Why should we believe a word the banks tell us about their ability to carry on business? The three biggest lenders — AIB, Bank of Ireland and Irish Life & Permanent — all insisted in the past fortnight that they’re not short of the capital required to issue new loans. But only the most naive would believe this latest confidence trick.

Put simply, the banks have form when it comes to understating their problems. For years they denied lending recklessly, despite being the prime players in a pyramid scheme where they lent massively to property developers. The developers then flogged over-priced houses, apartments and commercial buildings to people who borrowed far more than their income warranted. The buyers got that money from the same banks who had funded the developers in the first place.

As their share prices collapsed earlier this year, the banks insisted they were happy that most customers could meet their repayments. They even insisted that the security given for loans — usually property — had retained sufficient value if they had to be sold. They boasted that they were flush enough to continue paying out dividends to shareholders.

The technical term for all this guff is “maintaining confidence”. In reality it was an attempt to fool the investors who traded their shares. It didn’t work. Most investors ignored the spin and sold Irish bank shares, to the extent that they are now worth just a small fraction of their value 12 months ago.

Now those same banks are being forced to confront reality. They are finally admitting that some customers can’t repay loans and that the assets securing those loans have fallen in value. Money is now being put aside to meet bad debts. That’s eating into profits, but it’s not enough to cope with the coming crisis.

The banks are still looking after their biggest customers, particularly the property developers who have massive debts. They are giving them a holiday from repayments, or if the interest cannot be paid they are adding it to the loan. In cases where banks address the reality of falling asset values, they are forcing some borrowers to make sudden repayments to cover the reduced value. Shareholders won’t be getting dividends for the foreseeable future but that won’t be enough to protect the banks’ capital bases.

Given their parlous condition, you’d imagine all donors bearing fresh capital would be welcomed. An injection of funds would allow the banks to get on with business, using rebuilt profits to cover the losses on bad loans. It’s happening all over the world.

For some reason our own banks believe they are different. They insist they don’t need new capital, and certainly not from the state. AIB boss Eugene Sheehy told investors recently that he’d “rather die” than allow the government to become an investor in his bank.

This is an extraordinary statement. AIB had to be rescued by the government in the mid-1980s from the near fatal consequences of its purchase of an insurance company. Just six weeks ago AIB chairman Dermot Gleeson and his Bank of Ireland counterpart Richard Burrows went to the Department of Finance on bended knee pleading for government action to stop a potentially ruinous run on their banks.

The government acquiesced, and that was the correct decision. It didn’t want to bail out the banks, but ministers couldn’t risk the economic carnage that would have developed if a bank had collapsed. The banks may have exaggerated the crisis, but the government had little time to assess the situation and acted decisively, guaranteeing the deposits and liabilities of seven domestically owned lenders at a potential cost of ¤440 billion.

But that is not enough. The government needs to do more to reform the banks and that means going beyond the populist stuff such as curbing salaries and bonuses for top executives. It needs to find a way to ensure that the banks continue lending for non-property related activities, particularly to businesses.

The mounting anecdotal evidence is that they are failing in this basic function. Many companies with cash flow problems, exacerbated by difficulty in getting payments from customers, are facing ruin. Ironically, the banks have been given two years’ comfort courtesy of the taxpayers, but are not reciprocating where their customers are concerned.

They have no interest in new business and seem content to take in repayments on good loans and squeeze what they can from bad ones. They have turned into “zombie banks”. Even though their liquidity is no longer a problem (¤25 billion in deposits has come from abroad in just six weeks), they are keeping all the benefits of this cash themselves.

But the game is now up. Bank shares have continued to fall in the wake of the government guarantee because you can’t fool the investment community. They know new capital has to be raised. Hundreds of millions of new shares will have to be issued in exchange for money, which will dilute further the value of shares already in existence. It’s in the interests of existing shareholders to prevent this.

Directors and senior managers in all the banks have large shareholdings and they are now worth a fraction of what they paid for them. Some holdings were paid for with borrowed money. So while an injection of capital would improve a bank’s ability to do business, it could undermine further the financial positions of those who operate the banks, especially as any new owners would want to remove those responsible for creating the mess.

Despite their own problems — and their moral debt to taxpayers — the banks are cynically exploiting the government’s own weakness, refusing not just to raise new capital but also resisting mergers with weaker competitors or lending for anything but the safest of ventures. The banks can get away with this safe in the knowledge that the government is skint and doesn’t want to bear the cost of recapitalisation unless absolutely forced to do so. Worryingly, there is no sign of private investors lining up to plug the gap.

Price Waterhouse Coopers is in the second phase of an investigation into bank debts and that will put the government in a better position to decide how much, if anything, it should invest. The government has little time in which to act but should have no fears if it decides it must take control of the banks. This would allow it to get a fair return on its investment while ensuring that financial institutions play their essential role in the proper functioning of the economy. In time, it might even be able to sell on its investment at a profit.

In taking this step the government must be able to show that any purchase is in the best interests of the state and not the bankers who created the mess. That would require the wholesale firing of directors and senior managers to avoid the perception that they are being rewarded for failure.

Of course, if the same criteria was to be applied to the civil servants and politicians who have destroyed public finances over the past few years, there could be a lot of blood-letting by the time this crisis has run its course.

matt.cooper@sunday-times.ie

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