Most independent economists think that the Government has basically taken the correct strategy on the budget. But many have real difficulties with the Government’s approach to the banks. Over the next few posts I am going to analyses the banking situation and explain why I (and other economists) have such a problem with Government policy.

The basic problem is that the government has shifted far too much of the cost of cleaning up the banking mess on to the  shoulders of the taxpayers. In the end there has been a bailout – but not a bailout for developers. It has been a bailout for bondholders. In order to understand why the government did this and why most independent economists think this is a bad idea, we have to take a step back and think about how what a bank actually does.

Basically a bank takes money from depositors and lends it out to borrowers. The bank makes a profit by charging borrowers higher interest than it pays its depositors. So far, so obvious.  But what happens if some of the lenders default on the borrowings from the bank? In that case the bank could seize the borrowers’ assets, sell them off and use the proceeds to pay off the loan. But what if these proceeds were not enough to meet the loan? If the gap is large then the bank would not have enough money to payback its depositors and the bank itself would have to default. The depositors would bear the loss. They would probably get most of their money back through normal bankruptcy proceedings– but not it all.

Obviously this is not desirable from the point of view depositors. So over the centuries, the practice grew up of the owners of banks putting up some money so that they could guarantee that depositors would be paid even if borrowers defaulted. This “up front money” is the so called “equity” or “capital” that we keep hearing about. Nowadays, this equity is required by law and international treaties with various different technical requirements (such as the Tier 1  2 capital requirements you keep hearing about).

From the above discussion it is clear that the system has a problem. What happens when the borrowers default to such an extent that the losses are greater than the “up front” money put up by the banks owners? Answer: the bank must default on depositors — unless somebody does something.

Somebody did do something in September 2008 when the government announced it would guarantee the banks’ liabilities.

The became necessary because large sections of the banks assets (i.e. loans) are about to default. The focus initially was on the large loans to developers. But eventually there will be defaults on some mortgages, car loans credit cards etc. Default in itself is not the problem. If the borrowers defaulted the bank could seize collateral. The problem now is that almost of the collateral is property related and is therefore worth much less than the value of the loan it backs. How much less? We don’t know, we can only estimate. For the sake of simplicity let’s assume that the assets are now worth 50% of the loan book (this would be in line with my analysis of the housing market given here). This would wipe out the equity in most of the banks. In the light of the September guarantee, the difference would be met by the Irish Taxpayer. This is the root cause of the cash that we the people have had to throw at our banking system. In the next few posts, I will take a more nuanced look at some aspects of the government’s plan.

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