A bank funds its loans not only with deposits placed by its depositors and by its common equity shareholders. Indeed, in recent years, customer deposits and equity formed a diminishing fraction of Irish banks‘ resources, and they became dependent on other sources, including large amounts coming from abroad.
Thus in particular, banks also (i) borrow money from other banks, financial institutions, large companies and public institutions, often pledging collateral (or through a collateral-like mechanism called repo); (ii) issue uncollateralised debt instruments (e.g., bonds, notes or corporate paper) at various maturities ranging from a few days up to several years; (iii) issue asset-backed securities such as covered bonds – this was not a large part of Irish banks‘ business in the run-up to the crisis;172 and (iv) issue explicitly subordinated debt instruments, preference shares and other instruments which explicitly rank behind deposits and other debt.
Regulators insist that a certain fraction of the bank‘s assets be financed by risk capital, made up mainly of equity and various forms of subordinated debt which rank behind the rest of the bank‘s debt in a liquidation. The purpose of these regulations is to ensure that the bank can (a) survive despite losses, if the losses do not exceed the equity (b) depositors need not lose even if the bank becomes insolvent, if the losses do not exceed the sum of the equity and the subordinated debt. Equity can be seen as going concern capital, because it can be replenished before the bank becomes insolvent; while subordinated debt is gone concern capital – which need suffer loss only in the case of insolvency.
The various forms of non-equity capital which make up what we are calling subordinated debt can be divided into two main groups: those which qualify as ―upper Tier 1‖ capital – in particular these must not have a fixed redemption date, and the rest.
In addition to the fixed redemption date, at which bonds must be repaid, there can, however, be an earlier date at which the bank can choose (with the approval of the regulator) to repay. The practice has been to repay at this earlier date, and some argue that to do otherwise is almost like a default, though that is not legally the case.
172 Though notoriously it was central to the problems emanating from the US mortgage market.
Loss allocation
The isolated failure of a bank entails costs which will be borne by some stakeholders.
Even from the narrow contractual point of view of the direct financial losses, it is an important policy issue as to whether to intervene in the loss allocation that will result from the liquidation of the bank and the distribution of the proceeds to the creditors in accordance with their strict priority: shareholders to bear the first losses, then subordinated debt holders before the rest.
Containment and loss allocation are logically separate aspects of financial crisis management, but different containment measures can have implications for what is possible in terms of loss allocation. This is most evident in debt-insurance schemes, but is true for other measures also. An injection of equity capital protects all more senior creditors of the bank, for example, whereas ELA can protect (by allowing the exit of) depositors, but leaves equity and subordinated debtholders at risk. The Irish guarantee in effect protected all creditors with claims of less than two years‘ remaining maturity.
Of course, the failure of one or more systemically important institutions will entail losses going well beyond the contractual claimants on the bank‘s assets. It is indeed for the purpose of protecting some of these innocent others that governments may do well to choose an allocation of the direct financial losses that seems arbitrary or even regressive.
When considering the allocation of losses in the case of an insolvent bank, there is an important difference in the law between the United States on the one hand and Ireland (and the UK) on the other. Since 1993, US law gives depositors priority over bondholders and general creditors in their entitlement to be paid out of the proceeds of a bank liquidation. Irish and UK law make no such distinction: unless explicitly subordinated, bond-holders are entitled to share pari-passu with depositors and other general creditors. This is an important distinction presenting complications to the idea of discriminating between such creditors in a liquidation.
The relative importance of different funding sources in practice
Market value of shareholders‘ funds in the four listed Irish banks peaked in 2007 at an aggregate of around €60 billion. Market value of equity of course takes account not
only of the book value (share subscriptions and retained earnings, etc.) but also the market‘s expectation of future profits. Aggregate book value of shareholders‘ equity in these banks at the end-year balance sheets on or before end-September 2008 was €22 billion. Considering that most of this value is being wiped out by actual and prospective loan losses (the value of the life company in ILP being an exception), and the current estimates of the long-term direct fiscal cost of interventions to recapitalise the banks at around €25 billion, it can be argued that the State has paid for roughly one half of the banking losses; the shareholders for most of the rest. (That does not take account of the knock-on or indirect effects of the worsening of the recession exacerbated by the banking failure, which have been borne widely.)
Chart A4 shows the funding sources of AIB and Anglo in 2007-08, broken down into these categories. Note that less than half of AIB‘s funding came from customer deposits and about half of that for Anglo.173 Senior, i.e., unsubordinated debt accounts for between a sixth and a quarter of the financing sources, with banks (including central banks) representing another large element. Equity and subordinated debt represent only a relatively small cushion.
Table A4: Tier 2 Sub Debt, etc. in the Banks according to their 2008 Reports
€ billion Dated
sub-debt
Undated sub-debt, etc.
Shareholders’
funds*
AIB 3.0 1.6 8.4
Bank of Ireland 4.6 3.2 6.5
Anglo Irish Bank 2.1 2.8 4.1
Irish Life and Permanent 1.1 0.6 2.3
Irish Nationwide Building Society 0.3 0.0 1.3
Educational Building Society 0.3 0.0 0.7
Total 11.4 8.2 23.2
* Reserves in the case of Building Societies
Most of the banks covered by the end-September 2008 (CIFS) Guarantee conduct sizeable business (both assets and liabilities) outside the State. Heading into the guarantee they had sizeable net liabilities to non-residents: about three-quarters of the debt issued by these banks was held abroad, while about a quarter of the deposits (from nonbanks) were held by non-residents.
173 The customer deposit figures for Anglo do not include the large deposit received from ILP at end-September 2008.
About a half of deposits were held by individuals – the bulk of the remainder were held by nonbank financial institutions and nonfinancial firms. It can be assumed that a large fraction of the personal bank deposits were owned by relatively well-off individuals.
Indeed, judging from data available for other countries, aggregate bank accounts of individuals in the bottom half of the income distribution likely accounted for well under 10 per cent of total personal bank accounts. All of the bank deposits of these individuals were fully covered by the permanent Deposit Guarantee Scheme. So the guarantee protects the less well-off not directly by covering their bank deposits (if any), but by underpinning the functioning of the economy which provides employment and generates the tax revenue needed to pay for public services. Relatively little of the guarantee goes to protecting the bank deposits of the more prosperous members of society – though it does do that, in effect socialising their losses.
Chart A4: Composition of the liabilities of AIB and Anglo Irish Bank
Source: AIB, Anglo Irish Bank annual reports.
AIB
B anks
Depo sits Debt
Other Sub debt
Equity
Anglo
B anks
Depo sits Debt
Other Sub debt
Equity