Radical changes in store to shock banking system back into life

After two years of painfully slow moves, 2011 will see the biggest changes in Irish banks since the 1960s.

THE IRISH banking landscape will next year undergo the most radical changes since the 1960s, when Allied Irish Banks and Bank of Ireland Group were formed.

The six domestic banks – AIB, Bank of Ireland, Anglo Irish Bank, Irish Life and Permanent, the Educational Building Society and Irish Nationwide Building Society – are likely to become four or possibly even three by the end of 2011. Next month, the Government will start taking a sledgehammer to the banks to knock them down to a size that will reduce their drag on the State and restore the Government’s ability to borrow, in the process forcing some of the institutions out of existence.

The purpose of the reshaping of the sector is to increase the banks’ capital reserves and reduce their reliance on discounting funding from the European Central Bank and the Irish Central Bank on which they are hooked. The hope is that these actions will convince the financial markets that the banks have a viable future without State aid.

While the international markets – where the banks source most of their funding – never really believed that the institutions had put enough cash aside to protect against their massive exposure to the property market, the slow evaporation of liquidity over the past two years has left them on life support.

While the banks are undoubtedly afflicted by cancerous capital shortages, it is the heart attack caused by the loss of funding that has threatened their immediate survival.

The aim of the €85 billion emergency fund agreed by the Government with the EU and the IMF is to fund a restructuring of the banks and give an already-indebted Government a three-year holiday from borrowing in the bond markets to allow it to fix the financial sector.

Some €35 billion has been set aside within the programme to deal with the banks – €10 billion to overcapitalise them to international standards to try to restore market confidence and €25 billion for a contingency fund that can be drawn upon if loan losses spiral beyond even the worst-case scenarios tested.

The plan involves pushing the banks’ capital reserves to a ratio of 12 per cent – meaning broadly that they must set aside €12 for every €100 on loan – and forcing them to sell off assets to make the banks smaller so they don’t have to borrow as much. The downsizing or deleveraging of the banks will involve the banks splitting their businesses into core and non-core assets. These non-core businesses, assets and loans, will then be sold – through either outright disposal or securitisation deals – to bring their loans in line with deposits.

The first six months of 2011 will be action-packed for the banks. By the end of February, AIB must raise €5.3 billion more (on top of the €3.7 billion approved just before Christmas which pushes the bank into State control), Bank of Ireland €2.2 billion and EBS €438 million, while Irish Life and Permanent has until the end of May to find a further €100 million.

There will be another regulatory Prudential Capital Assessment Review stress test in March, with the possibility of further capital injections after that. For the first time, the Financial Regulator will perform liquidity stress tests on AIB, Bank of Ireland, Irish Life and Permanent and EBS by the end of March to assess their ability to withstand a run on deposits.

Then, detailed plans for disposal of non-core assets by each of these four banks must be ready by the end of April. All €90 billion in loans must be transferred to the National Asset Management Agency by the end of March.

Some €2 billion of the upfront €10 billion recapitalisation fund will be used to fund so- called “credit enhancements” to be applied to non-core businesses and loan books to be sold off to kick-start the shrinking of the banks.

These are guarantees and loss-sharing arrangements applied to loans to lure foreign buyers. The €25 billion contingency fund can also be drawn on to fund more of these guarantees to accelerate the sale of non-core assets.

ANGLO IRISH Bank and Irish Nationwide Building Society are to be closed over time and their deposits of €14 billion and €4 billion respectively moved to other banks, most likely AIB and Bank of Ireland, as a much-needed transfusion of funding. The wind-down plan, which will involve reversing the post-Nama remnants of Irish Nationwide into Anglo, will be completed and submitted to Brussels for approval under EU competition rules governing state aid by the end of January.

That will reduce the number of Irish banks to four. AIB and Bank of Ireland have already begun the process of downsizing their businesses. This will be intensified over the first half of 2011 as they must get their loans-to-deposits (LTD) ratio down closer to 100 per cent or below 120 per cent at least – meaning that for every €100 they have on deposit they will have less than €120 on loan.

