UCD CENTRE FOR ECONOMIC RESEARCH WORKING PAPER SERIES 2012 ELA, Promissory Notes and All That:

The Fiscal Costs of Anglo Irish Bank Karl Whelan, University College Dublin WP12/06 February 2012

UCD SCHOOL OF ECONOMICS UNIVERSITY COLLEGE DUBLIN BELFIELD DUBLIN 4

ELA,PromissoryNotesandAllThat:TheFiscal CostsofAngloIrishBank
ProfessorKarlWhelan UniversityCollegeDublin February2012
Abstract:ThisisabriefingpapertheauthordistributedtotheIrishparliamentarycommittee responsibleforfinanceandpublicexpenditure.ItdescribesthebalancesheetofIrishBank ResolutionCorporation,theorganisationthatwasformedbycombiningAngloIrishBankandIrish NationwideBuildingsSociety.ThenatureofthelongruncosttotheIrishstateoftakingoverthe liabilitiesoftheseinstitutionsisoutlinedandsuggestionsaremadeforreducingthesecosts.

1. Introduction
ItiswellknownthattheIrishstatehastakenonhugedebtsbytakingoverliabilitiespreviouslyowed by privatelyowned banks, with the majority of this cost related to Anglo Irish Bank and Irish NationwideBuildingSociety,whichhavebeenmergedtoformtheIrishBankResolutionCorporation (IBRC). The total cost of taking on these liabilities has been about 35 billion or 22 per cent of Irelands nominal gross domestic product in 2011. Without this cost, Irelands debtGDP ratio in 2011 could have been 85 per cent, roughly in line the Eurozone average, rather than the 107 per cent that was recorded. It is possible that without the cost of absorbing the IBRCs liabilities, Ireland may have maintainedaccesstosovereignbondmarketsandthusavoidedanEUIMFprogramme. It is also well known that a significant fraction of the funds provided by the state to the IBRC have gone to pay off unsecured bondholders and, perhaps for this reason, much of the domestic and international commentary has focused on the idea that the Irish government should change its policyinrelationtopaymentofunsecuredIBRCbondholders. It is worth stressing, however, that the amount of IBRC bondholders remaining is small when comparedwiththetotalcostofbailingouttheseinstitutions.Instead,themajordebtburdendueto the IBRC relates to promissory notes that the Irish government has provided, which in turn are largely being used to pay off socalled Exceptional Liquidity Assistance (ELA) loans that have been providedbytheCentralBankofIreland. ThispaperdiscussesthefiscalcostsoftheIBRCbailout.Theissuescoveredareasfollows: ThebalancesheetoftheIBRCandthecrucialroleplayedbyitsELAdebts. TheprocessofgrantingandrepaymentofELAandtheroleoftheECBinthisprocess. Thefunctionofthepromissorynotesandtheireffectonofficialdebtanddeficits.

Unfortunately, there are a lot of complex details associated with various aspects of the IBRCs relationship with the Irish government, the Central Bank of Ireland and the Eurosystem of Central Banks,sothisnotefocusesatlengthonanumberoftechnicalities.However,Iwouldflaginadvance thatthekeypolicyimplicationisasimpleone. There are a number of ways that the burden of the debt incurred in the IBRC bailout could be reduced,bothintermsofneartermfinancingdemandsandlongertermnetpresentvalue.Thekey obstacle to such a restructuring is that any plan of this type can be blocked by a twothirds majority oftheECBGoverningCouncil.Despitetheimpressionthatthisisacomplexissuerequiringtechnical discussions, the key question is whether the members of the ECB Governing Council are willing to lower the burden on the Irish people due their governments decision to take over the liabilities of AngloandIrishNationwideandensurethatitsdepositorsandseniorbondholderswererepaid.

2. TheIBRCsBalanceSheet
TounderstandthenatureofthefiscalburdenassociatedwiththeIBRC,thebeststartingpointisthe institutionsbalancesheet.TheIBRCwasformedonJuly1st2011byamergerofAngloIrishBank andIrishNationwideBuildingSocietybothofwhichwerebeingwounddownafterhorrificlosseson propertyloans.Table1onthenextpageillustrateshowtheliabilitysideofAnglosbalancesheet evolvedoverthepastfewyearsusinginformationfromthebanksannualandmidyearreports.

2.1.

AngloIrishBank

Attheendof2007,priortothefinancialcrisisthatrockedIrelandfromlate2008onwards,Anglo had58.4billionindepositsand23.6infundingfromdebtsecurities.Thesubsequentyears,amid financialcrisisandnationalisationofthebank,sawthevastmajorityofthesedepositspulledfrom thebankandasubstantialreductioninfundingfromdebtsecuritiesasinvestorsviewedthebankas toobigarisk.Combinedfundingfromdepositsanddebtsecuritiesfellfrom82billionattheendof 2007to19billionattheendof2010. Someofthefundstopayoffdepositorsandbondholderscamefromsellingsomeofthebanks assetsandfromloanrepayments,whichsawthetotalsizeofthebalancesheetfallfrom92.6 billionattheendof2007to68.6billionattheendof2010.Butmostofthefundscamefrom borrowingfromcentralbanks.Atfirst,mostofAngloscentralbankborrowingtooktheformof participationinstandardEurosystemrefinancingoperations.However,theseoperationsrequire counterpartiestopledgeparticulartypesofcollateralinreturnforborrowingmoneyandAnglo begantorunoutofeligiblecollateralastheIrishbankingcrisisbeganinlate2008. InMarch2009,theCentralBankofIrelandagreedaMasterLoanRepurchaseAgreementwith AngloIrishBank,lending11.5billionagainstcollateralthatdidnotqualifyforstandardEurosystem monetaryoperations.1ThiswasthefirstofaseriesofsocalledExceptionalLiquidityAssistance loansthatweremadetothebank.(Themechanicsandlegalitiesoftheseloanswillbediscussedin thenextsection.)Asthebankingcrisisintensifiedthrough2010,ELAborrowingsrampedup significantly.Bytheendof2010,Angloowed16.9billioninEurosystemborrowingsandhad28.1 billioninELAdebtstotheCentralBankofIreland. InFebruary2011,AnglowasinstructedtotransfermostofitsremainingdepositstoAlliedIrish BanksalongwiththeBanksholdingsofabout12billioninseniorbondsissuedtoitbytheNational AssetManagementAgency(NAMA)inreturnformostofitsportfolioofcommercialpropertyloans. BecausetheNAMAbondshadbeenusedascollateralforEurosystemborrowings,Anglohadtopay offmostofitsECBloans,whichfurtherincreaseditsdependenceonELAfromtheCentralBankof Ireland.BytheendofJune2011,Angloowed38.4billioninELAandhadEurosystemborrowingsof only2.4billion.
1

Seepage102ofAnglos2009annualreport.

Table1:AngloIrishBanksLiabilities(BillionsofEuros) TotalLiabilities OfWhich: Deposits DebtSecurities SubordinatedDebt OtherLiabilities EurosystemBorrowings ELADebtstoCBI End2007 92.6 58.4 23.6 5.3 5.3 0.0 0.0 End2010 68.6 12.1 6.9 0.5 3.6 16.9 28.1 Mid2011 50.7 1.2 5.7 0.5 2.6 2.4 38.4

2.2.

IrishNationwideBuildingSociety(INBS)

ThesmallerIrishNationwideexperiencedasimilarcollapsetoAnglo.AswithAnglo,anaggressive approachtopropertylendingcombinedwithdubiouscorporategovernancepracticescombinedto produceenormouslossesonpropertyloans,mostofwhichwerecrystallisedbythetransferofits commercialpropertyloanstoNAMA.From2008onwards,thebanksawacollapseinitsfunding fromdepositsandbondmarketsandahugeincreaseinitsrelianceoncentralbankborrowing.Table 2onthenextpageshowsthatthebuildingsocietylosthalfofitsdepositfundingbetweentheendof 2007andtheendof2010andalsopaidoffalmostallofitsoutstandingdebtsecurities.Bytheendof 2010,Eurosystemborrowingsaccountedformorethanhalfofitsliabilities. INBSdidnotpublishahalfyearreportin2011,sothereisnopubliclyavailableinformationabout howitsbalancesheetchangedinitsfinalsixmonths.However,its2010annualreport,publishedin May2011,reportedthatthebuildingsocietytransferredsubstantiallyallofitscustomerdeposits toIrishLifeandPermanent,aswellasNAMAseniorbondsworth2.9bnandotherbondsworth 790m.ThetransferoftheseECBeligibleassetsmeantthatIrishNationwidealsoneededtoapply forELA,soitlikelythatthebankhadELAdebtsofapproximately3.7billionwhenitwasmerged withAngloonJuly1,2011toformtheIBRC. 4

Table2:IrishNationwidesLiabilities(BillionsofEuro) TotalLiabilities OfWhich: Deposits DebtSecurities SubordinatedDebt OtherLiabilities EurosystemBorrowings ELADebtstoCBI End2007 14.6 7.3 6.7 0.4 0.1 0.0 0.0 End2010 12.2 3.7 0.6 0.4 0.2 7.4 0.0

2.3.

