If ever there was a symbolic attempt by the banks to show their recovery and transformation, it is the Permanent TSB office hidden away on Hatch Street in central Dublin.
The building, not far from the lender’s headquarters, houses its technology division called Project Forte. Staff are creating the latest mobile apps and digital tools, allowing customers to do more transactions online. The office now resembles a tech start-up.
Go back five years and the office had another use: it was the home to PTSB’s asset management unit, otherwise known as its internal bad bank, which dealt with customers in arrears. Hundreds of staff were crammed into row upon row of desks. Above their heads, screens displayed how much money they had collected from customers.
At the end of July, PTSB chief executive Jeremy Masding was happy to showcase the revamped office as the bank published its half-year financial results. These showed reduced bad debt levels, higher mortgage lending and customers making greater use of digital banking. They were themes echoed in recent weeks by Bank of Ireland, AIB and Ulster Bank.
Yet shares in all three of Ireland’s domestic banks fell to post-2008 financial crisis lows last week. PTSB shares slumped to below €1 and have lost almost 80 per cent of their value since the government sold part of its stake in the bank in early 2015.
Bank of Ireland shares are down by more than half of where they were last summer and are struggling to stay above €3. Even AIB, part-privatised in 2017, has had almost half of its value wiped out since then. What on earth is happening to the banking sector at a time when the economy is growing and they are finally cleaning up their legacy issues?
The global economy
To understand what is happening to Ireland’s banks, it is worth looking at global monetary policy. More than a decade on from the financial crisis, central banks have finally begun to normalise interest rates and unwind years of extraordinary measures to prevent economic chaos.
At the beginning of this year, many bankers expected the European Central Bank (ECB) to raise interest rates. For years now, the ECB’s main rate has stood at zero and its deposit rate was in negative territory, meaning that, in effect, banks were not making anything on the liability side of their balance sheets. On the asset (lending) side, they were being squeezed by the low interest rates which act as a drag on their profits.
That problem is more acute in Ireland because the banks are still weighed down with tracker mortgages whose pricing is tied to the ECB rate. As Irish banks do not engage in trading or wealth management, they rely more on traditional mortgages and lending to small and medium enterprises to make money, which is difficult in a low-rate environment.
The prospect of interest rates rising has gone. We have entered the era of “lower for longer”. The global economy faces an increasing number of threats. These culminated in recent days with the yields on longer-dated bonds falling below those of short-term date. This is known as the yield curve inversion and is normally considered a sign of impending recession.
ECB interest rates
Those signs are appearing in Europe too, with Germany’s economy shrinking in the second quarter, adding to fears that a combination of Brexit and a trade war between the US and China will send the continent into recession. What this means is that Mario Draghi, in one of his last acts before he steps down as ECB president, is likely to cut interest rates again. It couldn’t come at a worse time for banks across Europe.
“It’s a European banking phenomenon,” Masding said. “I have attended a number of different conferences and conversations with my peers where also there have been American bank CEOs in the room. The challenge for the European bank CEOs is if you have an American bank, which has the same liquidity profile . . . the level of income they are able to generate enables them to get ahead of the curve on digital, get ahead of the curve on thinking about [mergers and acquisitions]. It would be fair to say that . . . we are disadvantaged and that is a serious issue.”
The era of lower-for-longer interest rates is significant for Irish banks. Their actual net interest margin – the difference between what a bank makes from lending and its costs – is quite slim.
Eamonn Hughes, a Goodbody Stockbrokers analyst, last week trimmed his forecasts for AIB’s net interest margin over the next few years. The margin was 2.43 per cent at the end of June, and he estimates it will fall to 2.35 per cent next year and 2.29 per cent in 2021. That may not seem much, but it’s enough for Goodbody to cut its earnings targets for the next couple of years and slash its price target on the bank’s shares from €4.95 to €3.50.
It is not just AIB that is being squeezed by the lower rates. Last week, Owen Callan, a banking analyst at Investec, cut his forecasts for PTSB’s profits over the next few years.
“We see positives in the PTSB recovery story, with margins and market share holding up, legacy asset quality issues continuing to decline and capital buffers remaining robust. However, PTSB remains vulnerable to both weak credit growth and the lower-yield environment,” he said.
