home » media centre » press releases

Cowen fails to explain why high-risk money covered by bank guarantee

Issued : Wednesday 8 October, 2008

"I am greatly concerned at the failure of the Taoiseach, at Leaders Questions this morning, to clarify why dated subordinated debt has been included in the Government guarantee to banks, announced last week. When I raised the matter this morning, he was unable to provide a rationale for the inclusion of this form of quasi-equity in the Irish guarantee scheme.

"Dated 'Subordinated' bank debt are bonds issued by banks which are subordinate to (i.e. rank after) other debts which the bank owes, should the bank fall into receivership or be closed. Another term used to describe it is 'junior' debt.

"If the bank should fail, shareholders take the first loss, followed by subordinated debt. Other forms of debt have a higher priority when it comes to being paid.

"As a result, dated subordinated debt is regarded as a form of quasi-equity.

"My understanding is that there has been a significant market in this debt over the past six months, with many wealthy individuals buying up the debt at substantial discounts. Covering this debt by Government guarantee provides a major gain to the debt holders. This form of debt is specifically excluded from the scheme announced, for example, by the Danish Government.

"Given the exposure of the taxpayer, I believe it is important to have clarity on the following issues:
- Why was this form of debt covered by the Irish guarantee?
- How much of this debt has been issued by each institution covered by the scheme?
- Who holds this debt?

There are serious issues to be addressed in this matter, and the Taoiseach's non-answer is simply not adequate.

Note on Dated Subordinated Debt

'Subordinated' bank debt are bonds issued by banks which are subordinate to (i.e. rank after) other debts which the bank owes should the bank fall into receivership or be closed. Another word commonly used is 'junior' debt.

If the bank should fail, shareholders take the first loss, followed by subordinated debt. Other forms of debt have a higher priority when it comes to being paid.

As a result, subordinated debt is regarded as a form of quasi-equity. Subject to certain rules and restrictions, subordinated debt is part of a bank's regulated capital. This means that banks are allowed to lend a multiple of the subordinated debt that they hold. Again, this reflects the risk that the bondholder takes when they buy the debt.

Subordinated debt can be dated or undated. Effectively, a bank is not obliged to re-pay un-dated subordinated debt at any point in time. Dated subordinated debt is typically issued for long periods of time e.g. it may have a life-span of five to seven years or more, at which point the bonds will be redeemed at face value by the bank.

Banks issue these debts because they make up part of the bank's capital (if the debt has a long enough maturity date). Bank lending is limited to a specified multiple of its regulated capital, so by increasing the capital through issuing subordinated debt, the bank can increase the amount of lending and hence the amount of profit that it makes.

Once the bank issues the debt, it can be bought and sold on secondary markets.

Several Irish Banks have out-standing dated subordinated debt. Over the past six months or so, it is understood that there has been a large sell off of this kind of debt. Because of the fears attaching to Irish banks, the debt has been sold at a discount of 13% - 20%. It is believed, that many high-net worth individuals have been buying this debt, sometimes through their pension funds. The discounts involved in these sales reflect the fact that the debt is risky, and that there was a perception of significant default risk associated with the Irish banks.

In its statement last Tuesday morning, however, the Government included dated subordinated debt in the list of bank liabilities to be covered by state guarantee. This debt, which is a form of quasi-equity, is sold on the clear expectation that if a bank fails, the bond-holder risks not getting their money back.

As a result of the state guarantee, where the maturity date is within the two-year guarantee period, all risk has now been eliminated and the holder makes a windfall gain. What was once a risky investment is now a gilt-edged security, carrying a high rate of interest.

If the issuing bank were to fail within the two-year guarantee period, the holders of the longer-dated debt would receive the full face value from the state.