As 2020 drew to a close, it was clear that Ulster Bank's days in the Republic were numbered as its UK parent, NatWest Group, was in the throes of a strategic review of the unit. Few knew, however, that the other remaining overseas retail bank in the market, KBC Group, was also having a rethink.
By the middle of April, both had confirmed that they were exiting the Irish market, where industry profit returns have been depressed for years. The reasons are multifold: an ongoing ultra-low interest rate environment, high fixed costs, muted loan demand, and the relatively high levels of capital that Irish banks must hold in reserve against mortgages as a result of the same crisis.
However, with the remaining banks preparing to take over most of the exiting lenders' loan books, the Iseq financial stocks index – dominated by AIB, Bank of Ireland and Permanent TSB (PTSB) – has rallied 40 per cent over the course of 2021, bouncing back from an almost 60 per cent slump over the previous three years.
While consumer advocates fear that the ongoing consolidation of the banking market will see reduced competition among mainstream banks, leading to higher interest rates and other charges, stock investors are betting that the retreat of Ulster Bank and KBC will give the surviving banks a fighting chance of generating acceptable, sustainable returns after more than a decade of sub-par performance.
"There are a number of reasons why Irish banks' returns have fallen short of levels deemed acceptable by the market. Deleveraging is a prominent one," said Diarmaid Sheridan, an analyst with Davy, referring to how the banks have shrunk their loan books dramatically since the financial crisis by selling risky and non-performing loans (NPL) to Nama and overseas funds, while disposing other assets as a result of EU state-aid restructuring plans.
"While banks have restructured operations, the combined effect of reductions in balance sheets and low rates result in operating scale challenges. The exits of both Ulster Bank Ireland and KBC Bank Ireland, and the sale of performing loan portfolios to the three provide a good opportunity to reverse that trend."
Still, no one’s getting carried away, with all three stocks currently trading at 45-60 per cent of their inherent value, or what’s known as the tangible book value of the bank’s assets. The wider euro zone banking sector is trading at a discounted ratio of 70 per cent.
The retrenchment of Ulster Bank and KBC from the market is only going to begin in earnest in 2022.
While Bank of Ireland is preparing to take over €9.2 billion of KBC’s loans – or 90 per cent of the Belgian lender’s Irish portfolio – and its €4.4 billion deposit book, the Competition and Consumer Protection Commission (CCPC) decided in October to carry out a full, phase-two investigation to see if the deal would substantially lessen competition in the State.
Ulster Bank's chief executive, Jane Howard, told the Oireachtas finance committee recently that she expects most of the €4.2 billion of corporate loans she is selling to AIB and the €7.6 billion portfolio she plans to offload to PTSB will transfer in the second half of 2022.
Meanwhile, the industry is bracing itself for an unprecedented deluge with hundreds of thousands of personal and business account-holders searching for new homes for their money.
Ulster Bank, with €21.6 billion of deposits as of the end of last June, is expected to start issuing customers with six months’ notice from February to close their accounts. It told rivals in early December that 916,000 personal current and deposit accounts and 70,000 commercial accounts were affected. And it comes at a time when most other mainstream lenders are holding too much cash.
PTSB is alone among the three remaining banks in needing additional deposits, as it seeks to fund the purchase of Ulster Bank loans in a move that will increase the size of its balance sheet by 50 per cent.
The next 11 months will also be dominated by a review that Minister for Finance Paschal Donohoe has asked his department to carry out on issues facing Irish retail banking – precipitated, in part, by the planned exits of Ulster Bank and KBC.
The terms of reference also include plans to map out the current retail banking landscape and likely market trends over the next decade; draw lessons from banking sectors in similar-sized open economies; and the longer-term implications of Covid-19 and Brexit.
It will also assess “operational challenges” within Irish lenders’ business models and “structural changes stemming from fintech and digital finance, which are disrupting the traditional model”, according to the department.
While the review will look at the issue of the high levels of expensive regulatory capital Irish banks must hold against mortgages and other loans as a legacy of the crash, this area remains the preserve of European and Irish regulators.
Alastair Ryan, a banking analyst with Bank of America, rounded on Central Bank officials during a virtual presentation in late November, after the regulator indicated it will likely reintroduce a requirement to build up rainy-day capital reserves for a potential future economic shock. It had reduced the so-called countercyclical capital buffer requirement from 1 per cent to zero at the outset of the pandemic in early 2020.