Ulster Bank, which is owned by Royal Bank of Scotland, is also bracing itself. Paul Stanley, its chief financial officer, told this newspaper that it will be in 2020 and 2021 that the bank will feel the impact of lower rates.
Non-performing loan books
It is not just low rates that are acting as a drag on the Irish banking sector. Casting a shadow still are tens of thousands of mortgages in arrears. The unofficial target for the banks is to bring the total down to the European average of about 3.5 per cent in the next year or so. Getting that figure down has been the banks’ main priority for several years. It has taken on an extra urgency in the last few months as regulators apply pressure on lenders to clean up legacy issues before Brexit or another downturn.
The easy-to-reach solution to arrears now is to pull the trigger on loan book sales. Ulster Bank has launched the sale of a €900 million loan book called Project Deenish, while AIB has also begun similar sales.
It was summed up neatly by Colin Hunt, AIB’s chief executive, who said reducing non-performing loans (NPLs) now would strengthen the banks in the face of any potential downturn.
“The Irish economy is doing very well, but the clouds are gathering on the horizon,” he said. “The geopolitical environment is very difficult and getting increasingly difficult, global trade tensions are at levels we haven’t seen in decades, purchasing managers’ indices the world over are turning downward, monetary policy authorities are pointing to a loosening rather than expected tightening on the policy side and, of course, we have that conundrum of Brexit: we still don’t know what form it will take three years after Britain’s decision to leave the European Union.
“So all of these point to risks to the level of growth in the economy and it is incumbent upon us within AIB to ensure that we put our balance sheet into the strongest possible position to allow us to weather the storms that may lie ahead, and we will do that in the interest of our customers and our shareholders.”
Analysts at DBRS, the credit rating agency, said the banks cannot rely on loan book sales alone to solve their problems.
“While sales to investors are expected to remain the main strategy to reduce NPLs further, it remains important for banks to continue to seek alternatives to reduce NPLs organically, by working with borrowers to resolve NPLs and enforcing the loan collateral,” DBRS said in a report this month.
Paying staff and shareholders
If banks’ income line is out of their hands, the one area they can control is their expenditure. Staff costs are increasing due to pay rises and the need to retain key employees, and regulatory costs are also increasing. Cleaning up toxic debt will free up resources, however.
Combined, the banks have more than 2,000 staff working through arrears and the tracker mortgage scandal. AIB alone has about 1,000 people working in its financial solutions group. Will all those staff, who include contractors and consultants, be needed when arrears are normalised? Ulster Bank has also told this newspaper that it is considering cuts to its arrears unit. Bank of Ireland set out a plan last year to bring its annual staff costs down to €1.9 billion.
“We’ve set a clear cost target as part of our strategy, and we’re delivering,” Bank of Ireland chief executive Francesca McDonagh told analysts on a conference call last month. “We’ve reduced our costs by 3 per cent compared with the first half of 2018. That’s after absorbing costs linked to IT investment, various regulatory requirements and wage inflation. Excluding IT investments, we have reduced our day-to-day operating costs by close to 5 per cent.”
One of the more positive legacies of Irish banks’ recovery is that they are sitting on plenty of excess capital. Even with higher Central Bank requirements to maintain additional capital against loan losses, the ability of AIB and Bank of Ireland to pay dividends has made them attractive to investors. Irish banks have always been good at paying out cash to shareholders.
Earlier this year, AIB raised its dividend by 42 per cent to €461 million, with the taxpayer pocketing almost €330 million from its 71 per cent stake. Diarmuid Sheridan, a banking analyst at Davy stockbrokers, estimates that a special dividend of €300 million could be paid out next year and the bank would still have the capacity to spend hundreds of millions of euro buying back its shares, a move that should also prop up its share price.
Bank of Ireland, too, is upping its payout to shareholders. It set aside €100 million in the first half of the year to pay a dividend as it looks to boost the percentage of its profits that it returns to investors. “We continue to expect that dividends will build on a prudent and progressive basis towards a payout ratio of 50 per cent of sustainable earnings,” McDonagh said on the conference call.
