IRISH BANKING WOES: POLITICAL QUICKSAND

C O N F I D E N T I A L SECTION 01 OF 03 DUBLIN 000086

SIPDIS

STATE FOR TREASURY VIMAL ATUKORALA

E.O. 12958: DECL: 02/11/2019
TAGS: PGOV PREL ECON EFIN EI
SUBJECT: IRISH BANKING WOES: POLITICAL QUICKSAND

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Classified By: Acting Pol/Econ Section Chief Dwight Nystrom; reasons 1.
4(b/d)


1. (C) Summary: Recently, the Finance Minister Brian Lenihan
announced a recapitalization plan for Ireland's two largest
banks. The terms of the recapitalization stated that the
government would receive preferred shares in exchange for the
investment and the Minister for Finance would name 25 percent
of both banks' boards of directors. The compensation of bank
executives will be reduced by at least 33 percent. These
banks are viewed to be the strongest in Ireland and
economists and ex-management of other banks indicate that
Ireland's smaller banks will likely require government
support. Further, troubles continue to unfold at Anglo-Irish
bank, with the revelation of an additional Euro 451 million
in bad debt associated with the bank financing the purchase
of its own shares. The Irish police executed a search
warrant on Anglo-Irish's offices in connection with the
growing scandal. According to several of our contacts, the
banking sector troubles are becoming a political problem for
the government. As well, the small, generalist Department of
Finance is finding it difficult to deal with the twin crises
of the banking meltdown and an expandig fiscal deficit. End
Summary.

OWNERSHIP
--------------


2. (U) Under the terms of the recapitalization plan, the
Government will provide Euro 3.5 billion in Core Tier 1
capital to Allied Irish Bank (AIB) and Bank of Ireland (BOI).
In return, the government will receive preference shares
with a fixed dividend of 8 percent payable in cash or
ordinary shares in lieu of cash. Until the fifth anniversary
of the issue, the banks have the ability to repurchase the
preference shares at par value. After that time, they may be
repurchased at 125 percent of face value. Warrants attached
to the preference shares enable the government to purchase up
to 25 percent of the existing shares if share prices reach a
specific level. The strike price for the first 15 percent is
Euro 0.976 for AIB and Euro 0.52 for BOI. The strike price
for the balance is Euro 0.375 for AIB and Euro 0.20 for BOI.
As of market close on February 23, the share prices for AIB
and BOI were Euro 0.58 and Euro 0.30, respectively. If a
bank redeems up to Euro 1.5 billion of the state investment
in new preference shares from privately sourced Core Tier 1
capital prior to December 31, then the warrants will be
reduced pro rata to that redemption to an amount representing
not less than 15 percent of its ordinary shares.

MANAGEMENT AND FUNDING SOURCES
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3. (C) The Minister for Finance will name 25 percent of the
directors at each of the banks. Additionally, the government
will receive 25 percent of the voting rights in respect of
change of control and board appointments. All directors of
both banks will resign prior to the 2009 annual general
meetings. Additionally, compensation of senior executives
will be cut by at least 33 percent. They will receive no
bonuses or salary increases related to performance in 2008 or

2009. Payments to non-executive directors will be reduced by
at least 25 percent. The recapitalization program will be
funded from the National Pensions Reserve Fund, with Euro 4
billion from the fund's current reserves and Euro 3 billion
from a front loading of the Exchequer contributions for 2009
and 2010. Alan Barrett of the Economic and Social Research
Institute (ESRI) indicated that the expenditure and related
indebtedness is relatively minor given Ireland's debt to GDP
at the beginning of 2009.

CONTINUED DIFFICULTIES AT ANGLO-IRISH
--------------


4. (U) On February 20, Anglo-Irish Bank revealed that it
lent 10 customers (nicknamed "the golden circle" in Ireland)
Euro 451 million to purchase Anglo-Irish shares, with 75
percent of the loans secured by the shares and 25 percent
secured by the participants' "personal assets." David Drumm,
Anglo-Irish's former chief executive, assembled the group to
purchase 10 percent of the bank's shares in order to prevent
shares acquired through contracts for difference with
businessman Sean Quinn coming to market. He feared that this
would have led to a sharp decline in share price. On
February 22, the Irish Times reported the names of four of
the investors, all of whom are well-known real estate
developers. Anglo-Irish expects to write off Euro 300
million in relation to this transaction.


