Irish banks still grappling with legacy issues a decade after crash

Next month marks the 10th anniversary of when Irish taxpayers started to inject money into the State's domestic banks, a bill that ultimately ballooned to €64 billion and serving to tip the Republic into a bailout programme rescue of its own with the European Union and the International Monetary Fund.

AIB, Bank of Ireland and Permanent TSB will next week report their full-year results for 2018, with analysts expecting them to reveal that their combined net profits rose 4 per cent to €1.8 billion.

There are other signs of their return to health. AIB and Permanent TSB have both returned to the public markets over the past decade, while AIB and Bank of Ireland have resumed dividend payments to shareholders, including the State.

Yet, some of their problems are as intractable as ever, while others have been added to the mix, serving to push the Iseq financials index down 28 per cent over the past 12 months.

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Interest rates: lower for longer

Six months ago, euro-zone banks were optimistic that the European Central Bank (ECB) would start raising interest rates from the second half of 2019, which would allow them to grow their interest margins and profits by increasing rates on loans at a faster pace than customer deposits.

However, increasingly weak economic data – with figures out last week showing that Germany narrowly avoided recession in the fourth quarter of last year – have prompted financial market investors to push out their expectations for an ECB hike to the middle of next year at least.

Bank of France governor François Villeroy de Galhau, who is also a member of the ECB governing council, warned earlier this week that the slowdown of the European economy is “significant” and that the timing of its first post-crisis rate hike depends on whether this is a blip or a more protracted weakness.

Political noise

While Ireland stands out as a rare country to have escaped a populist wave that has swept through Europe in recent years, banking executives have found themselves having to explain the fragmented make-up of the current Dáil to debt and equity investors in recent years.

Fianna Fáil published a Bill aimed at giving the Central Bank powers to cap mortgage rates within weeks of agreeing to underpin a minority Fine Gael government in 2016.

While the Central Bank Variable Rate Mortgages Bill has failed to progress through the Oireachtas, with the Attorney General highlighting in 2017 that the proposed laws had "significant constitutional issues", Fianna Fáil made it clear late last year in extending its confidence-and-supply agreement with the Government that tackling Ireland's high mortgage rates is one of its key priorities.

Meanwhile, a new Sinn Féin Bill to prevent banks from selling problem loans to investment funds without borrowers' permission was backed by the Dáil late last month in an initial vote. The Central Bank had warned the Department of Finance that the No Consent, No Sale Bill 2019 could trigger unintended consequences. These include possible interest rate increases as banks are forced to hold more regulatory capital against defaulted loans; and risks to the stability of the financial system and the State.

Rebuilding loan books

The five retail banks that survived the crisis in Ireland – Bank of Ireland, AIB, Ulster Bank (owned by Royal Bank of Scotland), Permanent TSB and Belgian-owned KBC Bank Ireland – have seen the size of their loan books shrink by about 50 per cent in the past decade to €188 billion at the end of December, according to company filings and analysts' estimates.

This has been down to a combination of loan and asset sales by some lenders to the National Asset Management Agency and overseas investors, and households and companies repaying their borrowings at a faster pace than taking on new debt following the crisis.

While bank investors have long held out hope that Irish banks would turn the corner and start rebuilding their loan books again to boost their profitability and aid the wider economy, Bank of Ireland began to see its loan book begin to grow again for the first time since the crash only in the first half of 2018.

Although mortgage lending increased by almost 20 per cent to €8.7 billion last year, the figure was below the €9.5 billion that was being forecast 12 months ago by some observers, as Central Bank lending caps and low levels of housebuilding weighed.

Non-performing loans

They haven’t gone away, you know. The State’s banks have cut their combined non-performing loans (NPLs) from a peak of €80 billion, or 32 per cent of total loans, in 2013 to about €18 billion currently. That equates to a ratio of 9.5 per cent. However, banks remain under pressure from regulators to move their ratio to the European Union average of 3.5 per cent.

Permanent TSB, which entered 2018 with an NPLs ratio of 26 per cent, went on to become the first bailed-out Irish lender to put problem owner-occupier mortgages on the market, which courted significant political outcry. Analysts reckon that PTSB, in shifting €3.4 billion of NPLs through sales and securitisation deals late last year, will have reduced its ratio of below 10 per cent.

AIB, Ulster Bank and KBC Bank Ireland also sold NPL portfolios last year. AIB is currently marketing another €3 billion-plus portfolio, while Ulster has flagged that it will sell a sizeable pool of mortgages towards the end of 2019. Bank of Ireland may also sell loans. The final push may prove the trickiest.

Executive pay

AIB, which received a €20.8 billion bailout during the financial crisis, warned in its initial public offering (IPO) documents ahead of its return to the main Dublin and London stock markets in June 2017 that the €500,000 executive pay cap and effective ban on bonuses across rescued banks were making it difficult to attract and retain “skilled personnel of high calibre or in specialist areas”.

AIB proposed 12 months ago to reintroduce a share bonus plan for top executives, but Donohoe used the State’s 71 per cent shareholding to block the plan at the company’s annual general meeting last April.