TheIBRCsBalanceSheet

TheIBRChasnotyetpublishedabalancesheetbutTable3belowprovidesmyestimateofhowtheir balancesheetwouldhavelookedonitsdateofbirth,July1st2011.Thishasbeencalculatedby combiningthemid2011balancesheetofAnglowiththeend2010balancesheetofINBSand accountingfortheshiftofdepositsandbondsfromINBStoIrishLifeandPermanent. Asofmid2011,depositswereonlyaverysmallpartoftheorganisationsliabilities,whiledebt securitiesoutstandingweredownto6.3billion,abouttenpercentoftotalliabilities.Thevast majorityoftheIBRCsdebts48.2billionofatotalof58.6billionareowedtocentralbanksand thevastmajorityofthese(42.2billionbymyestimate)taketheformofELA. Therehasbeenaconsiderablefocusinthemediaandpopulardiscussionsonpaymentsto unguaranteedseniorIBRCbondholders.However,asofJune2011,only2.9billionoftheIBRCs debtsecuritieswereunguaranteedandunsecuredseniorbonds.SinceJune2011,therehavebeena seriesofpaymentsonthesebonds,includinga$1billionbondthatwaspaidoutinOctober2011 anda1.25billionbondthatwaspaidoutinJanuary2012.Asaresultofthesepayments, unguaranteedunsecuredseniorbondnowaccountforlessthan1billionoftheIBRCsdebts.So,at thispoint,ifthereistobeasignificantreductionintheburdenimposedbytheIBRContheIrish public,itwillneedtocomefromsomewhereelsethandefaultingontheremainingunguaranteed 5

seniorbonds.Specifically,itwillrequireanewapproachtodealingwiththeIBRCsdebtstocentral banks. ThelefthandsideofTable3explainswheretheIBRCistogettheresourcestopayoffitsliabilities asitwindsdown.Ithastwoprincipaltypesofassets.First,thereareloanstocustomers.Second, thereareaseriesofpromissorynotesfromtheIrishgovernmentthatwereprovidedtoAngloand INBSduring2010.ThesepromissorynotesarecurrentlyvaluedontheIBRCsbalancesheetat28.1 and(aswillbediscussedlater)arecurrentlyscheduledtoprovideaseriesofpaymentsoverthenext 20years. Animportantaspectofthisbalancesheetisthatwithoutthepromissorynotes,theIBRCwouldhave sufficientassetstopayoffallofitsdeposits,itsbondholders,itsEurosystemborrowingsandallofits otherdebtsapartfromELA.Only14.1billionofthe42.2billionELAdebtscouldbepaidoffifthe bankdidnothavethepromissorynotes.Thus,akeypointtounderstandaboutthefuturecostof IBRCtotheIrishpublicisthat,effectively,thepromissorynotesonlyexisttopayofftheELAdebtsto theCentralBankofIreland. Table3:EstimatedIBRCBalanceSheetatMid2011(BillionsofEuros) Assets PromissoryNotes Loans Other Total 58.6 28.1 27.5 3.0 Liabilities Deposits DebtSecurities SubordinatedDebt OtherLiabilities Eurosystemborrowings ELADebtstoCentralBank Total 1.1 6.3 0.7 2.3 6.0 42.2 58.6

3. TheABCsofELA
This section discusses the process by which Exceptional Liquidity Assistance is issued and moves on tothevariouslegalandaccountingissuerelatedtotheissuanceandrepaymentofELA.

3.1.

MoneyCreationandCentralBankBalanceSheets

BeforedescribingthespecifictopicofELA,itisworthclarifyinghowtheprocessofmoneycreation worksintheEurosystem.ItiscommontoseemediareportsstatingthattheEuropeanCentralBank isprovidingfundstothebankingsystem.Technically,however,thisisnttrue.TheECBitselfdoesnot lendmoneydirectlytobanks.Rather,theEurosystemsrefinancingoperationsinwhichitsupplies liquiditytoEurosystembanksareconductedonadecentralisedbasisbythenationalcentralbanks oftheEurosystem. Wheredothenationalcentralbanks(NCBs)getthismoneyfrom?Theansweristhattheydontget itfromanywhere.Theprocessworksasfollows.EverybankintheEurosystemkeepsasocalled reserveaccountwithitscentralbankandthisaccountcanbeusedtowritechequestocreditorsor torequestcashfromthenationalcentralbanktouseinATMmachines.Whenabankobtainsaloan aspartoftheEurosystemrefinancingoperations,itreceivesthefundsviaitsNCBcreditingits reserveaccount.Thisistextbookmoneycreationinwhichmoneyisconjuredoutofthinair. Eachofthenationalcentralbanksreportsonamonthlybasishowmuchmoneytheyhavecreatedin thisfashionwhentheyreleasetheirbalancesheet.Ahighlystylisedcentralbankbalancesheetis producedbelow. StylizedCentralBankBalanceSheet Assets Assetsacquiredbymakingloansandbuying securities Someotherassets Onthelefthandside,thebalancesheetdescribestheassetsthatthecentralbankhasacquiredvia moneycreationinadditiontoasmallamountofadditionalassetsthatitmayhaveacquiredover timeindependentofitsmoneycreationactivities(e.g.transfersfromthefiscalauthority).While centralbankswillhaveholdingsofgoldandothersecurities,formostcentralbanksthelargest categoryofassetsistheloansthatithasmadetobanks. Liabilities Moneycreatedbymakingloansandbuying securities CentralBankCapital

Therighthandsideofthebalancesheetshowsthetotalamountofmoneythatthecentralbankhas createdovertimeaswellastheresidualvaluebywhichthebanksassetsexceedthemoney created,whichisusuallytermedthecentralbankscapital.Notethatiftheassetsacquiredvia moneycreationriseorfallovertimerelativetotheiroriginalvaluewhenacquired,thencentralbank capitalneednotcorrespondtothevalueofassetsacquiredindependentofmoneycreation. Therighthandsideofthebalancesheetisoftendescribedasillustratingthecentralbanks liabilities.However,itisworthstressingthatacentralbanksliabilitiesarequitedifferentfromthose ofanyprivateentity.Acentralbankthatprintsafiatcurrencythatpeoplewishtousefor transactionscannevergooutofbusiness. Suppose,forexample,thatacentralbankprintsoffmoneytoacquiregoldandthepriceofgoldthen plunges.Inthiscase,thevalueofthecentralbanksassetsmaywellfallbelowtheamountofmoney thatithascreated,sotheentryforCentralBankcapitalwouldbenegative.Onecouldinthiscase labelthecentralbankasbeinginsolventinsometechnicalsense.However,thisisnotan insolvencythatcorrespondstoanyprivatesectorversionofthisconcept.Aslongasthebankcan createmoneythatpeoplewishtouse,itcanpayoffanydebtsthatfalldueandhonourallofits obligations.

3.2.

