Sigrún Davíðsdóttir's Icelog

The French-Belgian-Luxembourg bank Dexia lent its two largest shareholders to buy Dexia shares. This practice, as familiar to Icelanders as the Northern lights, was at the core of Icelandic banking. It enabled managers to control shares and to inflate the share price, as well as securing favourable connections and the left the banks fatally weakened when share prices fell. Why have banks been bailed out with no questions asked?

From 2006-2008 Dexia lent two of its largest shareholders €1.5bn to buy its own shares, with the shares as its collateral. In September 2008 the French, Belgian and Luxembourg Government bailed out Dexia with €6.4bn. At the time, lending against own shares was legal in Belgium. The two shareholders that borrowed from Dexia in these deals jointly owned 35% of Dexia’s shares and nominated two members to the board. How likely is it that this board would be truly independent in scrutinising the running of the company?

At the time, Dexia was running dangerously low on capital and used this creative method to inflate its own capital. This practice, widespread in the failed Icelandic banks, throws further light on how this can be used and the effect it has on the individual banks and the banking climate. This practice allows the managers to fool the market, fool other shareholders and, last but not least, fool the regulators.

Consequently, lending to buy own shares runs absolutely contrary to transparency and equal information to all players in the market. With this practice, the managers who carried and the shareholders who took part knew that the bank wasn’t as sound as it seemed to be whereas the regulators and other shareholders had an altogether different picture. Or, as one enlightened expert said, when Icelog explained this way Icelandic practice to him: ‘Ah, so they converted their loan book into capital.’ – Creative indeed.

In Iceland this practice of lending to buy its own shares, with the shares as a collateral, was widely practiced in all the three banks, Glitnir, Landsbanki and Kaupthing. Kaupthing used this method quite systematically. This lending practice is thoroughly documented in the SIC report.

Kaupthing’s systematic use is particularly indicative. It secured the managers a wide control over the bank since effectively the managers themselves chose the shareholders with whom they parked the shares. With this, they could fend off possible major changes in the shareholder group, ia a hostile overtake and cement the influence of the managers in all matters.

In the three Icelandic banks, the loans to buy shares in the banks were offered to favoured clients, not to just all and sundry. The loans were heavily weighted against the interest of general shareholders and in favour of these chosen clients. What they were offered was ‘risk free’ investment, ie no risk to the borrowers, all risk on the banks. In addition, this enabled the managers to offer these ‘risk free’ investments to people they wanted to be on good terms with. Some people would perhaps use the word ‘bribe’ in this context.

How badly these loans affected the banks became inordinately clear when the shares began to fall. The banks couldn’t make margin calls as they can with other collaterals. The banks couldn’t rake in their own shares, since they could neither hold them nor sell them. Selling them in big quantities would of course have caused further falls and ultimately there were no buyers. The SIC report points out that how these loans weakened the banks, creating what the report calls ‘weak capital.’

All these effects would apply to Dexia. It would be really interesting to know on what terms these two institutional clients were offered the loans. The bank claims the loans were just normal loans. Well, I wonder. The collaterals weren’t normal nor was it in any way normal for the bank to be lending to stimulate the sale of its own shares, thereby weakening its own capital. Why were these two shareholders offered this deal? And was the risk equally divided between borrower and lender? Obviously not since Dexia couldn’t do margin calls etc as was demonstrated in the Icelandic cases. Consequently, these loans can never be normal loans.

Dexia shareholders should be up in arms about this, as should the owners of the two companies that participated in this cosy deal with Dexia, not to mention the three governments that have now twice bailed out Dexia.

It’s interesting to note who Dexia’s two favoured shareholders were. Arco, borrowing €275m, invests for the Belgian trade unions. Holding Communal, borrowed €1.2bn, claims that the whole sum wasn’t used on shares, but it’s still fair to surmise that a large part of it was. Holding Communal belongs to Belgian municipalities.

And what’s now happening to Holding Communal? It’s being bailed out itself by Belgian regional governments by a state guarantee of €450m and a federal government contribution of up to €132.5m. In addition, Dexia will write off €101.5m of Communal Holding debt.

With the banking crisis now dragging on for three years and nothing really resolved it’s about time to consider that the bailed-out banks weren’t closely scrutinised by the governments who so freely have poured billions of tax-money into these banks. It’s quite understandable that this couldn’t be done when it was all happening in October 2008 – but the fact that it hasn’t happened since then is a gross negligence on behalf of those who are in charge, both regulators and financial services authorities.

At the core of the Eurozone crisis is reckless lending. And the reckless lending is part of reckless, possibly corrupt, banking that hasn’t been stopped although so many banks have been and are being saved by governments. These governments are trusted by their voters to make the best use of public money. In the case of Dexia and many other banks governments haven’t at all scrutinised what public money is bailing out. That is a serious failure of public duty.

*Earlier Icelogs on corruption and its effects on the Eurozone crisis can be found here and here.

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