This article was written by Professor Karl Whelan of UCD and published in Business and Finance November 2011.
Debates about burning bondholders who have already been repaid misses the point. It is all about promissory notes, writes Karl Whelan.
The repayment of a $1 billion unguaranteed unsecured Anglo bond in early November generated a heated debate about the burden that bank’s debts are placing on the Irish taxpayer. Most of this debate has focused on the question of whether it is fair for the Irish taxpayers to repay these bondholders.
One could debate the merits of the ECB’s position on Anglo bonds until the cows come home. However, the vast majority of the bonds of Anglo and Irish Nationwide, now combined to form the Irish Bank Resolution Corporation (IBRC), have been repaid. In addition, the bond debts of Bank of Ireland and AIB will end up being honoured both because these banks are now solvent thanks to massive taxpayer investments and write-downs of subordinated bonds.
So the debate about bondholders is largely a too-little-too-late affair. Strangely, however, there has been very little public discussion about a far more significant issue: The need to repay Emergency Liquidity Assistance provided to Anglo and Irish Nationwide. This issue is somewhat technical but I’ll do my best to explain it in simple terms.
Banks that cannot obtain market funding from depositors or bond investors often borrow from central banks as an alternative. Within the Eurosystem, the standard procedure for these loans involves banks pledging some financial assets to their national central bank as “collateral” which can be kept by the central bank if the borrowing bank does not pay back. If this collateral still does not cover the amount loaned out, the losses incurred by the central bank are shared with all the other central banks in the Eurosystem.
In general, the collateral required to obtain loans from the Eurosystem should be marketable assets of high quality. During the crisis, all of the Irish banks used up all their eligible collateral but still needed extra funding to pay off bonds and deposits.
Instead of regular Eurosystem loans, the Irish banks received what is known as Emergency Liquidity Assistance (ELA) from the Central Bank of Ireland. The Central Bank of Ireland is legally allowed to give these loans unless the ECB Governing Council finds by a majority of two thirds that these interfere with the objectives and tasks of the Eurosystem.
In practice, this means that the Central Bank of Ireland had to consult with the ECB Governing Council (whose twenty three members consist of the seventeen national country governors and the six members of the ECB Executive Board) to set the terms of its ELA operations. These terms included a guarantee from the Minister for Finance that the ELA would be repaid but no official timeline for repayment has been published.
The ELA is recorded on the Central Bank’s balance sheet under the heading “Other Assets” and this category rose from only a couple of billion euros before the crisis to €70 billion in February. This had fallen to €48 billion by October as money from recapitalising banks and selling off assets was channelled towards repaying the ELA.
At this point, the vast majority of the outstanding ELA, about €42 billion by my estimate, is owed by the dreaded IBRC. In fact, the ELA now appears to account for about two-thirds of the debts of the IBRC.
Unfortunately, the balance sheet of the IBRC shows very little in the way of good financial assets likely to yield funds to repay this enormous ELA debt, equivalent to almost €10,000 per man, woman and child in the Republic.
IBRC’s principal assets are what is known as “promissory notes” from the Minister for Finance. These notes promise to provide Anglo with €3.1 billion on March 31 every year up to 2023 and then an additional €7.6 billion in payments up to 2031. These notes currently account for 20 percentage points of GDP of our national debt and the interest payments on the notes will continue to be added to the debt in the coming years.
It is important to emphasise that even though the ELA repayments are going to the Central Bank of Ireland, a public sector body, there is no hidden benefit to the state from these repayments. The Central Bank will take in its €3.1 billion annual payment and then deduct this from the value of its ELA asset. On the liability side of its balance sheet (which shows how much money the Bank has created) it will reduce “other liabilities” by €3.1 billion because this repayment is effectively siphoning off part of the money that was created in the original ELA operation. In this case, no new securities are purchased by the Bank. It is as if the €3.1 billion is being burned.
It is true that the Irish taxpayer has taken on far too big a burden in ensuring that bondholders at Anglo and INBS were repaid. But quibbling about bondholders misses the elephant in the room. It is the huge burden of repaying ELA, not bondholders, that is going to bleed the taxpayer dry for the next twenty years.
It is time for the Irish government to declare that it has no intention of putting €3.1 billion towards repaying ELA in March and that it has arranged an agreement in principle with the Central Bank of Ireland that the state will repay this debt when it has fully recovered from its current crisis.
If my understanding of the legal situation is correct, then Patrick Honohan would only require the support of seven other members of the ECB Governing Council to proceed with this plan. This could easily be achieved with the support of Mario Draghi. Ireland has borne a heavy burden in the name of European financial stability. It’s time for a quid pro quo from super Mario.