CollateralandRiskSharingforEurosystemOperations

Bythesecommentsaboutthelackofimportanceofcentralbankcapital,Iamnotintendingtoargue that central banks should be able to print money for whatever task they wish and not worry about the consequences. The ability to create money is an extremely powerful tool and needs to be carefully monitored. In particular, within a common currency area, it is particularly important that each participating member state is not seen to be particularly responsible for fuelling inflation by abusingitspowertocreatemoney. Forexample, forcountries facedwith theproblemof failingbanks suffering a depositrun, it maybe tempting to provide such banks with loans from the central bank so that private creditors and depositors can be paid off and then allow for slow (or no) repayment of these loans. However, such a policy could be inflationary and would be open to accusations of corruption and abuse of the moneycreationpower. To prevent such abuses, the Eurosystems refinancing operations take the form of repurchase agreements that are handled in a way that is designed to prevent losses on money creating operationsofthetypejustdescribedabove. The Eurosystems repurchase agreements involve banks temporarily supplying financial assets to their local NCB as collateral in return for loans, with the terms of these loans set by the ECBs Governing Council (consisting of the seventeen national country governors and the six members of the ECB Executive Board) at its monthly monetary policy meeting. Haircuts are applied to the collateralsothattheamountthatisloanedtotheborrowingbankislessthanthevalueoftheasset,

with the amount that can be loaned increasing with the quality of the collateral.2 Should a bank default on its loans from an NCB, the collateral framework is intended to see the NCB still left with anassetthathasthesamevalueastheloan. That said, no riskcontrol framework can completely rule out the possibility of losses on monetary operations.Forexample,LehmanBrothershadborrowed8.5billionfromEurosystemcentralbanks when it entered bankruptcy and it was thought at first that there could be large losses on these loans. (In fact, recent media reports suggest the gradual sale of the pledged collateral will come close to recouping the full amount of money loaned.)3 More seriously, the Eurosystem has now loaned large amounts to banks that have used European sovereign bonds with low credit ratings as collateralandhasalsoengagedinlargedirectpurchasesofthesebondsonthesecondarymarket. The official legal statute governing the Eurosystem is quite vague about the implications for an NCB of losses incurred in monetary operations. Article 32.4 simply states The Governing Council may decide that national central banks shall be indemnified against costs incurred in connection with the issue of banknotes or in exceptional circumstances for specific losses arising from monetary policy operationsundertakenfortheESCB.Inpractice,theGoverningCounciloftheECBusedthedefaults by Lehmans and other banks in 2008 to clarify in a statement in March 2009 that losses should be sharedinfullbytheEurosystemNCBsinproportiontotheirECBcapitalkeyshares.4 Note that despite regular commentary pointing to the relatively small size of the ECBs capital base oflessthan10billion,theactualamountavailabletotheEurosystemtoabsorblossesonmonetary operations is significantly larger: As of February 2012, the Eurosystem has a combined 81 billion in capitalandreservesandanadditional394billioninrevaluationaccountsthatcanalsobeusedto absorblosses. Still, this does raise the question of what would happen should one or more Eurosystem central banks have their capital eliminated by losses on operations. Perhaps surprisingly, as far as I can tell, the legal structures underpinning the Eurosystem dont discuss this eventuality. Article 27.1 of the ECB Statute requires each NCB to have its accounts audited by independent external auditors recommended by the Governing Council and approved by the Council but it does not state what should happen if the Governing Council is unhappy with the accounts. Still, it is generally understood that NCBs would need to be recapitalised by fiscal transfers from their national government.

3.3.

ELA,MonetaryFinancingProhibitionandtheECBGoverningCouncil

TheEurosystemallowsforabroadrangeofassetstobepledgedascollateralinitsrefinancing operations.However,from2009onwards,eachoftheIrishbankscoveredbystateguarantees exhaustedtheirstockofeligiblecollateralandwouldhavedefaultedonbondsorfailedtohonour

SeeEuropeanCentralBank(2011)foradetaileddiscussionoftheoperationalframeworkformonetarypolicy intheEuroarea. 3 SeethisreportfromtheFinancialTimes,datedJanuary20,2012. www.ft.com/cms/s/0/30d1a26e42b811e193ea00144feab49a.html. 4 Seepressreleaseherewww.ecb.int/press/pr/date/2009/html/pr090305_2.en.html.
2

depositwithdrawalswithoutadditionalhelp.ThathelptooktheformofsomethingtheCentralBank ofIrelandtermsExceptionalLiquidityAssistancebutwhichtherestoftheworldcallsEmergency LiquidityAssistanceeitherwayitsELA.Thisassistancetakestheformofloansthatareprovided tobankswhopledgecollateralthatitisnotacceptableforEurosystemoperations. TounderstandthelegalbasisforELA,onehastostartwiththeobservationthatallofthenational centralbanksintheEuroareawerefoundedpriortothestartofEMUandthuseachhavepre existinglegalpowersandobligations.Somearegivenvariousregulatoryandsupervisorypowers whilesomearenot.Moreimportantly,itiscommonfornationalcentralbankstobegivenanexplicit setofpowersrelatedtofinancialstability. TheActcurrentlygoverningtheCentralBankofIrelandgivesitageneralpowertolendagainst securitytocreditinstitutionsandalsoprovidesitwithanexplicitfinancialsecurityobjective.Thus, theoriginallegalbasisfortheBankspowertoprovidebankswithELAtopreventabankfromfailing andtriggeringfinancialstabilityproblemscomesfromIrishlaw. Thisdoesnotmean,however,thattheBankhascompletefreedomtooperateitsELAprograms howeveritwishes.AnumberofdifferentlayersofEurosysteminvolvementareworthflagging. First,in2005,thebankingsupervisoryauthorities,thecentralbanksandtheFinanceMinistriesof theEuropeanUnion(EU)haveagreedonaMemorandumofUnderstandingoncooperationin financialcrisissituations.ThisMoU,whichisnotapublicdocumentnorlegallybinding,consistsofa setofprinciplesandproceduresforcrossbordercooperationandlikelyincludesagreementabout theuseofELA. Second,the2008ECBConvergenceReportofferstheopinionthatNationallegislationforeseeing thefinancingbyNCBsofcreditinstitutionsotherthaninconnectionwithcentralbankingtasks(such asmonetarypolicy,paymentsystemsortemporaryliquiditysupportoperations),inparticularto supportinsolventcreditand/orotherfinancialinstitutions,isincompatiblewiththemonetary financingprohibition.5HowexactlytheECBsdefinesoftemporaryoperationsisunclear. Third,anarticleintheECBsFebruary2007MonthlyBulletinstatesthattheEurosystemalsohas proceduresinplaceregardingtheprovisionofELAtoindividualcreditinstitutionsintheeuroarea, whichareundertheresponsibilityofthenationalcentralbanks(NCBs).Theseproceduresareaimed atensuringanadequateflowofinformationwithintheEurosystemtothedecisionmakingbodiesof theECB.Inthisway,theimpactofanELAinterventiononaggregateliquidityconditionsintheeuro areacanbemanagedinamannerconsistentwiththemaintenanceoftheappropriatesingle monetarypolicystance.6 Finally,andmostcrucially,Article14.4oftheProtocolontheStatuteoftheEuropeanSystemof CentralBanksandoftheEuropeanCentralBankstatesNationalcentralbanksmayperform functionsotherthanthosespecifiedinthisStatuteunlesstheGoverningCouncilfinds,byamajority oftwothirdsofthevotescast,thattheseinterferewiththeobjectivesandtasksoftheESCB.7

5 6

Seewww.ecb.int/pub/pdf/conrep/cr200805en.pdf Seewww.ecb.int/pub/pdf/mobu/mb200702en.pdf 7 Seewww.ecb.int/ecb/legal/pdf/en_statute_2.pdf

10

Tosummarise,theECBmustbeconsultedwhenELAisissuedanditwillassesswhethertheissuance ofELAinterfereswithitsmonetarypolicystance.TheECBalsoviewsloanstoinsolventcredit institutionsandnontemporaryliquiditysupportprogrammesasillegal.AndtheGoverningCouncil canvoteatanytimebyatwothirdsmajoritytostopanyELAprogramme. Forthesereasons,theECBhasbeenheavilyinvolvedinthedesignoftheELAprogrammefromthe start.Forexample,itislikelythattheECBapprovalwasrequiredinrelationtothepayment structureofthepromissorynotesthatIBRCisusingascollateralforELAloansandwhichprovides thefundswithwhichELAwillberepaid.Inaddition,theECBlikelysoughtvariousassurancesthat ELAwouldberepaidsuchasthe(apparentlylegallynonbinding)lettersofcomfortsentfromthe MinisterforFinancetotheGovernoroftheCentralBankoneachoccasionanewELAprogramme wasinitiatedindicatingtheintentionthattheELAwouldberepaidandtheprovisionofsocalled facilitydeedswhichtheCentralBankannualreportasprovidingagovernmentguaranteein relationtorepaymentofELA.8 Inpractice,itappearsthatELAcreditisprovidedtobanksforaveryshortperiodoftime(acoupleof weeks)andtheECBsGoverningCouncilregularlyconsiderswhethertostoptheprogramme.In addition,theECBsviewontheneedforsolvencyofinstitutionsinreceiptofELAmeansthatmost likelytheymustapproveofanyrestructuringoftheassetsofsuchabank,suchasachangeinthe termsoftheIBRCspromissorynote.