The ratio has not been going the right way. Bank of Ireland’s LTD ratio jumped to 160 per cent from 145 per cent in November as the bank lost €10 billion in deposits as large companies withdrew funds when the credit ratings of the Government and the banks were downgraded during August and September. AIB has also seen its LTD ratio spiral as the bank shed €13 billion in deposits from the start of the year to the middle of November.

The six guaranteed institutions had loans of about €400 billion at their peak and deposits now account for about half of this level. Nama will take about €90 billion in loans out of five of the institutions – Irish Life and Permanent is not participating in Nama – but this will still bring the LTD ratios down to only about 150 per cent. Bank of Ireland had pushed several businesses and loan books into a “run-off loan portfolio”. This comprised €30 billion in UK residential mortgages and €4 billion of international corporate banking assets.

To secure EU approval for the State bailout, Bank of Ireland also agreed to sell pensions and investments company New Ireland, ICS Building Society and Bank of Ireland Asset Management, which was sold in October. The bank has planned to retain about €89 billion in loans in its core business, primarily loans in the Irish market, funded mostly by deposits.

AIB has already offloaded its Polish business Bank Zachodni and its 22 per cent stake in US regional bank MT, generating about €4 billion in capital. The bank put on hold plans to sell its UK bank, which has assets of about €20 billion, but this will be earmarked for sale under the EU-IMF downsizing programme. AIB’s fund management business, AIBIM, is also to be put on the block.

So, by the end of 2011, AIB and Bank of Ireland will be smaller retail banks and will have shed of most of their international businesses to focus almost exclusively on serving the credit needs of customers at home.

Irish Life and Permanent doesn’t have anything like the capital problems that the others face as it has a profitable pensions and investments business and didn’t follow the other banks down the hole lending to builders. The company has severe funding problems though, with the biggest LTD ratio across the sector standing at more than 250 per cent. This company is more heavily reliant on wholesale funding than any other financial institution.

To bridge the gap between loans of €38 billion and deposits of €15 billion, Irish Life must either sell off large parts of its loan book or sharply increase deposits. The former option is tricky but possible; the latter option is near impossible, given the attitude in the markets towards the Irish banks. The company’s UK loan book of €8 million, comprising many buy-to-let mortgages, could be offloaded with State guarantees applied but this will still only bring their LTD ratio down to 200 per cent.

Irish Life and Permanent also holds a heavily loss-making book of tracker mortgages, which account for about 60 per cent of the bank’s €27 billion Irish loans. Selling these would involve a substantial discount and an estimated loss of €3 billion.

A SOLUTION may lie in the future of State-owned building society EBS and a private equity consortium led by Dublin firm Cardinal and backed by US buyout firms WL Ross Co and Carlyle as the final bidders in the race. Cardinal is offering to inject new capital into EBS, while Irish Life and Permanent would rely on the Government to pump in the remaining €438 million required at the building society as the company has its own issues. Irish Life and Permanent needs about €900 million to cover its own bank, Permanent TSB, to merge it with EBS.

A takeover by Cardinal, which would send out an important message that the Government can attract foreign investment to the crippled Irish banking sector, could lead to the consortium using the building society as a “consolidation vehicle” to mop up parts of other banks, creating an enlarged banking entity or so-called “third force” to compete with AIB and Bank of Ireland.

The Government’s bank fix-it legislation – the Credit Institutions (Stabilisation) Bill – gives the Minister for Finance unprecedented powers to break up and repair the banks to the end of 2012, which ensures much quicker action. So, by December 31st, 2011 the banking system may look substantially different or be well on the way to a radical makeover.

AIB and Bank of Ireland will be back to where they were in the 1960s, focused almost exclusively on their home market. Anglo and Irish Nationwide will be en route to the morgue. Irish Life and Permanent is most likely to be carved up and its banking unit, Permanent TSB, merged with EBS as the genesis for a domestic third banking force to keep the two big banks in check from a competitive perspective.

After two years of painfully slow government action to save the banks, 2011 will begin with the Minister for Finance using his new legislative defibrillator to shock the flat-lining banking sector back to life.