Governor Honohan hopes Irish banks will get private funding for capital requirements in the future

By Sean Whelan, Economics Correspondent

Will the Irish banks need more capital?

Yes they will, says the governor of the Central Bank, Patrick Honohan.

He is sure because the new Basel 3 international banking rules change the classification of what counts as bank capital, and this will need more money – about €6 billion I hear.

That may not be a serious issue, for reasons outlined below.

But what about the known-unknown – the risk of more losses emerging in the mortgage and SME lending books of the banks?

That question can only be answered by running another stress test on the banks, and it looks like that is going to happen in the autumn. If the stress test reveals a new capital hole, it could do big damage to the Irish recovery story.

But first, let’s deal with the capital we know the banks will need, and why it’s not such a big deal.

The Basel 3 rules set higher targets for how much capital banks need to hold, and what counts as capital.

A big impact here in Ireland will be the ending of the bank’s ability to classify tax losses as part of their capital base.

It may make sense to classify tax losses as part of a bank’s capital structure from an accountancy point of view, but not if there’s a liquidity or solvency issue, as you can’t sell a tax loss on a failed business.

And as the capital structure of a bank is supposed to absorb losses, something that has no resale value is useless.

My understanding is that this change – when it finally comes in, sometime around the end of the decade – will require about €6 billion in real capital for the banks.

This doesn’t automatically mean the taxpayer is on the hook for this amount.

Remember, the ending of the ELG guarantee in March will save the banks up to €1 billion a year (when the covered liabilities are fully run off).

This is money they have been paying to the Government over the past few years, which they now get to keep. Over the next five or six years this could take care of a large chunk of the extra capital required by the Basel 3 changes.

Then there is the banks own internal drive for profitability. Once they start making profits again they can use them to shore up capital (AIB say this could be next year, Davy stockbrokers think it could be the same for Bank of Ireland, PTSB looks like taking considerably longer).

And then there are market sources – investors from the private sector buying into the banks. This is what Governor Honohan seemed to be pinning a lot of hope on, when asked about the bank’s capital needs at the Central Bank’s annual report news conference.

He said strengthening banks capital positions was a multi-year process, and that if at the end of it they haven’t got the banks into a position to attract private investment, then they will have failed in their project.

He also said the target was a percentage of capital, not a cash amount.

His views were expressed after questions on the timing of the next bank stress test (known as PCAR in central bank jargon).

The Troika have been pushing for a test in the early autumn, to have a clearer view on the situation in the banks before the bailout programme ends. The Government wants to run the Irish stress test at the same time that the European Banking Authority, the EBA, does a general stress test on all European Banks.

That was supposed to be in the late autumn, but is now pushed out to next spring, complicated by moves to set up a single bank regulator.

This delay may force the Governments hand, leading them reluctantly to agree to an Irish only stress test in the autumn.

That will leave the Irish banks exposed to the full glare of international scrutiny, whereas being part of the crowd in the EBA test, the Irish banks would be less vulnerable to a savaging from the market wolf-pack.

This is what the governor said:

“We know they (the banks) will need more capital by 2019 because of a number of changes in what is measured as capital between now and 2019, when Basel 3 comes into effect…… in an ideal situation that capital will come from private investors as is happening all over Europe and all over the world, where private capital is being pushed up all through the system.

“Now our banks obviously are still in repair/recovery mode – although Bank of Ireland did get private investment in the last year or so, but it may not be the exact moment to expect large amounts of private capital to go in – so what the PCAR will clarify is just at what point over the next six years additional capital strengthening will be needed – definitely some will be needed – but the PCAR will tell us if there will be some losses in the years ahead, when they move in, and when that capital will be required, and hopefully we will have brought sufficient credibility back to the Irish banking system so that they can add to their capital.

“You know people think ‘oh capital – isn’t that just a black hole’ – it’s not: capital is what people invest in bank shares to get return from them. That is the normal thing – in the middle of a crisis you see the capital eroding , so building capital to the higher levels required by Basel 3 is something where you’re attracting investors in the expectation of a return”.

In other words, if the banks are profitable, private investment will come, and the taxpayer won’t have to cough up more.

In the benign scenario, a growing economy helps to cure a lot of the distressed loans, aided by a swift but not too costly restructuring process, leading to profitable banks surfing on and helping to power a resurgent economy.

But the less rosy scenarios projects a miserable grind, in a stalling economy, leading to higher levels of distressed loans and not enough capital to restructure them in the banks, and none available from the state.

That’s why the stress test will be important in determining whether the banks – which got us into the bailout programme in the first place – are in good enough shape to let us get out of the bailout cleanly.

No wonder the Troika want another peek inside the banks before signing off on the end of the programme.