3.4.

Target2andIntraEurosystemAssetsandLiabilities

BeforedescribingthemechanicsofhowexactlyELAworksandhowitaffectsthebalancesheetof theCentralBankofIreland,ithelpstodescribeoneaspectitsbalancesheetinabitmoredetail. IntraEurosystemBalances Onthenextpage,Iveproducedaslightlylessstylisedcentralbankbalancesheetthantheone describedbefore.Itislessstylisedinthatititemisesthedifferentsubcomponentsthatcorrespond towherethemoneycreatedbyacentralbankendsup. Thethreesubcomponentslistedhereare:Reserveaccounts,banknotesandIntraEurosystem liabilities.Thefirsttwoofthesecomponentsaresimpleenough;thelastone,unfortunately,isoften misunderstood. Whenacentralbankcreatesmoneyviaaloantoafinancialinstitution,itcreditsthatbanks reserveaccount.Thisshowsupasincreasedliabilitiesonthecentralbanksbalancesheet, withtheloanshowingupasacorrespondingentryontheassetside. Iftheborrowingfinancialinstitutionrequestsadeliveryofbanknotes,theirreserveaccount isdeductedbytheamountdeliveredandthebanknotesentryonliabilitysideofthe

Copiesofmostofthelettersofcomfort,whichwereobtainedviaaFreedomofInformationrequestbyRTE, areavailableatwww.rte.ie/news/2011/0718/centralbankbusiness.htm.
8

11

centralbankbalancesheetiscredited.Thereisnochangetotheassetsideofthecentral bankbalancesheet. ASlightlyLessStylizedEurosystemCentralBankBalanceSheet Assets Assetsacquiredbymakingloansandbuying securities Someotherassets Moneycreatedbymakingloansandbuying securities ThatbringsustoIntraEurosystemliabilities.Thisitemisbestexplainedviaatransactioninwhicha depositor(callhimJean)withanIrishbank(callthemAnglo)requeststhat100betransferred fromtheiraccounttoadepositaccountwithaFrenchbank(callthemSocGen).Thisworksas follows: Jeansbankaccountisdeducted,reducingAnglosliabilitiesby100. Atthesametime,AngloinstructstheCentralBankofIrelandtodeduct100fromitsreserve accounttosendthefundstoSocGen. ThereductioninAnglosdepositaccountwiththeCentralBankofIrelandreducesthis componentoftheBanksliabilitiesby100.However,theCentralBankofIreland immediatelyincreasesanentrylabelledIntraEurosystemLiabilities. ViatheEurosystemsrealtimepaymentssystem,Target2,theBanquedeFrancethen receiveseithera100credittoitsIntraEurosystemAssetsora100reductioninits IntraEurosystemLiabilitiesdependingonwhetheritisanIntraEurosystemcreditoror debtor. Offsettingthis100improvementinitsbalancesheet,theBanquedeFrancecredits SocGensreserveaccount,thusincreasingSocGensassets. SocGenthencreditsJeansdepositaccountwiththatbank. Ofwhich: ReserveAccounts BankNotes IntraEurosystemLiabilities Liabilities CentralBankCapital

NotethatfromJeanspointofview,allthathashappenedisthathis100hasgonefromhisIrish bankaccounttohisFrenchbankaccount.However,thewaypaymentssystemsactuallyoperate, therehavebeensixdifferentoffsettingtransactionsthathaveoccurredalongtheway.Most 12

importantlyforthepurposesofthispaper,theassetsideoftheCentralBankofIrelandsbalance sheethasnotchangedbuttheliabilitysideshows100lessinreserveaccountsand100morein IntraEurosystemliabilities.AsimilarchangewouldhaveoccurredifAnglohadwrittenachequeto payoffabondholderwithadepositaccountoutsideIreland. TheseIntraEurosystembalancesaveragetozero.ThosecountrieswithIntraEurosystemliabilities payinterestontheseliabilitiesattherateoftheEurosystemsmainrefinancingrate(currently1per cent).ThisinterestisaccumulatedattheECBandredistributedtothosecountrieswithIntra Eurosystemcredits. AnAside:TheTarget2Debate Ashasnowbeenwelldocumented(e.g.pages34and35oftheBundesbanksMarch2011Monthly report)themovementsofdepositsassociatedwiththebankingandsovereigncrisesofrecentyears havegeneratedverylargeIntraEurosystemliabilitiesincountriessuchasIrelandandaparticularly largeIntraEurosystemcreditfortheBundesbank. Itisbeyondthescopeofthispapertodiscussthevarioustechnicalissuesthathaveariseninrelation totheIntraEurosystemflowsthathavebeengeneratedbythecapitalflightfromtheperipheryto thecore.However,Iwouldnotethatanumberofeconomistshavereceivedsubstantialmedia attentionformisleadingclaimsrelatingtotheBundesbanksIntraEurosystemcredits. Inanumberofcontributions(ofwhichSinnandWollmershuser,2011,isthemostcomprehensive) HansWernerSinnoftheIfoInstitutehascharacterisedtheBundesbanksIntraEurosystemcredits asTargetLoans.Thischaracterisationisunhelpfulinrelationtobothwordsemployed. Asdescribedabove,thepurposeoftheTargetsystemistoseethatJeancantransferhis 100fromhisIrishaccounttohisFrenchaccount.Sinnhasproposedanumberofwaysto restricttheoperationoftheTargetsystem.Byrestrictingthefreemovementofcapitalwith theEurozone,theseproposalsareeffectivelyacalltoendthecommoncurrency. Thesecreditshavenoneofthecharacteristicsofloans.Theyarenotinstigatedbythe BundesbanksupplyingitsownfundstotheCentralBankofIreland.Rather,theyrepresenta transferoffundsoutofIrelandtowardsGermany.

Morerecently,anumberofmediacommentatorshavefocusedontheideathatGermanyissubject toanenormouscreditriskinrelationtoapossibledefaultonitsIntraEurosystemcreditsinthe eventofaEurobreakupandconsequentlargefiscalcostsofaBundesbankinsolvency.Thesefears areunfoundedfortworeasons.First,thevariousEurosystemcentralbanksretainsufficientassetsto allowforafullandfinalsettlementoftheIntraEurosystembalancesifsuchwererequired.Second, asnotedabove,concernsaboutinsolvencyofcentralbanksareunfoundedprovideditprintsafiat currencythatpeoplewishtohold.OnecanbesurethatintheeventofacompleteEurobreakup, theBundesbankwillfindplentyofdemandforitscurrency. 13

3.5.

