Restarting flow of credit the most immediate challenge facing main banks


The substantial scale of the National Asset Management Agency’s proposed asset cleansing process for bank loans may represent overkill, at least for now, writes OLIVER O'SHEA.

THE BANKS’ full-year reports provided more detail than usual on asset quality, with the position of the two core systemic banks – AIB and Bank of Ireland – of most interest.

While management lost credibility given the time taken to realise the extent of the credit quality issue, after numerous reviews of their loan books, it is not unreasonable to assume and expect that their loan quality “stress tests” are now more rigorous.

Both banks claim to have more than sufficient capital to meet their “worst case” bad debt scenarios through 2009-10. If this is the case, the greater immediate issue is not the cleansing of balance sheets but more how to restart the flow of credit given this surplus capital.

At the same time, however, their market value implies an expectation that future loan losses will virtually wipe out the existing equity base as well as future earnings streams – the management teams which oversaw the growth in credit do not now appear to carry sufficient market credibility in accurately defining the scale of bad debts.

Nama (National Asset Management Agency) is intended to address the credibility issue with capital investors – however, if market perception and not any real lack of capital is the reality, the substantial scale of Nama’s proposed asset cleansing process may represent overkill, at least for now.

Despite the extent of public discussion on capital adequacy, it is often characterised by an absence of numerical rigour. To try and address the key issue of uncertainty regarding the capital position of the banks, this analysis estimates what level of asset write-downs the banks can sustain over 2009-2010 while still retaining sufficient capital to remain as “going concerns”. This then provides a baseline from which to begin estimating what the additional cost of any required recapitalisation might be.

I have excluded Permanent TSB and EBS from the analysis given that any requirement for additional capital support will be immaterial overall. Taking the other four institutions, their total capital base, including existing provisions against future bad debts, is currently about€50 billion. By end-2010, I estimate that combined capital and provisions increase to about €59 billion, assuming pre-provision profits run at about 70 per cent to 75 per cent of 2008 reported levels through 2009/10. Of this, about €30 billion is required to support a “going concern” banking sector – admittedly this assumes a 4 per cent (core) Tier I ratio and an 8 per cent capital ratio overall, the lowest allowed. At this level, however, the US Federal Reserve regards a bank holding company as “adequately capitalised”.

If it is also assumed that Irish Nationwide and Anglo Irish Bank are closed to new business and wound down, obviating the need for capital to support ongoing operations, the capital requirement could potentially be a minimum of about €22 billion.

This includes the €1.5 billion that AIB intends to raise via the sale of “marketable assets”, implying that it is holding assets undervalued by €1.5 billion. MT is valued in AIB’s balance sheet at €1.5 billion – about €400 million higher than AIB’s share of its current quoted market value of $6.0 billion.

BZ WBK is a better prospect, trading at a premium to its about €1 billion book value but giving an estimated gain of just about €400 million.

Thus it is likely that AIB is targeting additional disposals, resulting in a much smaller and more regionally focused banking operation – the ability to raise this capital is the most significant variable in this analysis.

On this basis, there is currently about €22 billion available to absorb future loan losses, rising to an estimated €29 billion (see table) by the end of 2010, while still retaining enough capital (€30 billion) to support a viable “going concern” banking sector. If regulatory capital can also be released intact (not a foregone conclusion) from Anglo Irish Bank and Irish Nationwide, the above figures could increase to a maximum €30 billion and €37 billion, respectively.

In rebuilding capital, the Irish banks also have a clear advantage over their EU peers via Ireland’s 12.5 per cent corporation tax rate, allowing them to retain a far higher proportion of their taxable earnings. This capital is not fungible, however, whereby a shortfall in one bank can be made up by transferring capital from another – this is limited to the extent that institutions have different owners. It also assumes that surplus capital can be used in a bank group irrespective of which bank subsidiary holds it.

To benchmark these estimates, AIB provides the most recent, and thus most relevant, stress test scenarios. The 2008 results presentation shows bad debt provisions of about €9.0 billion to 2010 under its “stress test”. This assumed write-offs of 27 per cent, 12 per cent and 7 per cent, respectively, of the average Irish residential development, commercial development and investment property portfolios (16 per cent of the combined average property and construction book). In total, a write-off of almost 7 per cent of the average group loan book was factored in. AIB has since increased its estimate by a further €1.5 billion, reflecting either higher overall expected losses or earlier recognition of the level of losses originally estimated. In Q1, actual loan loss experience was running ahead of the stress test and the forecast provision increased by a further €300 million.

This revised €10.8 billion forecast compares with the €11.6 billion of capital and provisions estimated to be available here. The conclusions of this analysis – and associated assumptions – are:

If worst-case stress tests materialise, both AIB and Bank of Ireland have more than sufficient capital to meet regulatory requirements through 2010;

If the stress test outcomes are exceeded – by about €1 billion in AIB and about €4 billion in Bank of Ireland – both banks will still meet minimum regulatory capital ratios;

If Anglo Irish Bank has the same level of write-offs assumed in AIB’s initial stress test (about 16 per cent), on property and construction, its capital will be wiped out, requiring a €6 billion – €3 billion Tier 1 – injection to support existing assets;

If Irish Nationwide has the same level of write-offs as AIB, it remains just adequately capitalised. Should write-offs reach about 27 per cent, its capital will be eliminated.

There is a discrepancy between the objectives of Nama and the two major banks’ own assessment of their current capital position.

The Government appears to believe that additional capital will be required sooner rather than later and that Nama will quickly attract it in.

From this particular perspective, the Nama “bank levy” introduces a contingent liability which could still deter investors.

Based on bank forecasts, core capital ratios remain strong – 8.4 per cent, reducing to about 5 per cent for AIB by 2010 and 9.5 per cent to about 7.5 per cent for Bank of Ireland.

Undoubtedly, it is possible that a solution on the scale of Nama’s proposed asset cleansing will ultimately be required.

As of now, however, capital availability is not the pressing issue – the more immediate requirement is how to leverage available capital to get a sufficient level of credit flowing again.

Oliver O’Shea is leading a new social banking venture in France (Voxpay365). He was previously chief financial officer of the UK’s Abbey National and senior banking analyst with Goodbody Stockbrokers. He also worked with international management consultants Accenture and BearingPoint.