The Brexit effect
Yet Irish banks face another headache that many in Europe do not have to worry about: Brexit. Just as the ECB prepares to cut interest rates, Ireland could be dealing with the calamitous effects of Britain crashing out of Europe with no deal. This matters more to Bank of Ireland because 40 per cent of its assets are in Britain, including joint ventures with Post Office, the AA, a mortgage bank and other activities. What was once a way to reduce its reliance on Ireland is now another drag. Analysts at Bank of America Merrill Lynch said the value of its British arm could be zero given the challenges it faces. Already McDonagh has moved to sell off some of its less profitable elements, including its credit card division.
Even leaving aside banks’ direct exposure to the British economy, a no-deal Brexit would also cause second-order effects on their Irish balance sheets as companies and consumers feel the pain.
Facing the future
Perhaps the biggest issue is how to address the future. Does Ireland need five high street banks? Australia and New Zealand survive with four between them. There are many alternative lenders in the country offering specialist services from loans to debt finance. That does not include the new generation of start-up banking apps that are increasingly gaining new and younger customers.
This has prompted the banking sector to increase its own investment in IT. Bank of Ireland is spending €1.4 billion on a technology overhaul, with the launch of its new mobile banking app expected later this year.
Is more consolidation needed? There has long been speculation that the smaller three of Permanent TSB, Ulster Bank and KBC would be better off merging so that they could compete effectively with AIB and Bank of Ireland and also sustain themselves in the long-term.
The return on equity generated by PTSB and Ulster Bank was just 2 per cent in the first half of this year. This is not something that any banker is willing to contemplate right now. Ulster Bank has said that its parent company is committed to Ireland, and the bank is in the process of putting together a plan to boost its profitability.
Callan of Investec said “consolidation with an existing incumbent or a large foreign entrant that could extract significant cost efficiencies from the current business model” could make sense for PTSB. Not so, or at least not right now, responded Masding when asked whether PTSB was too small to survive. He points out that it is only now, after seven years of painful restructuring, that the bank can fully compete against the bigger players.
“I owe it to a number of different stakeholders, from the board to my staff to the shareholders, now that the vast majority of our legacy issues are behind us, to at least give it a go. To use some of this digital investment, to use the human capital I have in terms of the leadership team, to use the distribution channel to get value from the country’s economic strength,” he said.
“Now the sceptics would say even doing your best you might not get there. And that might be true. I don’t know. But what I do know is we have not maxed out yet. And if we max out, at least the franchise is growing. At least something that was basically illiquid and insolvent has a value to the Irish taxpayer.
“And in that time if I think we’ve maxed out, then there is a different conversation that I have to have with both the board and Minister for Finance about some sort of tie-up. But I would not want to do any tie-up if I left value on the table.”
Right now the state is back to nursing losses on its investments in the banks. The state’s 71 per cent stake in AIB was worth just under €5 billion on Friday, the 14 per cent holding Bank of Ireland under €500 million and the 74 per cent of Permanent TSB just over €300 million.
On the Pat Kenny Show on Newstalk last week, Minister for Finance Paschal Donohoe said there was a “bright future” ahead for the Irish banks and that the state was in no rush to sell down any of the taxpayers’ holdings.
Of course, the fall in Irish bank shares and the stress they face is being mirrored across Europe. The once mighty Deutsche Bank’s share price slumped to an all-time low last week.
Earlier in the summer it was forced to capitulate on its plans to conquer Wall Street and announce sweeping cost-cutting that involves more than 20,000 job losses, pulling out of some markets and cutting its dividend. By that standard, Irish banks are still looking pretty healthy.
If this is the moment when the global economy and markets begin a downward spiral, at least Irish banks enter it in a much better position than last time. Not only has there been no credit bubble, largely down to the actions of the Central Bank, the banks have moved to resolve toxic debt.
Still, it is hard not to see what has happened at Irish banks in the last couple of months as a worrying sign.
One of the many forgotten memories of the 2008 financial crisis was that the damage was done well before that infamous September, as share prices had plummeted from the previous summer. Nobody can say now that the warning signs aren’t there.