IssuanceandRepaymentofELA

HereIwanttodescribethemechanicsofhowELAissuanceworksaswellaswhathappens afterwardsinrelationtointerestandprincipalrepaymentsonELA. Issuance ThereasonIhavedescribedIntraEurosystemtransactionsinsuchdetailisthattherehasbeensome confusioninmediaandpoliticalcirclesinrelationtothenatureoftheELAissuance.Anumberof mediastorieshavereportedthattheELAmoneywasborrowedfromtheECB.Thisisnotthecase. TheECBdoesnotissuemoneyatallasthistaskisdelegatedintheEurosystemtonationalcentral banks. AmoresubtleversionoftheELAwasborrowedfromtheECBclaimwasprovidedinananswertoa parliamentaryquestionbytheIrishMinisterforFinance,MichaelNoonan,onJanuary31,2012.9Mr. NoonanstatedthatELAisitselffundedbytheCBIthroughIntraEurosystemliabilities. Thewordfundedcanhaveanelasticmeaning.However,thisanswersuggestsaninterpretationin whichtheappearanceofanELAassetontheCentralBankofIrelandsbalancesheetisaccompanied byanincreaseinIntraEurosystemliabilities.Itismyunderstandingthatthisisnotthecase.Atthe momentofconception,sotospeak,oftheELA,thecorrespondingincreaseinliabilitiesisacredit tothereserveaccountofthebankreceivingtheELAloans.OnlyifthatbankthenusesitsELAfunds totransfermoneytobankaccountsoutsideIrelanddoestheCentralBankofIrelandsbalancesheet starttoshowanincreaseinIntraEurosystemliabilities. BecausetheIBRCappearstohaveusedthevastmajorityofitsELAloanstopayoffforeign bondholdersandpeoplemovingtheirdepositsoutsideofIreland,thereislittledoubtthatthe issuanceofELAhasledtoasignificantincreaseintheCentralBanksIntraEurosystemliabilities. However,itisnotaccuratetodescribetheELAashavingbeeneitherborrowedfromtheECBorto describeanincreaseinIntraEurosystemLiabilitiesasthesourceofthefunds. IshouldemphasisethatinpointingoutthatELAfundswerenotborrowedfromtheECBortherest oftheEurosystem,itremainsthecasethattheECBGoverningCouncilcaninsistonanendtothe ELAprogrammeatanypointandisalsolikelytorequireconsultationinrelationtoanyproposals thatwouldinvolvechangestothenatureoftheIBRCsassets. InterestPaymentsonELA TurningfromELAissuance,toitsrepayment,afirstquestionrelatestotheinterestratesthatthe CentralBankofIrelandchargesonitsELAloans.TheBankhasnevercommentedpubliclyonthis interestrate.GiventhatELAisnormallyissuedattimesoffinancialcrisisanditsmereexistencemay beaverysensitivematter,itislikelythattheyarefollowingEurosystemguidelinestoadoptthe FightClubapproachtocommunicationsonELA(ThefirstruleofELAis:YoudonottalkaboutELA).
9

Seewww.kildarestreet.com/wrans/?id=20120131.767.0&s=mathews#g774.0.q

14

Despitethisofficialapproach,AngloIrishBanksrecentreportshavenotedthattheinterestrateon itsELAloansislinkedtotheECBmarginallendingfacility,whichiscurrently1.75percent.In addition,theCentralBankofIrelandreported510millioninELAinterestin2010initsannual report,whiletheentryforOtherassetsaveraged21.3billionin2010.Dividingtheinterestbythe averagevalueofotherassetssuggestsaninterestrateof2.4percent.Giventhatthemarginal lendingfacilityratewas1.75percentthroughout2010,myguessisthattheformulausedto determinetheELAinterestrateissomethinglikemarginallendingfacilityplus75basispoints. GiventhattheCentralBankiscurrentlypayingoutinterestof1percentonbothmoneyheldin reserveaccountsandonIntraEurosystemliabilities,thisraisesthequestionofwhathappenstothe profitsincurredviatheestimated75basispointspreadchargedonELA. ProfitsrelatingtoEurosystemmonetarypolicyoperationsaresharedamongthevariousnational centralbanks.However,asfarasIcantell,thisisnotthecaseforprofitsassociatedwithELA operations.Ifthisiscase,thenthe75basispointmargincanberemittedatsomepointbythe CentralBankofIrelandbacktotheExchequer. ThismeansthattheultimateinterestcosttotheIrishstateoftheELAfundingthatissuppliedtothe IBRCisthemainECBrefinancingrate,whichiscurrentlyonepercent. ELARepayments WhatoccurswhenELAprincipalisrepaidbytheIBRC?Therearetwopotentialscenarios.Inthefirst, theCentralBankofIrelandmaintainsitsbalancesheetsizeexactlyasbeforeandsimplyaddstoits stockofassets;forexample,theycouldpurchasegoldorsecurities.Profitsfromtheseinvestments couldeventuallybereturnedtotheIrishstate. Inthesecondscenario,theCentralBankdoesnotacquireanynewassetsbutsimplyreducesthesize ofitsbalancesheet,markingdownboththevalueofitsELAassetandthevalueofitsliabilities.This isthescenariothatactuallyoccurs. ThegraphbelowshowswhathashappenedoverthepastfewyearswiththeOtherAssets categoryontheCentralBankbalancesheet,whichprimarilyconsistsofELA.Afterreachingapeak of70billioninFebruary2011,thedeleveragingprogrammesoftheIrishbanks(sellingassetsand takinginloanproceedsandthennotlendingthemoutagain)haveallowedthemtorepayELAso thatbyDecember2011,OtherAssetshaddeclinedto44billion(seechartbelow).Itappears nowthatalmostalloftheoutstandingELAisowedbytheIBRC.

15

 whowthesedevelopmen d ntsalteredth heCentralBa anksbalance esheet,desc cribingit Tables4and5show ofFebru uary2011andDecember r2011respectively.Therewasasma alluptickinthe t Banksho oldings ofsecurities,goldan ndotherclaimsandverylittlechange einbanknot tesortheam mountheldin n reserveaccounts.Thus,thedeclineof26billion b inELAhastranslatedintoadeclineinOthe er Liabilitie es,thecatego orythatinclu udesIntraEurosystemliabilities:Thiscategoryfe ellby30billion. Indeed,inthesameparliamenta aryanswernotedabove,MichaelNoo onanhassai idthatrepay yments 10 ofELAendupreducingIntraEur rosystemliab bilities. Thatthe eELAgoesto owardsreduc cingtheCentralBanksli iabilitiesef ffectivelyred ducingtheam mountof moneyt thatithascreatedisim mportantbec causeitcorre ectsamiscon nceptionthathasappear redin somepu ublicdiscussi ionofthisiss sue.Because ethepaymentofmoneybytheIrishExchequertoIBRC andthepassingofth hismoneyon ntheCentralBankarebo othtransactionsinvolvin ngarmsofth heIrish states,some s haveco oncludedtha atthesetran nsactionsare ecompletelycircularandhavenonet tcostto thestate e.Thereality yisthatthew whenIBRCrepayitsELAdebts,thatmoneyissim mplytakenoutof circulation.Effective ely,itisasifitisbeingbu urned:There eisnohidden nbenefittothe t Irishstat tefrom thesere epayments.
10

Seeww ww.kildarestre eet.com/wran ns/?id=201201 0 31.767.0&s s=mathews#g g774.0.q

16

Table4:CentralBankofIrelandBalanceSheet,February2011(BillionsofEuros) Assets EurosystemLending Securities,gold,otherclaims Otherassets(mainlyELA) Total Table5:CentralBankofIrelandBalanceSheet,December2011(BillionsofEuros) Assets EurosystemLending Securities,gold,otherclaims Otherassets(mainlyELA) Total 176 107 25 44 Liabilities Banknotes Reserveaccounts OtherLiabilities CapitalandReserves Total 13 6 155 2 176 117 21 70 208 Liabilities Banknotes Reserveaccounts OtherLiabilities CapitalandReserves Total 12 9 185 2 208

17

4. PromissoryNotes
TherehasbeenconsiderablepublicdiscussioninIrelandabouttheideaofrestructuringtheIBRCs promissorynotes.However,IthinkitisimportantthatthepriorissuesrelatingtotheIBRCsbalance sheet,thenatureofitsELAdebtsandtheroleplayedbytheECBGoverningCouncilareestablished beforeonecanaddressthekeyissuesrelatingtoanypotentialrestructuringofthenotes.

4.1. PaymentStructure

During2010,itbecameapparentthatAngloandIrishNationwidehadtwoseriousproblems.The firstwasaliquidityproblem;bothinstitutionswerelosingdepositsandhadnoaccessto internationalbondmarkets.Inaddition,therewasasolvencyproblem,asitbecameclearthatboth institutionshadsufferedenormouslossesonpropertyrelatedloans. TheliquidityproblemwaslargelysolvedbyissuingtheAngloandINBSlargerandlargeramountsof ELA.Thesolvencyproblemwastrickier.Ifthestatewasgoingtoseethatdepositors,bondholders andELAdebtswereallrepaid,wherewasitgoingtogetthemoneyfrom?AsconfidenceintheIrish statefinanceswanedduring2010,itwasclearthattherewasnowaythatthegovernmentcould obtaintheenormoussumrequiredtorestoretheIBRCorganisationstosolvency31billionor20 percentofGDPbyborrowingfromfinancialmarkets. ThusthedecisionwastakentosupplytheIBRCinstitutionwithassetsworth31billionintheform ofpromissorynotes.TheseareeffectivelyIOUsfromtheStatetotheIBRCthatpromisetopay moneyaccordingtoanagreedschedule. Table6reportsthefullscheduleoftotalpaymentsonthenotesthathavebeenissuedasdescribed inananswertoaparliamentaryquestioninSeptember2011byMinisterNoonan.11Thefirstthing tonoteaboutthescheduleisthatitdiffersfrom,forexample,afixedratemortgageinthatthe annualpaymentschangeovertime: Thepaymentsare3.1billionperyeareveryyearonMarch31throughto2023(thefirst paymentwasmadewithoutmuchfanfareonMarch31,2011). Apaymentof2.1billionisduein2024. Paymentsof0.9billionayearareduefrom20252030. Afinalpaymentof0.1billionisduein2031.

