The contingent liability on non-defaulting banks appears to have been removed, writes Colm McCarthy

THE CREDIT Institutions (Financial Support) Scheme 2008, passed by the Oireachtas last week, is the statutory instrument giving effect to the Government's two-year guarantee of the Irish banking system's liabilities. An important modification to the scheme appears to have been made in a market notice posted on its website by the Department of Finance on Wednesday last.

The scheme as agreed by Dáil and Seanad has several key features. The first is that participation is voluntary. All liabilities apart from shareholder equity are guaranteed for two years. A levy on the balance sheets of participating banks is to be imposed, possibly differentiated by perceived riskiness.

If the Government pays out to the creditors of a bank, it would seek to recover the cost in the first instance from the defaulting bank. Should that fail, recourse to the non-defaulting banks that have chosen to participate would be had. Non-participating banks would not, it would appear, have to pay up. The potential contingent liability could be enormous, relative to the capitalisation of a non-defaulting bank. The scheme states: ". . . in particular where the guarantee is called upon and a payment is made but the financial support cannot be recouped in full from the covered institution to which it was provided, the principle is that it would be recouped in full from the covered institutions by the State over time in a manner consistent with their long-term viability and sustainability".

Eleven banks (six Irish, five foreign-owned) have been deemed eligible. The foreign banks are owned by British and Dutch parents. The parents have been recapitalised and/or have access to support schemes offered by their home governments. While the six Irish banks are believed by the markets to be under-capitalised, some may be in reasonable shape but some may not, and could make calls on the guarantee. These latter will join the scheme for sure. But why should anybody else?

The Government would, under the terms of the scheme, inflict certain other "hardships" on participants, including board members, officials on various committees, remuneration caps and the like. Most importantly, there could be balance sheet controls, that is, a growth cap or requirements to contract.

From the standpoint of the five foreign banks, once the wholesale markets get back to normal, the attractions of an Irish guarantee will fade. Opting out achieves two key commercial benefits. There would be no liability to pay for the losses of defaulting banks, plus freedom from balance sheet constraints and the opportunity to win business from constrained participating Irish banks.

Any of the Irish banks that feels it could survive outside the scheme would also be tempted to stay out, particularly if it could access capital through either a rights issue or through becoming foreign-owned. If one of the six Irish banks believes itself to be the best capitalised, and sees the foreign banks opting out, it has every incentive to try to do the same. The fewer that opt in, the worse it gets, since there are fewer partners to share the costs imposed by the defaulters.

The Government, possibly in the realisation that some banks would indeed stay out, appears to have removed the contingent liability on non-defaulting banks. The Department of Finance's market notice reads: "A covered institution is not required to indemnify the Minister in respect of any payments made by the Minister under a guarantee given to any other covered institution which is not a member of its corporate group." This is in fairly flat contradiction to the intention stated in the statutory instrument, and appears to mean that the taxpayer will meet the cost of default. This may of course have been inevitable anyway, since a fragile and possibly undercapitalised group of "good" banks are hardly the most obvious source of bailout funds for the "bad" banks. A voluntary scheme with contingent liabilities and other handicaps for those with least incentive to join never made much sense.

The blanket guarantee, however modified, has substantial potential cost unless all of the banks turn out to be solvent, and does not of course address the capital adequacy question.

Colm McCarthy lectures in economics at UCD