Eoin Fahy, Chief Economist with Kleinworth Benson Investors has produced an excellent summary of the recently announced EU/IMF support package. With his kind permission, it’s reproduced below.

Last night’s announcement of the details of the EU / IMF support package contained some elements that were as expected, but others that were genuinely surprising. The key issue now is the reaction of depositors. 

Key Features:

• The package will total €85bn.  
• Of the total, €35bn will be used to support the banks, and the remainder is to finance the Government’s own requirements.  
• Ireland will itself provide €17.5bn of the total, from existing cash reserves and the National Pension Reserve Fund.   
• The EU and EU governments will supply two-thirds of the external amount of €67.5bn, and the IMF will contribute the other one-third.
• The average interest rate on the €67.5bn being borrowed, if it was all drawn down today, would be about 5.8%  That’s about as expected, and is in line with the average interest rate assumed in the National Recovery Plan published last week.  
• The loans will on average be for 7.5 years (longer and therefore more expensive than the three years that Greece borrowed for).
• €10bn will be used to ‘immediately’ recapitalise the banks, and another €25bn is contingent funding available for the banks if they need it over the next three years.
• Excluding Anglo Irish Bank and Irish Nationwide, the four other banks will have to have a core “Tier 1″ capital ratio of at least 12% within a few months (up from the old 8% target), and this and other measures together mean that the banks now have to raise an extra €8bn in capital, over and above the amounts they had already been told to raise (about €5bn).  Presumably this extra €8bn will in practice all come from the €10bn set aside in the overall package for immediate recapitalisation, although Bank of Ireland stated last night that it would seek to raise the €2bn it needs from other sources.
• The four banks will be examined again in March, at which time external independent assessors will look at the asset quality in the banks.  If there is a risk at that stage that their capital ratio might fall below 10.5% in a stress scenario, they will have to raise still more capital then.
• The four banks have been given until the end of April to sell more non-core assets to reduce the amount of capital and liquidity that they require.  The Government will, if necessary, provide ‘credit enhancement’ to assist with the sale.  In essence this probably means that the Government will indemnify buyers of those non-core businesses against certain types of losses in the future.
• Land and development loans between €5m and €20m will after all be transferred to NAMA (losses on these loans were taken into account in calculating the total amount of capital the banks require).
• This all means that AIB will need €10bn in capital by February, Bank of Ireland will need a little more than €2bn, also by February, and EBS will need about €1bn by December. Irish Life and Permanent has until May to  raise a more modest €0.24bn.  These are the NEW totals: these banks had already been told that they needed to raise about €5bn between them.
• The capital required for Anglo Irish Bank and for Irish Nationwide was not announced, presumably as their restructuring plans have not yet been approved by the EU.
• Senior bank bondholders will not be affected, as it was agreed that to make senior bank bondholders take a hit would destabilise the European banking system.
• Ireland will now be allowed an extra year to get its deficit down to the 3% of GDP target, if required.  So the target year moves out from 2014 to 2015.  This is quite significant as obviously it gives some leeway if economic growth turns out to be somewhat slower than expected (a genuine concern for the financial markets).

 

How Much Will This Cost?

Of the €67.5 Ireland is due to borrow, about €50bn was due to be borrowed anyway over the next three years, to finance the deficit and maturing debt. So for that €50bn, the cost, if any, is the difference between the 5.8% that Ireland will pay, and whatever rate it would have paid if it had been able to borrow the money on the financial markets.  At the moment that latter rate would arguably be considerably higher than 5.8%, so there is no extra cost on that basis.

The remaining €17.5bn can be broken down into an amount of €5bn which will be drawn down immediately to recapitalise the banks, and another amount of €12.5bn which may or may not be needed, depending on whether the banks turn out to need the money.  If it is all needed, the cost of €17.5bn at 5.8% is about €1bn p.a. In addition to that, of course, Ireland will lose whatever interest it now gets on its cash reserves, but that’s likely to be quite small.

As an aside, it is conceivable, if by no means certain, that the capital that the state is putting into the banks could begin to earn dividends and/or rise in value over some years, if the economy returns to reasonable growth and the banks eventually return to profitability. 

Will the immediate €10bn for the banks, plus an additional €25bn in contingency funds, be enough to properly capitalise the banks?

The amounts that the four banks need in capital are calculated on the basis that all four need to have a core equity capital of at least 12%, and in addition that even in a stress scenario they maintain core capital of more than 10.5%.  That compares well with other European banks, and of course there is another €25bn of standby funding if they need to get even more capital than that.  So if markets, and depositors in particular, are rational, the €35bn should in fact be more than is needed to stabilise the banks, from a capital point of view.  (One caveat though is that it isn’t clear whether any of the stand-by €25bn might be needed for Anglo, in which case the amount available for the four main banks will decline).

 

Q: If the banks have more than enough capital, does that solve their problems?

Not necessarily.  Banks have to address their shortage of liquidity as well as their shortage of capital.  And liquidity is a real problem for the banks as they have seen depositors withdrawing funds on a large scale in recent months.  The ECB and the Central Bank of Ireland have stepped in to fund the resultant shortage of liquidity, but it is very clear that the ECB is uncomfortable with doing this, and would ideally like to reduce the banks’ dependence on this emergency funding, which probably amounts to about €100bn at the moment.

This means that how depositors react to this package is absolutely crucial. Will depositors look at the huge amount of capital available to the Irish banks and conclude that they are among the world’s best-capitalised banks (taking account the €25bn of stand-by funding), and therefore perfectly sound banks with which to place deposits or lend funds?  If so, liquidity will return to the banks and they will be both well capitalised and liquid.  

On the other hand, depositors could just take the view that there are plenty of other banks to deposit with, which don’t have any question marks at all,  and so continue to avoid Irish banks. If so, the banks will be well capitalised, but not very liquid, and ECB emergency liquidity funding will have to continue for a long time, and perhaps even have to be expanded - if the ECB is willing, of course.

At this stage it is just not possible to determine how depositors, and particularly international depositors will react.  But certainly we will all be watching this very closely. By the end of January 2011 we should have a good idea of how depositors in the Irish banks are reacting to the package. 

Q: What about the €50bn for the Government’s own financing needs, will this be enough?

If future deficits are as expected, the €50bn amount would be enough to finance Ireland’s deficits, plus bond redemptions, for the next three to four years, so yes it does appear to be enough.  Of course, if economic growth turned out to be far lower than expected the deficits would be larger, so the money would not last as long.

On the other hand, of course, if the Government can return to the bond markets at any point in the next couple of years, it would not require all of the €50bn, as would also be the case if economic growth was much higher than expected.

 

Q; When will the Government be able to, and want to, borrow from the bond markets instead of the EU/IMF?

Presumably the government will try to borrow from the markets as soon as something like normality returns to the bond markets, or in other words when (if) the Irish bond yields returns to 6% or below.  It’s safe to assume that the authorities here would far prefer to borrow in the normal way from the markets rather than rely on this emergency package.  But there is of course no way of knowing when that might be.

 

Q: What is the single biggest risk to this plan?

Confidence is the key issue.  If depositors and other market participants believe that the plan will work, it will work even if in fact it is flawed.  Conversely, even if the plan is superb, it won’t work if the markets don’t believe it will work. 

Within quite a short time, we should have a good feeling for whether the markets, and particularly depositors, have confidence in the Irish banks.  That is the key thing to watch over the next few weeks.”

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