Inrelationtotheinterestpayments,thesearedealtwithsomewhatlikeafixedratemortgage.An annualinterestchargeisappliedtotheoutstandingprincipalandthereductionintheprincipal outstandingequalstheannualpaymentminusthecalculatedinterest.Anexceptionisthetreatment ofinterestintheyears20112013,wherealowerrateofinterestwasapplied(noneatallin2012). Thenoteswereissuedgraduallyoverthecourseof2010andweregiveninterestratesthatwere similartotheratesthenprevailingonIrishgovernmentbonds.(Theseratesrosesharplyoverthe

11

Availableherehttp://www.kildarestreet.com/wrans/?id=20110927.896.0&s=promissory+notes#g897.0.q

18

courseof2010.)Thedeferralofinterestover20112013thenmeantthatforthebondstostillpay outtheinteresttotalsoriginallyagreed,theinterestrateappliedfortheremainderofthepayment schedulewouldbeapproximately8percent.Thus,onceinterestonthenotesisappliedatthislevel in2014,therewillbeaninterestchargeof1.8billion,whichwillgraduallydeclineinlateryears. ItisclearthatthispaymentstructurewastacitlyagreedtobytheECBGoverningCouncil,whoare thereforeawarethatIBRCwillnotbeabletopaybackitsELAformanyyears.Indeed,the promissorynotecouldbesaidtorepresentanimplicitlongtermtimetableforELArepayment.

Table6:PromissoryNotePaymentSchedule TotalInterest Repayments TotalCapital Reduction 31/3/2011 31/3/2012 31/3/2013 31/3/2014 31/3/2015 31/3/2016 31/3/2017 31/3/2018 31/3/2019 31/3/2020 31/3/2021 31/3/2022 31/3/2023 31/3/2024 31/3/2025 31/3/2026 31/3/2027 31/3/2028 31/3/2029 31/3/2030 31/3/2031 TOTALS 0.6 0.5 1.8 1.7 1.7 1.5 1.4 1.3 1.2 1.1 0.9 0.7 0.6 0.4 0.4 0.3 0.3 0.2 0.1 0.0 16.8 3.1 3.1 3.1 3.1 3.1 3.1 3.1 3.1 3.1 3.1 3.1 3.1 3.1 2.1 0.9 0.9 0.9 0.9 0.9 0.9 0.1 47.9 19 2.5 3.1 2.6 1.2 1.3 1.4 1.5 1.6 1.7 1.9 2.0 2.2 2.3 1.5 0.5 0.5 0.6 0.6 0.7 0.8 0.0 30.6 TotalAmount Outstanding 28.1 25.0 22.4 21.2 19.9 18.5 17.0 15.4 13.7 11.8 9.8 7.6 5.3 3.8 3.3 2.8 2.2 1.6 0.9 0.1 0.0

4.2.

TheLongRunIrrelevanceoftheInterestRateontheNotes

Muchofthemediacommentaryonthepromissorynoteshasfocusedontheirhighinterestrateand suggestedthatareductioninthisrateshouldbethefocusofanyeffortstoreducetheburdenof IBRCdebtonthetaxpayer.Inparticular,therehasbeenconsiderablefocusonthefactthatthefull totalofscheduledpaymentsonthenotesis48billiononceinterestpaymentsareaddedtothe31 billionprincipal. Itshouldbestressed,however,thatloweringoftheinterestrateonthenoteswilldolittletoreduce thelongrunburdenoftheIBRCdebtontheIrishstate.Indeed,verylittleofthe17billion differencebetweenthepaymentstotalof48billionandtheprincipalof31billionrepresentsanet costtothestate. Toseethispoint,itisworthworkingthroughthestructureofpaymentsthatwehaveoutlined: PromissorynotepaymentsareultimatelybeingusedbytheIBRCtopayoffELAtothe CentralBankofIreland.IBRCthusneedsanadditional28billiontorepaytheprincipalonits ELAdebts. IBRCalsoneedstopayinterestonitsELA.However,theELAinterestrateisapproximately 2.5percent,soanyadditionalinterestpaymentsabovethisratewillrepresentaprofitfor IBRCwhichcanultimatelybereturnedtothestate. TheCentralBank,inturn,currentlypaysaninterestrateofonepercentonitsreserveand IntraEurosystemliabilities,soitisalsomakingaprofitofanestimated150basispointson itsELAloanswhichcanalsobereturnedtothestate.

Puttingthesepointstogether,itturnsoutthatonlyasmallfractionoftheinterestpaymentsonthe promissorynotesrepresentanetcosttothestate. Anotherwaytoseethispointistoconsiderhowlongitwilltakethepromissorynotepaymentsto clear28.1billioninELAdebt(effectively,ImassumingthattheIBRCsotherassetswillbeusedto payoffallotherliabilitiesandtheadditionalELAestimatedaboveat14.1billionatmid2011). Table7providesascheduleforhowtheIBRCcanusetheannualpaymentsonitspromissorynotes toreducetheamountofELAoutstanding.IhaveassumedthattheELAinterestrate,whichis ultimatelylinkedtotheECBsmainpolicyrate,willnotremainaslowas2.5%foreverandhaveset outascheduleinwhichitwillmoveuptowards4.5%andthenstaythere. Accordingtothesecalculations,thecurrentschedulewouldmeanthatIBRCwillbeabletopayoffits ELAdebts(withpresumablyallotherdebtslonggone)in2022.Atthatpoint,thegovernmentcould winduptheIBRCandsimplycanceltheremainingpayments.Noteherethatthetotalamountof promissorynotepaymentsinthisexamplewouldbe37billion.Theadditional11billionin paymentsscheduledafter2022justwouldnthappen. Thus,theintensefocusonthetotalrepaymentsfigureof48billionismisplacedandany restructuringofthepromissorynotesthatissoldashavingthebenefitofreducingthe48billion figuretosomethinglowerwillactuallybedoingverylittletoreducethelongtermburdenofthe IBRC. 20

Table7:ANotionalScheduleforRepaying28.1BillioninELAUsingPromissoryNotePayments ELAInterestRate Repayments InterestPayments TotalAmount Outstanding 31/3/2011 31/3/2012 31/3/2013 31/3/2014 31/3/2015 31/3/2016 31/3/2017 31/3/2018 31/3/2019 31/3/2020 31/3/2021 31/3/2022 0.025 0.025 0.025 0.030 0.035 0.045 0.045 0.045 0.045 0.045 0.045 0.045 3.1 3.1 3.1 3.1 3.1 3.1 3.1 3.1 3.1 3.1 3.1 2.8 0.78 0.70 0.64 0.70 0.73 0.82 0.71 0.60 0.49 0.37 0.25 0.12 28.1 25.7 23.3 20.7 18.3 15.8 13.4 10.9 8.3 5.6 2.7 0.0

4.3.

TheShorterTermRelevanceoftheInterestRateontheNotes

Whiletheamountofinterestpaidonthepromissorynoteshaslittlelongrunimpact,theseinterest paymentsaresettohaveanunfortunateimpactontheIrishbudgetaryprocessoverthenextfew years.ThisimpactrelatestoEurostatsaccountingtreatmentofthepromissorynotes. Eurostatsaccrualsbasedaccountingforbudgetdeficitscountedthefull31billionprincipalofthe promissorynotesonIrelandsgeneralgovernmentbudgetdeficitin2010.Theinterestpaymentson thepromissorynotesarethencountedonthegeneralgovernmentdeficit(GGD)intheyearsthat theyoccur.However,Eurostatsrulesallowfordebtinstrumentstohaveinterestholidaysinwhich nointerestischargedandthepromissorynotesweredesignedwithsuchaholidayperiodover 20112013.12 Whenthisperiodisscheduledtoend,theinterestpaymentsonthenotewillgofromhavingno impactontheGGDthisyeartoa500millionimpactin2013anda1.8billionimpactin2014.Even thoughthecashflowimpactofthenoteswillnotchangeduringtheseyears,thegovernmentwill needtofindanadditional1.8billioninspendingcutsandtaxincreasesoverthenexttwoyearsifit istosticktoitsofficialtargetsforthismeasureofthedeficit.
SeethisDepartmentofFinanceinformationnotereleasedinNovember2010: www.finance.gov.ie/documents/publications/reports/2010/noteprommissory2010.pdf
12

21

5. PotentialPolicyOptions
Thissectiondiscussesthereasonsinfavourofrestructuringthepromissorynotes,outliningmy preferredoptionsforrestructuringaswellasthepotentialargumentsthatarelikelytolevelled againstthisapproachbymembersoftheECBGoverningCouncil.Ialsoprovidesomeargumentsfor changingtheIBRCsaccountingtreatmentofthenotes.