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5. (U) On February 24, the Garda (the Irish police force)
executed a search warrant on a number of Anglo-Irish Bank
offices in Dublin. According to press reports, the police
are searching for documents that could provide evidence of
offenses under company law. Justice Minister Dermot Ahern
said, "legislation is in place to bring to justice those who
may have played hard and fast with the financial security of
this country." He continued, "we operate the rule of law.
As far as I am concerned, that provides that, whether you
have a balaclava, a sawed-off shotgun or a white collar and
designer suit, the same rules apply."

THE FUTURE OF BANKING IN IRELAND
--------------


6. (C) Economists generally agree that AIB and BOI are on
sound footing. However, they have expressed considerably
more concern over the smaller banks. Barrett indicated that
the Irish people would have been better served had
Anglo-Irish been allowed to fail. Rumors continue to
surround the future of Irish Nationwide, whose former
Chairman, Dr. Michael Walsh, resigned on February 17. The
building society is currently run by 71 year old former
managing director, Michael Fingleton. Following his surprise
resignation, Walsh stated that Irish Nationwide could not
survive without significant government support. The
Department of Finance is currently reviewing the likely
capital needs of Irish Nationwide, Irish Life & Permanent,
and EBS building society. Barrett indicated that there would
likely be continuing fallout in the sector.


7. (C) Emboffs have had recent conversations with others who
agree with Barrett that there is more to come from the
banking scandals. Andrew McDowell, economic advisor to
opposition party Fine Gael, said that Fine Gael hopes that
the Euro 7 billion bank recapitalization scheme works but
that it is probably only a temporary solution.
Unfortunately, he said that was all the money the government
could pull together at the time. He worried that in three
months the government will need to inject fresh capital into
the banks and he was unsure where this money would come from.
Fine Gael preferred the idea of setting up a "bad bank" that
would hold the bank,s impaired assets. McDowell also
believes that we have not seen the end of revelations of
misconduct in the banking sector. However, he said for the
time being opposition parties are not going to cause a fuss
over the issue because of the fragility of the economy but in
a few months "all bets are off."


8. (C) Eoin Fahy, chief economist at KBC Asset Management,
worried that the scandals at Ireland's banks are permanently
damaging the country's image as a safe, steady place for
financial institutions to do business. He said that the
"light touch" regulatory system that has served to draw in
these firms will be revamped with the result that firms will
leave. Fahy confirmed that the low corporate tax rate is
"untouchable" but he worried if this was enough to keep these
companies in Ireland (Note: Fahy is on the Commission on
Taxation, which was tasked by the government to make
recommendations about how to improve the tax code. End
Note.) Fahy noted that it is "quite likely" that the Fine
Gael leadership knows the identity of "the golden circle"
individuals but he is not convinced that the Fianna Fail
leadership does. He asked two Cabinet-level Fianna Fail
members (who happen to be personal friends) whether they knew
the identities. They maintained they did not. Nevertheless,
he believes, "this will not end well for the government."

COMMENT
--------------


9. (C) Economists generally believe that the banking sector
will weather the current storm and that AIB and BOI will
emerge from the wreckage. However, the fate of the smaller
banks is more uncertain. Our contacts agreed that the
banking crisis is rapidly becoming a political headache for
the government and that the government's raid on
Anglo-Irish's offices may be an indication of the desire to
deal firmly with the problem. The public has come to believe
that the revelations about Anglo-Irish to date represent only
the tip of the iceberg. Beyond the scandals, the
government's lack of institutional capacity to deal with the
banking crisis and a burgeoning fiscal deficit at the same
time is worrying. According to Barrett, the generalist
nature of the civil service diminished the ability to
adequately monitor and regulate financial institutions and
allowed larger organizations to dictate to the regulators,
who were wholly incapable of understanding the deception
present in Anglo-Irish. Unless the government acts quickly

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to rectify this problem, Ireland's tarnished reputation could
blacken further.
FAUCHER