Donohoe subsequently put the vexed topic of bankers pay out to consultation, hiring executive search group Korn Ferry late last year to draw up a report. An initial draft of the report is said to have characterised the status quo as unsustainable, especially as overseas financial services companies are moving activities to Ireland in light of Brexit.

In the past six months, both AIB's chief executive Bernard Byrne and chief financial officer Mark Bourke have handed in their notice, adding to 15-odd per cent of senior managers that the bank has claimed to have lost since the IPO.

Bank of Ireland chief executive Francesca McDonagh also said last year that the remuneration restrictions had curbed her ability to make senior hires, leaving an element of risk to her medium-term strategy for the bank.

Brexit

Some 40 per cent of Bank of Ireland’s loan book is based in the UK, leaving it the most exposed to any economic wobble that occurs as a result of Brexit.

Data published last week showed that the UK economy slowed sharply towards the back end of 2018, pushing annual growth down to 1.4 per cent, a six-year low. The British government estimates that as much as 10.7 per cent would be wiped off the size of the country’s economy over 15 years in the event of a disorderly Brexit.

AIB and Permanent TSB, as pure plays on the Irish economy, would bear the brunt of the knock-on impact on the Republic.

“The UK is Ireland’s largest destination for services exports, accounting for 8.3 per cent of GDP [gross domestic product] in 2018, and the third largest market for merchandise exports, after the EU27 and the US, worth approximately 5 per cent of GDP,” Standard & Poor’s said in a report published this month.

The Department of Finance estimates that the size of the Irish economy could be 4.25 per cent smaller than current projections over the medium term under a “hard Brexit” scenario.

Recovery of the State bailout

Ireland’s three surviving bailed-out banks, which received €29.3 billion in taxpayer bailouts during the crisis, have since returned a total of about €19 billion to the State – including share sales, the repayment of bailout bonds, interest income and fees on State guarantees.

However, taxpayers’ combined holdings in AIB, Bank of Ireland and Permanent TSB currently amount to €8.36 million – leaving a paper shortfall of almost €2 billion, after Irish financial stocks slumped more than 28 per cent in the past 12 months.

With shares in all three banks currently trading at deep discounts to the value the banks place on their own assets, it is unlikely Donohoe will be in a position to sell further shares any time soon.

Tracker scandal

More than three years after the Central Bank ordered lenders to look through their books for cases where mortgage holders were wrongly denied their right to a cheap loan linked to the main ECB rate, the number of impacted customers continues to rise.

The Central Bank reported earlier this month that banks had identified a further 1,400 cases in the past four months of 2018, bringing the total to 39,800 – almost double the level of late 2017.

While regulators have said the examination is entering its final phase, they are continuing enforcement investigations against the country’s six main mortgage lenders, looking at how the companies – and individuals within them – acted as far back as a decade ago when they started reneging on borrowers’ tracker rights. They’re also assessing how banks have dealt with the scandal in recent years.

Law changes in 2013 doubled the maximum financial penalty the Central Bank can impose to €10 million, or 10 per cent of turnover, and for individuals from €500,000 to €1 million.

The scale of the country’s largest overcharging debacle has also prompted Donohoe to commit to introducing laws this year to give the Central Bank more powers to make top bankers accountable for failings under their watch. A Department of Finance spokesman said that while the aim is to introduce the heads of a Bill by the end of March, that may be pushed out due to Brexit.

Risk-weighted assets

Bankers love their jargon. But if you want to know the main reason why Irish mortgage rates are currently at more than 3 per cent, when the average euro-zone rate is below 1.8 per cent, you need to get your head around risk-weighted assets (RWAs).

These are assessments of how risky certain bank assets are, and they determine how much expensive capital banks must hold in reserve to absorb shock losses. Mortgage RWAs in Ireland are more than three times the euro-area median, according to Goodbody analyst Eamonn Hughes.

“So, Irish banks must hold €50 of capital for every €1,000 of lending versus just €16 in Europe,” Hughes said in a recent report. This is largely a result of how bad the Irish property crash and mortgage arrears problem became during the crisis.

“In our view, the simplistic comparison of headline mortgage rates across Europe is misleading, comparing ‘apples with oranges’, due to differences in mortgage risk weights, capital targets, cost-income ratios, other mortgage-related income [fees] not relevant in Ireland and the pace of access to underlying collateral in repossession,” Hughes said.

Goodbody said that Irish banks’ return on shareholders’ equity – the most straightforward measure of how profitable lenders are – lies in the bottom quarter of the European league. It will be some years before Irish banks will be able to reduce their RWAs to norms elsewhere.

Costs

The Irish banking sector has shed more than 25,000 jobs over the past decade, as some overseas lenders fled the market and those that remained reined in costs.

However, analysts believe that the banks’ costs base still remains too high, with further cuts likely over the coming years as lenders increase their spending on technology.

Bank of Ireland, currently in the middle of a €1.4 billion IT and transformation programme, is expected to axe up to 20 per cent of its workforce by the end of 2021 – equating to more than 2,000 jobs – according to some analysts. It’s unlikely to be alone as machines increasingly take over roles carried out by people in the industry.