5.1.

WhyRestructurethePromissoryNotes?

Beforeconsideringpolicyoptionsforchangingthestructureofthepromissorynotes,itisworth emphasisingwhysucharestructuringisdesirable. TheEuropeanCommissionslatestreportonIrelandprojectsthattheIrishdebtGDPratiowillpeak at119percentattheendof2013,justasthestateissettorunoutofitsEUIMFfunding.Thisdebt ratioiswellbeyondlevelsthathavetraditionallybeenconsidereddangerous,evenpriortothe recentexampleofprivatesectorsovereigndebtrestructuringwithintheEurozonesetbyGreece.As currentlystructured,thereislittledoubtthattheIBRCspromissorynoteswillrepresentasignificant negativefactorinrelationtofinancialmarketsassessmentofthesustainabilityofIrelandsdebt burdenatthattime. Ihaveprojectedabovethat,basedonthecurrentscheduleandthenatureofIBRCsELAdebts, Irelandissettomakeitstwelfthandlastpromissorynotepaymentin2022.Effectively,the promissorynotesactliketwelvedifferentzerocouponbondswithmaturitiesrangingfromoneto twelveyears.Thus,theeffectiveaveragematurityofwhatisleftofthisdebt,whichaccountsfor twentypercentofGDP,isaboutfiveyears. CombinedwithanaveragematurityasofMarch2012onIrelandsexistingprivatedebtofabout80 billionofaboutsixandahalfyears,thismeansthatIrelandwillhaveverysignificantfunding requirementsoverthenextfewyears,evenbeforeoneconsiderstheincrementalborrowing associatedwithbudgetdeficits.13 ItisthefirmhopeofIrelandsEurozonepartnersthatIreland,whichiswidelypraisedforits willingnesstoimplementausteritymeasures,beabletoaccesssovereigndebtmarketsby2013.Any stepsthatcanbetakentohastenIrelandsdeparturefromtheEUIMFprogrammeareinthe interestsofboththeEurozonememberstatesandtheIrishpeople.Areductioninthefunding burdenassociatedwiththepromissorynotesrepresentsarelativelysimplewaytotakesuchastep.
13

Calculationsbasedoninformationinwww.ntma.ie/GovernmentBonds/Daily_Bonds_Outstanding.pdf

22

5.2.

WhattheIrishGovernmentShouldLookFor:PaymentDeferral

Anysuccessfulnegotiatingstrategyrequiresacleargoal.Inthecaseofthepromissorynotes,the Irishgovernmentshouldbeproposingtorestructurethenotessothereisno3.1paymenttoIBRC onMarch31,2012orforanumberofyearsafterthat.Thiswouldreducethestatesfunding requirementsoverthenextfewyearsand,byreducingthenetpresentvalueburdenofthisdebt, helptoconvinceinvestorsthatIrelands120percentdebtGDPratioisnotasonerousasitlooks. Forhowmanyyearsshouldthepromissorynotepaymentsbedeferred?Clearly,fromanIrish perspective,theidealanswerwouldbetodeferthepaymentsaslongaspossiblebut,giventhe needforagreementfromtheECBGoverningCouncil,thisisunlikelytobeobtained.Aslightlyless strongapproachwouldbetolinkthebeginningofpromissorynotepaymentstoquantitative benchmarksinrelationtotheperformanceoftheeconomy:Forexample,thatpaymentswould beginwhennominalGDPhasrecovereditsprecrisispeakandunemploymenthasfallenbelowten percent.AnevenweakerapproachwouldbetosuspendrepaymentsuntilIBRChasusedupallits nonpromissoryassets.Asnotedabove,theIBRCwouldbeabletorepayapproximately14billion overtimeinELAevenifitwasneverreceivedanypromissorynotepayments. Whataretheobstaclestothegoalofpaymentdeferral?Anyonewhohastakenapassinginterestin thisissuewillknowbynowthattheIrishgovernmentishavingtechnicaldiscussionswiththe troikaaboutthisissue.ThetruthisthattheECBGoverningCouncilistheonlybodythatreally mattersforthisquestion.Ifaplantorestructurethepromissorynoteswasacceptedbythe GoverningCouncil,thenitisveryunlikelythattheeithertheCommissionortheIMFwouldobject. WhatobjectionsmightGoverningCouncilmembershavetorestructuringthepromissorynotes?In reality,membersoftheCouncilhavebyandlargeavoidedcommentingonthisissue(partlybecause theyarerarelyasked.)Butitislikelythatobjectionstakethefollowingform: TheMoralHazard/SlipperySlopeArgument:Ifpromissorynoterestructuringleadstoa slowerpaceofrepaymentofELA,thenothercountriesmayalsoseektouseELAtobailout theirbankingsystemsandtheconsequencesmaybeinflationary,violatingtheECBsprimary policyobjectiveofpricestability. TheLegalisticArgument:ItislikelythatvariouslawyersandcentralbankersattheECBand nationalcentralbanksbelievethattheexistingELAprogrammefortheIBRCcomescloseto violatingtheirunderstandingofthemonetaryfinancingprohibitionarticleintheTreaty.For theseindividuals,anychangetothecurrentarrangementshouldnotbeconsideredbecause itmayrunintolegaldifficulties. TheWhatsYourProblem?Argument:ManyEuropeanpoliticiansandcentralbankersare fondofpraisingIrelandsEUIMFprogrammeasagreatsuccess.Fortheseindividuals,they wouldprefertowaittoseefirmevidencethattheprogrammehasgoneofftrackbefore acceptingtheneedtochangeanyofitskeyaspects. 23

Eachoftheseargumentsareworthrespondingto: ELAprogrammesneedtheacquiescenceandcooperationoftheGoverningCouncil.TheECB wasstronglysupportiveofprovidingfundstopayoffbondholdersanddepositorsatfailing IrishfinancialinstitutionsonthegroundsthatthesedecisionspromotedEuroareafinancial stability.However,theIrishELAprogrammedoesnotrepresentaslipperyslopetofrivolous ELAprogrammesacrosstheEurozonebecausetheGoverningCouncilcansimplychooseto saynotofuturerequeststhatitdoesnotsupport. SlowrepaymentofELAdoesnotcauseinflation.TheELAmoneyhasalreadybeenprinted anddidlittletostokeEurozoneinflation.Choosingtorepaythemoneymoreslowlywillonly contributetoEuroareainflationarypressuresifthemonetaryaggregatesareexpanding morerapidlythantheECBiscomfortablewith.Atpresent,growthinEuroareaM3isvery slow.Ifinflationbecomesaconcern,theGoverningCouncilcouldmakedeferredrepayment ofELAconditionaloncontinuedslowgrowthintheEuroareamoneysupply. Thelegalisticargumentsagainstrestructuringthenotesarerelativelyweak.IBRCisasolvent institutionthatisbeingprovidedwithsufficientfundstorepayallofitsdebtsovertime.A deferralofELAdoesnotchangethatsituationandsoitdoesnotbringusclosertomonetary financingofaninsolventinstitution.AndanyprogrammetopaybacktheELAeventually technicallycountsasatemporaryprogramme. InrelationtotheWhatsYourProblem?approach,itcouldbearguedthatnowisthetime tolooktobuildonwhateverpositivemomentumisthereinrelationtothesuccessofthe Irishprogramme.WiththeEuroareaeconomyapparentlyenteringrecessionandIrish exportsweakening,IrelandislikelytoneedanimproveddealfromtheEUiftheprogramme istotrulysucceed.

