Irish banks must not forget the sky-high cost of money
One of the starkest consequences of the financial crisis affecting everything, from countries to banks to businesses to borrowers, is that money is now far more expensive than it was just a few short years ago.
So when you hear the new management at the surviving Irish bank (AIB) that has sucked up the most public money (€21 billion) saying that it will offer returns of between 8 and 12 per cent to investors, you wonder who exactly will pay for this.
AIB chief executive David Duffy has set out his stall several times, most recently at the Oireachtas finance committee last month. He believes a simple bank with low costs and high technology that is competitive and has a stable market share can offer investors these kinds of annual returns.
But if a bank’s starting point is capital and having enough of it to raise sufficient deposits and other funding to lend on to customers, then – in the current climate of cash being so costly – making these returns on that cash is not so straightforward.
The international financial crisis has taught us that the world of banking got it badly wrong when it came to deciding what levels of capital banks should be setting aside to protect against losses.
The Basel international banking rules fell well short of what was required on how much capital banks must hold. The crisis has shown that there should have been about four times the original minimum levels of capital under the earlier rules.
This means that most banks, even the most prudent, now require further capital. Take Europe’s biggest bank, Spanish lender Santander. This was shown to be in rude financial health in the country’s bank stress tests in September, yet it has been busy shoring up capital by selling assets.
When cash is tight and banks are not lending cash to each other as the European Central Bank had hoped with its injection of about €1 trillion of discounted three-year money into the system, the cost of capital and funding will remain high.
AIB told the Oireachtas committee last month that mortgages rates may have to rise to 5-6 per cent . And head of Danske Ireland Terry Browne told The Irish Times last week that mortgages may need to reach 5 per cent (from current levels of in or about 4 per cent) over time.
Breaking link with banks
Ireland’s prospects of emerging from this crisis rest partly on breaking the State’s link with the banks so the banks can stand on their own and get on with fixing themselves on their own, and the State can deal with its own non-banking problems.
That’s all well and good. But one of the ways the Government is trying to make the banks somebody else’s problem is to try to sell down its stakes in Bank of Ireland (15 per cent), AIB (99.8 per cent) and Permanent TSB (99.5 per cent) in the near term.
Any investor will only part with their cash if they believe that these banks are profitable or at least getting there.
To get profitable, interest rates on loans must rise and this will further exacerbate the problems in the mortgage books for the minority of customers on standard variable rates which the banks can change.
Higher rates will also further deter bank customers from becoming active consumers who are willing to stop saving and start spending. This will inevitably delay the much-needed domestic economic growth.
So if the cost of bank capital remains high there is little chance that borrowers can avoid paying more for money unless the banks cut their overheads to shreds.
Dysfunctional banking creates opportunities for a more advanced market in Europe for commercial mortgage-backed debt, a market where US companies raised as much as 75 per cent of their funding.
But that is still some way off.
The news this week that Europe is about to follow the US in delaying stricter rules on banking capital will create breathing space. The Basel III rules were due to start coming in next year and this would have added further pressure on banks meeting anything like the investor returns of old.
Given the current price they must pay for money and the capital they are likely to have to hold, banks could be for a more mundane life as boring, utility businesses providing credit at levels that will offer investors nothing more than steady-as-she-goes returns. This does not bode well for a Government looking to dump its stakes in the banks, but going in the other direction would mean customers will be squeezed.
Either way, it raises the question whether Ireland is a country with bankrupt lenders and an economy attached or vice versa.