Banking system not out of danger yet

Ireland is one of the most open economies in the world. Consequently, if the global economy recovers, this country should benefit.

A recovering economy should be fertile ground for banks.

However, the landscape is muddied. Ireland remains mired in the ongoing eurozone saga, and two thirds of the pillar banks are in State control.

This is the current feedback loop between the banks and the Irish economy. Banks need to put a floor under losses to stabilise and start growing again. But the economy needs a robust supply of credit from the banking system if the unemployment rate and the housing market are to recover.

AIB and Permanent TSB both released results this week. Bank of Ireland and Ulster Bank unveiled their 2012 figures earlier in the month.

Losses are still horrendous. Among the three pillar banks, Bank of Ireland is in the best position to fully exit the Government fold. PTSB faces the biggest challenges and its future is still uncertain. AIB is in between.

The good news is that the banks are close to completing their deleveraging programmes. During the boom years, all of the domestic banks recklessly grew their loan books relative to the size of their deposits. They have spent the past three years selling assets to shrink their loan-to-deposit ratios.

As long as banks are trying to scale back their loan books, they are not lending. This has starved the domestic economy of much-needed credit.

But there are still huge legacy issues that have to be worked through.

The basic operating model for a bank should be simple: Take in deposits and make loans. The difference in interest rates charged on loans and deposits is the profit. During the years before 2008, Irish banks borrowed heavily in the often opaque and complex wholesale markets at very low interest rates and then used this money to lend.

However, the financial crisis has wreaked havoc across the wholesale markets and put them off-limits to Irish banks. Because the Irish banking system is in a weakened state, it has to pay premium interest rates to attract deposits. Unfortunately for the banks, a large swathe of their loan books is priced at the low rates that prevailed during the noughties.

Consequently, they are now paying more in funding than the interest they receive on many of their mortgage and other loan products.

The priority for the next two years will be resolving the mortgages arrears problem. But the next round of stress tests for the banks are due for the second half of this year. The results of the stress tests will determine whether each of the banks are sufficiently capitalised to withstand future losses.

If they are not, then they will have to raise fresh capital. The chances of the banks writing down unsustainable mortgage debt against this backdrop are very limited. However, unless the mortgage arrears crisis is tackled effectively and expediently, then domestic spending and demand will remain anaemic, which in turn will undermine the profitability of the banking system.

Recent events in Cyprus have added an unwelcome variable into the mix. From now on, large depositors will be targeted when a bank fails. As long as there is uncertainty over the Irish banks, they will find it that bit harder to attract big — and particularly corporate — deposits.

The Irish banking system is coming off life support, but it is not out of the danger zone yet. Attracting outside investors and returning money to their shareholders — the taxpayer — hinges on overcoming many formidable obstacles.