5.3.

AccountingTreatmentofPromissoryNotes

Aseparateissuefromthekeygoalofachievingasignificantdeferralofpromissorynotepaymentsis theaccountingtreatmentofthepromissorynotes. Therehasneverbeenanofficialexplanationofwhythepromissorynotesneededtocarryasimilar yieldaswasprevailingonIrishgovernmentbondsin2010.ANovember2010DepartmentofFinance notereportedthatForcapitaladequacypurposesthePromissoryNotesmustbevaluedatparinthe institutionsaccounts.Accordingly,interestmustaccrueonanyamountdueuntilitispaid.The interestratechargedisbasedonthelongtermGovernmentbondyieldappropriatetowhenthe amountswillbepaid. Effectively,theapproachtakenin2010wastovaluethepromissorynotesaccordingtoamarkto marketapproachsimilartohowbanksvaluebondsthatarekeptintheirtradingbooks.However, mostEuropeanbanksallocatethemajorityoftheirsovereignbondstotheirsocalledbanking bookswhichisintendedforassetsthatareheldtomaturity.AstheEuropeanBankingAuthority 24

explainedinanotediscussinglastyearsEUbankingstresstestsTherealityisthatshocksto sovereignbondsonlyimpacttheregulatorycapitalpositionviathetradingbook.14 Thepromissorynotesarenotintendedtobetradedontheopenmarketandareintendedtobeheld tomaturity.Thusabankingbookaccountingtreatmentisappropriate.Inaddition,theriskprofile ofthepromissorynotescanbedistinguishedfromthoseofregularsovereignbondsduetothe additionallettersofcomfortandfacilitydeedsthathavebeenprovided. Evenifthegreatergoalofdeferringpromissorynotepaymentscannotbeachieved,thegovernment shouldatleastseekagreementwiththeECBGoverningCounciltoissuenewnoteswithaninterest rateequaltotherateontheIBRCsELAloansandtovaluethesenotesatparonaholdtomaturity basis.SuchanapproachwouldprovideIBRCwithsufficientfundstorepayitsELAdebtsasoutlined inTable7inthispaperwiththeinterestcountingagainstthegeneralgovernmentdeficitbeingthe muchloweramountsreportedthere.Forinstance,theinterestchargeontheGGDunderthis accountingmethodin2014wouldbeabout700millioninsteadof1.8billlion.

6. Conclusion
TothosewhohaveexperiencedtheIrishbankingandfiscalcrisisatfirsthand,themoraland practicalargumentsforeasingtheburdenontheIrishtaxpayeroftheIBRCsdebtmayseem obvious.MuchofthisdebtwasincurredbytheIrishstatesothatunsecuredandunguaranteed seniorbondholdersinthenotoriousAngloIrishBankandIrishNationwideBuildingSocietywouldbe paidback.ThiswasapolicythattheEuropeanCentralBankrepeatedlyurgedtheIrishgovernment toadoptintheinterestsofEuropeanfinancialstabilitybutwhichleadIrelandtothevergeof nationalbankruptcy.Today,Irelandisagaintoutedastheposterchildforausterityandreformand aneasingoftheburdenofthisdubiouslyassumeddebtwouldgreatlyimprovethechancesofa successfuloutcomefromthisprocess. Inreality,theunderstandingofIrelandseconomicwoesfromEuropeanpolicyauthoritiestendsto belesssympatheticandmoralisingargumentstendtohavelittleimpact.TheECBGoverningCouncil isextremelyfocusedonitspricestabilitygoalandmanyofitsmembersviewrepaymentofthe IBRCsELAdebtsasquicklyaspossibleasessentialtoavoidsettinginflationaryprecedentsinthe conductofmonetarypolicy. Intheory,IrelandneedsonlytogetablockingonethirdminorityontheECBGoverningCouncilto alterthetermsofitsELAprogramme,whichwouldallowforarestructuringoftheIBRCspromissory notes.Inpractice,theGoverningCouncildoesnotoperateinthisway,preferringunanimousor nearunanimousdecisions.Whilehopeshavebeenraisedthatanagreementmanysoonbereached toreducetheburdenofthepromissorynotes,Iexpectanyprogresstobeslowandincremental. AngloandIrishNationwidearelikelytocontinuetoposeaburdenontheIrishstateforalongtime tocome.Makingprogressonreducingthisburdenislikelytorequireasustainedcampaignfrom IrishpoliticianstoexplaintherelevantissuestotheirEuropeancounterpartsandthewider Europeanpublicandtoputthecaseforrestructuringasclearlyaspossible.
14

Seewww.eba.europa.eu/EUwidestresstesting/2011/QuestionsandAnswers.aspx

25

References
EuropeanCentralBank(2008).ConvergenceReport.May2008. EuropeanCentralBank(2011).TheImplementationofMonetaryPolicyintheEuroArea,February 2011. Sinn,HansWernerandTimoWollmershuser(2011).TargetLoans,CurrentAccountBalancesand CapitalFlows:TheECBsRescueFacility.CESIFOWorkingPaperNumber3500.

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UCD CENTRE FOR ECONOMIC RESEARCH RECENT WORKING PAPERS WP11/08 Kevin Denny: 'Civic Returns to Education: its Effect on Homophobia' April 2011 WP11/09 Karl Whelan: 'Irelands Sovereign Debt Crisis' May 2011 WP11/10 Morgan Kelly and Cormac Grda: 'The Preventive Check in Medieval and Pre-industrial England' May 2011 WP11/11 Paul J Devereux and Wen Fan: 'Earnings Returns to the British Education Expansion' June 2011 WP11/12 Cormac Grda: 'Five Crises' June 2011 WP11/13 Alan Fernihough: 'Human Capital and the Quantity-Quality Trade-Off during the Demographic Transition: New Evidence from Ireland' July 2011 WP11/14 Olivier Bargain, Kristian Orsini and Andreas Peichl: 'Labor Supply Elasticities in Europe and the US' July 2011 WP11/15 Christian Bauer, Ronald B Davies and Andreas Haufler: 'Economic Integration and the Optimal Corporate Tax Structure with Heterogeneous Firms' August 2011 WP11/16 Robert Gillanders: 'The Effects of Foreign Aid in Sub-Saharan Africa' August 2011 WP11/17 Morgan Kelly: 'A Note on the Size Distribution of Irish Mortgages' August 2011 WP11/18 Vincent Hogan, Patrick Massey and Shane Massey: 'Late Conversion: The Impact of Professionalism on European Rugby Union' September 2011 WP11/19 Wen Fan: 'Estimating the Return to College in Britain Using Regression and Propensity Score Matching' September 2011 WP11/20 Ronald B Davies and Amlie Guillin: 'How Far Away is an Intangible? Services FDI and Distance' September 2011 WP11/21 Bruce Blonigen and Matthew T Cole: 'Optimal Tariffs with FDI: The Evidence' September 2011 WP11/22 Alan Fernihough: 'Simple Logit and Probit Marginal Effects in R' October 2011 WP11/23 Ronald B Davies and Krishna Chaitanya Vadlamannati: 'A Race to the Bottom in Labour Standards? An Empirical Investigation' November 2011 WP11/24 Wen Fan: 'School Tenure and Student Achievement' November 2011 WP11/25 Mark E McGovern: 'Still Unequal at Birth - Birth Weight, Socioeconomic Status and Outcomes at Age 9' November 2011 WP11/26 Robert Gillanders: 'The Mental Health Cost of Corruption: Evidence from Sub-Saharan Africa' November 2011 WP11/27 Brendan Walsh: 'Well-being and Economic Conditions in Ireland' December 2011 WP11/28 Cormac Grda: 'Fetal Origins, Childhood Development, and Famine: A Bibliography and Literature Review' December 2011 WP12/01 Mark E McGovern: 'A Practical Introduction to Stata' January 2012 WP12/02 Colm McCarthy: 'Irelands European Crisis: Staying Solvent in the Eurozone' January 2012 WP12/03 Colm McCarthy: 'Improving the Eurosystem for Old and New Members' January 2012 WP12/04 Ivan Pastine and Tuvana Pastine: 'All-Pay Contests with Constraints' February 2012 WP12/05 David Madden: 'Methods for Studying Dominance and Inequality in Population Health' February 2012 UCD Centre for Economic Research Email economics@ucd.ie