t worry enough about whether the value of their collateral might evaporate in tougher times (sound familiar). No prizes for guessing what happened next. Yeh, property prices imploded and the bubble started bursting in 1991. By 1992, Sweden’s banking system was, for all intents and purposes, insolvent.

So what did the Swedish government do? Firstly they guaranteed all bank deposits and creditors of the nation’s 114 banks (again to us Irish this’ll sound familiar). But they went a lot further. They acted quickly and comprehensively: investing government funds and setting up “bad banks” to manage the banks non-performing assets i.e. bad debts. The state-owned “bad banks”, named Securum and Retriva, then restructured the non-performing assets before selling them back into the market when the time was right. The initial outlay was about 4% of GDP and, in return, the State received a 20% stake in the banks. Eventually markets stabilised and with the banks reorganised, by 1994, they were back in profit. The Swedish state then sold their 20% stake back to the market. The eventual cost was somewhere between 0% – 2% of GDP, as estimates vary widely. Even if nearer 2%, it was cheap as the economy was swiftly put on the road to recovery.

Switzerland Adopts The Scheme In This Crisis
A nice solution for the 1990’s, but is a Swedish “bad bank” scheme still viable in this crisis? The Swiss government thinks so and have set up a $60B “bad bank” for UBS. What’s happening is that UBS will take the losses on the first 10% ($6B) and then the government will be liable for any potential losses after that. UBS’s benefit is that they now know how much they are going to lose through write-downs. They can now move forward with their normal operations and start planning with more certainty for the future. The Swiss government benefits from a generous yearly payment and a 9.3% stake in the company.

Could It Work In Ireland?
So this “bad bank” scheme is being tried in the current banking crisis too. I think that it could be successfully applied to Ireland.

What would need to happen? Firstly all non-performing assets of the banks would need to be substantially written down; no more of the piecemeal writes-downs we have been seeing. This would reduce the government’s liability.

Once this is done, all the bad commercial and residential loans could be consolidated under the management of the Irish State. They can then appoint restructuring experts to do what is needed for the greater good of the economy. If the cost was 4% of GDP, that’d work out at around €6 billion. But this expenditure could certainly be justified in an once-in-a-lifetime crisis. Plus the government will also have their substantial stake in the banks, which they would sell-off (hopefully at a profit) in a few years time.

Effectively the banks would be passing on their worst loans to a debt collector. But this debt collector, the government, could afford to take more of a long term view to the loans. For example the government could restructure property developer’s debts in a way that gives more benefit to the economy as a whole. Their efforts could ensure a minimum amount of bankruptcies in 2009 and 2010. The mortgages of struggling families could be restructured so that a situation of mass repossessions (such as the one occurring in the US) doesn’t happen here. Essentially the government could do what is needed to ensure a recession doesn’t turn into a depression.

What Will The Government Do?
Right now the government is very reluctant to get further financially involved in helping the Irish banks. Their budget is strained as it is and likely to get worse; they don’t want to have to take on the debts of the banks too. But as the public banks have seen their share prices fall by an average of over 92% from their highs, the industry is dealing with a systemic failure. As Sweden’s Minister for Fiscal and Financial Affairs Bo Lundgren said in 1992 “you can’t rely on the private market sector or markets alone to solve systemic banking problems”. He’s right. The government needs to finally step in and take decisive action.

There are other options open to the government. For a look at them, check out “What’s Next For The Irish Banks”.

How Would Bank Share Prices React?
Any “bad bank” scheme would see a dilution of existing shareholders holdings as the government takes its stake. But significant government intervention is already priced into share prices. In my opinion, the stock market would react positively to a “bad bank” plan. There would be a short term rally in banking share prices as much of the uncertainty would be taken out of the equation. The ISEQ would probably also jump too as other Irish companies indirectly benefit. This belated government move could signal the bottom for the forward looking stock market.

Into the medium term, I think that a “bad bank” solution would result in the Irish banks being a good long bet. They would benefit from getting a lot of their toxic loans off their Balance Sheets. They would also effectively have closure to the open question of how much they are going to lose through write-downs. They would then be able to move forward with their normal operations and start planning with more certainty for the future. It is obviously a long road back to their share price highs of February 2007, but a general “bad bank” could mark the beginning of the end of the banking crisis in Ireland.