ANALYSIS:Scheme is similar to the solution Sweden used to fix its banks in 1990s

THE DEAL between the British government and its two most troubled banks – Royal Bank of Scotland and Lloyds Banking Group – to place £585 billion of toxic assets into a risk insurance scheme raises the question about whether such a plan could work for Irish banks.

While the dodgy assets in the UK banks include complex, hard-to-value credit market investments, the contaminated assets in Irish banks are primarily property loans to builders and developers.

By insuring the UK banks, Britain aims to cap their losses on toxic assets in a bid to free up lending. This is to stop the institutions becoming “zombie banks”, reluctant to lend in an effort to shore up their capital.

Translating the same scheme to the Irish banks, however, raises difficulties. Minister for Finance Brian Lenihan has already protected Irish banks and building societies to the tune of €440 billion with the State guarantee, so the Government is unlikely to agree another risk insurance plan for the sector.

He told an Oireachtas committee last month that a risk insurance scheme to remove bad loans from the banks would lead to an “indefinite liability” and could be “a time bomb for the taxpayer”.

Instead he floated the possibility of “some uniquely Irish solution”, which could involve moving impaired assets – property loans and the properties securing them – into “a separate property company that would not operate as a bank and which could be capitalised and attract investment in due course”.

To that end, the Minister has hired economist Dr Peter Bacon to assess whether there is an appropriate tailored Irish solution.

There is also a sense of urgency attached to devising a solution. The head of the European Commission’s competition directorate, Philip Lowe, said last week that EU governments must submit restructuring plans on how they intend to resuscitate their banks and added that many of these plans will be assessed before July.

Judging from Lenihan’s comments, the creation of a bad property company to solve the problem of toxic assets is officially gaining credibility. So how would the plan work and what are its merits?

One detailed proposal within official circles centres around the Minister’s suggestion. Under the option being considered, the banks would move capital equal to 30 per cent of the value of their toxic loans to the “bad company” to cover them.

This closely follows the Swedish solution used to fix its banks following their collapse in the 1990s.

By removing the bad loans, the Government, as the instigator of the scheme, would create good banks out of the troubled lenders.

This would reduce the taxpayer’s exposure under the State guarantee as the cleansed banks would be regarded as lower risk by bond and debt investors in the lenders.

Without bad loans weighing them down, the institutions would be more profitable as they would no longer have to continually set aside more and more in provisions to cover rising loan losses. They would grow their capital ratios and become freer to provide more new loans.

By moving capital to the bad property firm, each lender would take a stake in the venture. The Government would take “a special share”, which gives the taxpayer a stake in any potential profit made on working out the bad loans. Each bank would relocate a team of lending managers to work out the loans in the bad company.

The key to the scheme’s success is two-fold – the guaranteed lenders must move all possible toxic assets to the company and the Government must set the right “transfer value” on the assets. If this value is set correctly, the Government will ringfence any capital it has invested in the banks and put a floor under the capital requirements for the entire sector.

However, if, at 30 per cent, the Government sets the wrong capital weighting against the bad assets and property values fall further, Lenihan can raise more capital for the bad property company by levying the entire sector and investing this in the company.

A valuation committee comprising accountants, auctioneers and the Financial Regulator could assign a value on the assets. Auditors at present are battling with “point in time” or “through the cycle” valuations. Moving toxic assets would allow values to be assigned over time without leaving banks hamstrung in the interim.

Difficulties arise with “co-mingling” bad assets from the various lenders. However, dealing with the same type of bad loans in one entity would create a unified solution to an industry-wide problem.