Why Ireland’s two biggest banks are making their highest profits since 2007

With less than two months to the 15th anniversary of Brian Cowen’s government being forced to guarantee the Irish banking system to prevent its collapse, the two largest surviving players in the market are making the types of profits last seen during the property boom.

AIB said last week that its net profit jumped 79 per cent to €854 million, turbocharged by the European Central Bank (ECB) hiking official interest rates. Chief executive Colin Hunt forecast that the group’s full-year earnings would equate to more than 20 per cent of equity that shareholders hold in the bank.

Return on tangible equity (RoTE) is the key measure of the profitability of the bank, and the expected result this year will be well above the 13 per cent ratio that Hunt has set as his financial north star over the medium term. Analysts see a ratio of 8-10 per cent as a sign of a healthy bank.

“While the 2023 performance of AIB will be regarded as truly exceptional with a RoTE of above 20 per cent, we are very confident in the ability of our franchise and our business to generate very strong returns over the years ahead,” Hunt said to analysts last week.

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At Bank of Ireland chief executive Myles O’Grady unveiled figures on Monday showing the group’s net profits soared almost 200 per cent to €853 million, delivering a RoTE of 17 per cent.

The last time either bank was generating returns of this order was at the height of the property bubble in 2007. This time earnings are being driven by a spike in net interest margins, the difference between the average rates at which banks fund themselves and lend to customers, and as the remaining banks carve up most of the loans of exiting lenders Ulster Bank and KBC Bank Ireland as, in contrast with the boom, underlying loan demand remains muted.

Hunt and O’Grady have emphasised in the past week that they see net interest income peaking soon, as customers are only beginning to move money out of current and on-demand accounts, which are earning little or no interest, to interest-bearing products. Almost 95 per cent of Irish household deposits are sitting in on-demand accounts.

“We believe 2023 will be the high point [for profit returns],” says Maria Parra, an analyst with debt ratings agency DBRS Morningstar.

Still, both banks are counting on most of the savers’ money staying put in transactional accounts, even if they have been seeking headlines in recent months with improvements to their deposit offerings, with offers of up to 2 per cent on some accounts.

“We’ve a range of products. We’ve a 2 per cent regular saver product out there,” says Hunt. “We led the market in terms of moving deposit rates higher last November and we do expect to see customers moving.”

The buzz phrase these days among banking analysts is “deposit beta”, the percentage of central bank rate hikes that are passed on to deposit customers. AIB expects its ratio to rise from less than 10 per cent in the first half of the year to almost 30 per cent by the end of the year.

While the ECB has increased its main lending rate from zero to 4.25 per cent since last July in its war against inflation, Irish banks have lagged most European peers in raising mortgage rates – beyond automatic increases on tracker loans – as they are more reliant on cheap household deposits to fund loans.

But the rocket fuel for Irish earnings has been what the Central Bank of Ireland – on behalf of the ECB – is now paying banks for excess deposits stored with it. That rate stands at 3.75 per cent and compares to the 0.5 per cent charge that the ECB was imposing on banks for the luxury of holding their surplus cash a little over a year ago.

Following a decade and a half of households and businesses paying off debt and increasing savings, Irish banks have, for some years, been sitting on more customer deposits than they know what to do with. The situation was exacerbated by increased savings rates during the pandemic and, more recently, a wholesale move of accounts from Ulster Bank and KBC in the past 18 months.

The ECB abandonment last summer of a negative rate policy, after eight years, has turned banks’ excess deposits from a loss-making headache into massive profit machines – for now.

AIB and Bank of Ireland are making more money today out of the combined €60 billion of surplus cash parked with the Central Bank than they are from their €60 billion or so of mortgages.

Even factoring in the ECB decision last week to stop paying interest on the minimum reserves banks must hold with it from September – equating to about €2.175 billion for the two main Irish banks – the pair will still be earning an annualised €2.2 billion of gross interest, at the 3.75 per cent rate, on cash sitting with the Central Bank.

By contrast, the weighted average rate that applies to almost all outstanding mortgages in the Irish market was 3.34 per cent as of May, according to the latest Central Bank data.

Adding in the higher costs of writing mortgage business compared with taking in deposits, and the fact that banks must hold high expensive capital in reserve against home loans, underlying profitability of surplus cash with the Central Bank is much higher than what they are generating on their mortgage books.

However, Davy analyst Diarmaid Sheridan cautioned: “Comparing the returns banks could make putting deposits with the ECB, rather than lending out, is quite a short-sighted way to look at things. ECB rates can change dramatically in a matter of months. Banks issuing mortgages funded by deposits are writing business with an eye on long-term returns. Investors and regulators want to see banks run for long-term returns.”

Permanent TSB (PTSB) used up much of its excess deposits to fund the €6.75 billion of loans it has acquired in the past nine months from Ulster Bank. It has close to €2.5 billion of deposits with the Central Bank in excess of minimum reserves.