“There’s clearly no excuse for you to put this in place,” he said. “Your mortgage measures have been highly effective; they’re the most restrictive in the western world, SME lending is down, what, 65 per cent in the last 14 years… what you’re doing is what you’ve been doing for years, which is putting more capital in the banks regardless because it makes you feel better.”
Still, Central Bank officials offered banks hope that they may be approaching the peak of regulatory capital demands, saying they are looking at “the interaction between different macroprudential capital buffers, and the interaction with other elements of the capital regime, in a holistic way”, with the aim of providing clear guidance in the next 12 months.
Industry watchers will also eagerly await the outcome in 2022 of the Central Bank’s overarching review of mortgage restrictions, which were introduced in 2015 to prevent a repeat of the credit bubble that burst in 2008.
While the Minister kept the thorny issue of senior executive remuneration off the terms of reference for the department’s review, he knows only too well that the industry will make submissions lobbying for a relaxation of a €500,000 pay cap and bonus ban that has remained in place for bailed-out banks since the financial crisis.
A Banking and Payments Federation Ireland (BPFI) report in September said the ongoing ban on variable pay among domestic banks was putting them at a "considerable and growing disadvantage" in recruitment and retention to other lenders, IT companies and corporates.
However, the Government has refused to change the regime because of fears of a political backlash.
Still, with Mr Donohoe on track to complete the State’s retreat from Bank of Ireland’s shareholder register in 2022, having started to sell down his remaining 13.9 per cent stake in the lender last July, it’s likely the bank will use the milestone to pursue its case for a return of variable pay.
Mr Donohoe also announced just before Christmas that he plans to start selling down the State’s 71 per cent stake in AIB over the coming six months. Analysts estimate it will be left with 68-69 per cent at the end of the period.
Meanwhile, the planned introduction of laws to make it easier to hold financial services sector managers accountable for failings under their watch – under long-awaited legislation that’s set to wing its way through the Oireachtas in 2022 – will also be used to petition for an easing of remuneration restrictions.
The case will be difficult to argue until retribution arrives for the two largest banking groups in the State for their roles in the tracker mortgage scandal.
The Central Bank’s move in March to fine Ulster Bank a record €37.8 million for its involvement in the industry-wide scandal, brought the total levied against lenders to date to almost €82 million.
But 2022 will likely see the day of reckoning for the two biggest lending groups: AIB and its EBS subsidiary; and Bank of Ireland. AIB has so far set aside €70 million to cover likely fines. Bank of Ireland had ringfenced funds for a monetary sanction as part of €72 million in tracker-related provisions on its balance sheet at the end of June.
Elsewhere, the Central Bank rattled the wider banking industry in early December by fining Bank of Ireland €24.5 million separately for failing, over the course of more than a decade, to have an adequate system in place to ensure continuity of service to customers in the event of a serious IT disruption. The deficiencies weren’t fully addressed until 2019.
Laura Wadding, a partner at Deloitte Ireland specialising in risk advisory, said the fine reflected the increased digitalisation of banking in recent times, a tougher enforcement regime, and how financial firms are expected to take a preventative approach to risk identification and management.
“IT systems are no longer behind the scenes, they are a key part of how customers interact with their bank and the impact on customers of a failure in the system can potentially be much more detrimental than in the past,” she said.
European Central Bank (ECB) president Christine Lagarde has been nothing if not consistent in recent months, repeatedly saying that the prospect of interest rate increases in 2022 is unlikely, even as other major central banks have turned more hawkish amid a global spike in inflation in recent months.
With euro zone consumer prices currently rising at more than double the ECB’s 2 per cent target, and many economists estimating that inflation may prove stickier than expected, the ECB could be forced to hike rates at some stage during the year.
The biggest drag on Irish banks’ profit margins is not the ECB’s zero headline rate, but the negative charge of 0.5 per cent on excess deposits they place with the Central Bank.
AIB chief financial officer Donal Galvin thought it was time, as the bank issued a trading update in November, to share his calculations with analysts on what rising rates would do for his income line.
A one percentage point upward move in all interest rates would boost AIB’s annual net interest income to the tune of about €250 million, based on the current composition of its balance sheet, he said.
“I have a feeling we’ll be discussing this quite a bit more in the coming quarters,” he said. “I think the interest rate story for banks and particularly AIB is going to be an area of acute interest in the future.”