We met again in Galway some weeks later, on 15 September. I had been invited, along with economist Philip Lane from Trinity, to speak at the Fianna Fáil Parliamentary Party meeting about the Irish economy. That same day, the US investment bank Lehman Brothers filed for bankruptcy, sending violent shockwaves through the global financial system. On the fringes of the meeting, Lenihan and I chatted again about the state of the banks. Lenihan mused whether it would be possible ‘to knock over two dominoes without knocking the other four.’ I assumed at the time that he was contemplating the closure of Anglo and INBS, but was concerned about the knock-on effects on the other banks of such a move. He was exploring a wide range of alternatives, which I later learned was his modus operandi in making decisions. (He himself would have described it as his method of operating, as he disliked the unnecessary use of Latin in popular speech.)
Two weeks later, with the banking system on the brink of running out of cash, the Government introduced a blanket guarantee of the debts of the six main domestically owned financial institutions. The guarantee was identical to a successful scheme introduced in Sweden in the early 1990s. The emergency measure was aimed squarely at helping the banks to retain and attract new funding. In signing the guarantee order, Lenihan said: ‘The guarantee has as its central objective the removal of any uncertainty on the part of counter parties and customers and gives absolute comfort to depositors and investors that they have the full protection of the State.’
European finance ministers on 7 October announced a coordinated response to the financial crisis, though undoubtedly a clear message had been sent out from Brussels and Frankfurt to European capitals weeks earlier that there was to be no repeat of the Lehman’s debacle in Europe.
Although in the public mind the guarantee is most closely associated with the two Brians, it is often forgotten that the scheme was overwhelmingly supported by the Oireachtas. The introduction of the guarantee was also widely welcomed in the media. Criticisms of the move at the time were few and far between.
Judged against its immediate objective of keeping enough cash in the banks to forestall a widespread closure of the financial system, the guarantee worked a treat. With repayment of debt guaranteed by the (then) AAA-rated Irish State, the banks were able to raise €40 billion in new funding within six weeks. Lenihan described the bank rescue scheme as ‘the cheapest bailout in the world so far,’ a phrase that later was thrown back in his face many times as the cost to the State of shoring up the banks mounted.
Lenihan did not believe that rescuing the banks would involve no outlays. He speculated some time later that the resolution of Anglo and INBS would cost the State about €5 billion, but that the State would, in time, profit by a similar amount from its investments in the other banks. He realised that the State would incur substantial up-front costs as a result of the intervention to save the banks, but he expected that most of this outlay would eventually be recouped.
Many others shared this assessment. The Financial Regulator, Patrick Neary, in late 2008 described the banks as well capitalised, though he acknowledged that the banks might need more capital if the economy deteriorated further. Outside commentators were also relatively sanguine about the prospects for the banks. Not long before the introduction of the guarantee, the ratings agency Fitch affirmed Anglo’s long-term rating at A+ and maintained its outlook on that bank as stable. Later, in an article in The Irish Times in November 2008, ten academics specialising in finance and banking recommended that the State inject €10 billion of capital into the banks to repair them. They predicted a ‘good prospective return’ for the State on this investment.
All of these projections proved optimistic. To be fair, the ultimate cost of a banking crisis is impossible to determine early on. In the end, the State would inject €64 billion into the banks, much of which will probably not be recouped.
The higher-than-expected cost of saving the banks in part reflected the greater-than-expected severity of the recession. In Budget 2009, which was announced two weeks after the introduction of the bank guarantee, the Department of Finance projected a small decline of 1 per cent in economic activity (measured by GNP) for 2009, followed by a rebound to positive growth of 2.5 per cent in 2010 and 3.5 per cent in 2011. The Department anticipated that the unemployment rate would peak at 7.3 per cent in 2009.
Other economic forecasters were also pencilling in a relatively soft landing for the economy. In the ESRI’s Quarterly Economic Commentary (QEC) for autumn 2008, released just before Budget 2009, the QEC team forecast a modest contraction of less than 1 per cent in GNP in 2009 and a small increase in consumer spending. The Central Bank of Ireland and the IMF published similar projections. In the event, GNP plummeted more than 9 per cent in 2009 and consumer spending slumped more than 5 per cent. By the end of 2013, the depth and length of the economic downturn was such that both these measures of economic activity were still far below their peak levels in 2008. Unemployment soared to roughly twice the rate that economists had forecast.
If the economy had performed as anticipated in late 2008, banks’ losses would have been contained. But the exorbitant cost of shoring up the banks was also due to another factor. Reckless lending practices by the banks during the bubble years meant that the underlying quality of the banks’ loan books was much worse than could be gleaned by reading the banks’ financial statements. The detailed loan-by-loan due diligence examinations of the banks’ loans carried out in late 2009 and 2010 as part of the NAMA valuation process revealed a disturbing picture of poor loan documentation, of loans not properly legally secured and of marked deficiencies in the banks’ measurement and management of risk. The banks’ books were laden with landmines hidden beneath the financial accounts.
The blanket bank guarantee covered some €440 billion of banks’ debt. Deposits and bonds that were scheduled to be repaid by the banks over the next two years were covered. If the banks were not in a financial position to meet these obligations, then the State promised to make good on the repayments. The scheme categorically ruled out imposing losses on senior bank bondholders – also known as burden sharing with or bailing in bondholders – for a period of two years. Contrary to claims from some quarters, the blanket scheme was not extended beyond September 2010. Two other bank guarantee schemes were still in operation at that time and were extended well beyond 2010, but neither covered bank bonds issued before 2010. The two-year duration of the scheme meant that there would be no opportunity to bail in bondholders until October 2010. By that time, however, most of the bonds had reached their maturity dates and had been repaid in full.
Some people have argued that a narrower guarantee scheme which excluded existing senior bonds would have allowed burden sharing and reduced the cost to the State of rescuing the banks. At an abstract level, this might be true. In practice, however, this argument ignores the European Central Bank’s entrenched position regarding burden sharing with senior bank creditors. The ECB vehemently opposed bailing in bondholders. The ECB’s stance on this issue would later frustrate Lenihan’s plans to impose losses on senior bonds after the blanket scheme expired. Although promises to burn the bondholders featured in the general election campaign in 2011, to date no losses have been imposed on senior bonds of any bank in the euro area. At this remove, it is clear that the State would have had to make good on senior bank bonds, even if they had been excluded from the blanket guarantee.
More generally, there are mixed views among observers today as to whether the blanket guarantee was a mistake. A well-researched book by Donal Donovan and Antoin Murphy concludes that the guarantee was the least-worst option and that critics have failed to supply evidence that other solutions would have worked. The former President of the European Central Bank, Jean Claude Trichet, recently described the decision by the Government as ‘justifiable given the situation it found itself.’ In contrast, European Commissioner for Economic and Monetary Affairs Olli Rehn recently said: ‘In retrospect I think it is quite easy to spot some mistakes like the blanket guarantee for banks.’ Rehn’s comment is puzzling since the European Commission approved the guarantee scheme for state-aid purposes. To conform to EU state-aid rules,