Goodbody stockbrokers analyst John Cronin noted in a recent report that the Irish market has “not seen any significant political intervention in the context of low deposit rates like we have observed in the UK”.

UK chancellor of the exchequer Jeremy Hunt met the heads of major banks in that market in June and pressed home “in no uncertain terms”, as he put it, how they have been slow to pass on rate increases to savers. Earlier this week the UK Financial Conduct Authority (FCA) said that it was giving banks until the end of the month to justify low deposit rates, before facing “robust action”.

UK lenders have been moving their fixed mortgage rates much more aggressively in the past year than Irish peers to keep in line with market pricing – or what are known as swap rates – as global investors bet on where Bank of England rates will end up.

The Irish Central Bank, on the other hand, is loathe to get involved in rates setting. The authority’s governor, Gabriel Makhlouf, highlighted to the Oireachtas finance committee in April that “the lower rates [banks] are paying on deposits are subsidising lower rates that they are charging on mortgages”.

“We strongly suspect that the philosophy amongst ‘relevant actors’ [in the Republic] is that it is not undesirable to see the depositor bail out the mortgage-holder [and the shareholder for the time being, too],” says Cronin in the report. “Nor would we expect any eventual government change to culminate in a marked change in policy ethos.”

Irish taxpayers continue to own 46.9 per cent of AIB and 47.4 per cent of PTSB.

For Brendan Burgess, a consumer activist and founder of askaboutmoney.com, the onus is on savers to find the best deposit deals.

“If I’m stupid enough to keep savings in an on-demand account earning zero, that’s my problem. Banks are profit-maximising entities. Consumers are responsible for getting the best rate possible. They need to start shopping around,” he says.

The 83 per cent surge in net interest income among the three remaining banks in the market, to a combined €3.87 billion, in the first half compares, according to Morgan Stanley calculations, to a 33 per cent increase across the euro zone. Over three-quarters of European banks having so far reported interim results.

Some 75 per cent of those lenders have also raised their earnings forecasts in recent weeks on the back of ongoing ECB rate hikes and the quality of loans holding up better than anticipated, even as loan growth “remains subdued”, Morgan Stanley analysts say in the report.

Executives at AIB, Bank of Ireland and PTSB all said in the past week that they have not seen signs of stress among mortgage borrowers amid the cost-of-living crisis, as the domestic economy remains in what is considered full employment, at a jobless rate of 4.1 per cent as of last month, and more than 60 per cent of home loans on their books having been written since the Central Bank introduced lending restrictions in 2015.

Credit quality across the wider euro zone has been helped as the labour market remains in good shape despite weak economic growth. The single-currency area’s unemployment rate dipped to all-time low rate of 6.4 per cent in June.

“As in many other European jurisdictions, Irish banks are not yet seeing a strong deterioration in their portfolios, as macroeconomic conditions have been generally better than initially forecast,” says Parra of DBRS Morningstar.

The recent spike in banks’ interest margins and the ongoing ability of borrowers to meet repayments – for now – have, however, masked one area of Irish banking that has consistently disappointed investors over the past seven years.

The three bank’s total loan books have contracted by more than 50 per cent from the peak in 2008 – driven by the sales of toxic commercial property loans to the National Asset Management Agency, other non-performing loan disposals and households and business paying off loans at a faster rate than taking on new debt.

There have been a number of false dawns in the past seven years on when loan books might grow again but Brexit, Covid, a dysfunctional housing market and the impact of the Ukraine war and soaring inflation on business sentiment have all got in the way. The banks have had to resort to buying portfolios from exiting rivals Ulster Bank and KBC Ireland to help reboot their balance sheets.

“Loan growth has been a perennial disappointment over the years since the great financial crisis in the context of the Irish banking sector,” says Cronin. “But there are signs of some structural pick-up and we see low single digit growth in net lending stock over the course of our medium-term forecast period through 2025″.

Bank of America analyst Alastair Ryan reckons that Bank of Ireland’s loan book will grow naturally by more than 7 per cent over the next two years to reach €89 billion in 2025, and that AIB’s – which is more exposed to the Irish economy – could see its portfolio expand by 11.5 per cent to €75 billion.

In the meantime, investor focus is on how quickly the two main banks will return billions of euros of capital on their balance sheets to shareholders, through dividends and large share buyback programmes. AIB and Bank of Ireland, having carried out small buy-backs in the past two years, have signalled that shareholders will have to wait until early next year for any big capital return announcements.

“The Irish banks have deleveraged for a decade and now have significant capacity to buy back stock,” says Seamus Murphy, founder of Carrighill Capital, a boutique financial research firm, adding that their reluctance so far to announce large buyback programmes “is perplexing”.

With the banks generating close to 20 per cent RoTE and their share prices still below their intrinsic value – or so-called tangible book value – Murphy estimates they could generate better returns investing in share buy-backs than on any other deal they could strike.