Ireland's bailout proposal boosts confidence

Dublin, Ireland – In response to money markets freezing due to the global banking crisis, the Irish government has drafted emergency legislation to help Irish banks access funds on the international markets.

After a turbulent day of trading on Monday, when shares in Irish banks suffered their sharpest fall in more than 25 years, Finance Minister Brian Lenihan pledged to fully guarantee deposits, bonds, and debt against Irish banks up to an amount of €400 billion ($563 billion).

“Coming into work on Tuesday we were expecting the worst,” says Ciaran Callaghan, an equity analyst at NCB Stockbrokers. “If there was no government announcement … then there was a threat that some Irish banks could go under because they weren’t able to fund themselves.”

Although the legislation is still making its way through the Irish parliament, the announcement increased confidence in the Irish financial markets. On Tuesday the Iseq index of Irish financial shares increased 28 percent, its biggest gain in 15 years.

“It’s all about confidence,” Mr. Callaghan says. “Now the cost of interbank lending and wholesale funding will be lower for Irish banks.”

Although not unprecedented, the move is unusual.

“Nobody uses it as a first option, and the textbooks say that you should avoid it if at all possible,” says Patrick Honohan of Trinity College’s School of Economics in Dublin. “There is clear evidence that crises that involve deposit guarantee end up more costly to the government in the end, probably because it reduces the market discipline pressure. It makes bankers who have a tendency to take risks to take even more risks,” he says.

Some opposition politicians have also expressed misgivings about the amount of risk, which is twice the country’s gross national product.

"We’re effectively being asked to put up the deeds of the country by [being] guarantors," said Eamon Gilmore, leader of the Labour Party, during the government’s debate.

If, as expected, the legislation is approved, it could give Irish banks an unfair advantage over their European counterparts. But Irish Prime Minister Brian Cowen maintains that there is a full understanding of the Irish government's position. Speaking at a news conference after a meeting with his French counterpart and current European Union president Nicolas Sarkozy in Paris, he said: "I think the [European Union] understands precisely why the Irish government had to act, and the circumstances in which we found ourselves.”

Nevertheless the European Commission will monitor the legislation with attention to any potential breach of competition law, although the commission is expected to support national initiatives. In a statement, Neelie Kroes, competition commissioner, stated that the commission would look at any state aid involved as a matter of urgency.

International banks with Irish branches are also at a disadvantage as they are not included in the legislation. “It is important that there continues to be a level playing field so that customers enjoy equal choice from all Irish licensed banks,” says Mark Duffy of the Bank of Scotland (located in Ireland), which has asked to be included in the plan.

The guarantee will last until September 2010 and will be monitored by Mr. Lenihan’s office.

“The bill will give significant power to the minister, including the option to force mergers or takeovers,” says Mr. Callaghan. It could also force a rights issue if a bank was severely undercapitalized.

Like other governments’ bailouts, the Irish plan’s success will depend on effective regulation.

“Regulators all around the world have got a fright because of this crisis and their models have been seen to be unreliable,” says Professor Honohan. “Their mechanical approaches to rating agencies to assess risks is not up to the complexities of the modern world. They need to have a more holistic approach to risk management. You are dealing with people – decisionmakers – not just mathematical models of risk.”

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