Banks still in the dock
It is going to be more expensive for everybody, from small retail customers looking for anything from car loans to mortgages right up to businesses looking for capital to fund expansion plans.
Two key developments in banking book-ended the Celtic Tiger years. The former US Federal Reserve chairman Alan Greenspan dropped interest rates to very low levels at the beginning of the last decade in an effort to stave off the collapse of the dotcom bubble. This released a huge amount of liquidity into the financial system. At the same time, the German economy was still struggling. The ECB kept interest rates low in an effort to boost growth in the eurozone’s largest economy. German workers were saving instead of spending, which meant German banks were awash with cash.
But at the start of the noughties, the Irish economy had been firing on all cylinders for a few years on the back of massive levels of mainly US foreign direct investment. The low interest rate set by the ECB added fuel to the fire. A buoyant economy and surging population growth caused a ramp up in demand for housing. The government did its bit by providing tax concessions for property developers. The warning signals were there for anybody who was looking.
Banks are supposed to be conservative institutions with a simple operating model. They take in deposits by offering an interest rate that appeals to customers. They then offer loans at an interest rate higher than the level they provide for depositors. That is how they make a profit. The potential for a bank to lend should be scaled relative to the size of its deposit book.
However, the Irish property market was offering limitless lending opportunities. Competition among financial institutions became intense. At the lower end, foreign invaders such as Bank of Scotland began offering 100% mortgages. At the upper end, Bank of Ireland and AIB threw caution to the wind and followed the lead set by Anglo Irish Bank by doling out vast sums to property developers.
As a way of getting around limits imposed by the size of their deposit books, banks looked to the wholesale money markets for extra funds. This was a fatal mistake. The wholesale markets work by banks lending to other banks, usually at cheap interest rates and typically with terms of between two and five years. Irish banks were hoovering up massive amounts of money in the wholesale money markets. German banks in particular channelled billions of euro in Irish banks looking for exposure to the fastest- growing economy in the eurozone.
Even though Irish banks were borrowing on wholesale markets at maturities of between two and five years, they were then lending out this money in the form of mortgages or development loans on terms much longer than they were borrowing.
While this was happening in Ireland, events across the Atlantic would ensure that the good times came to a shuddering halt. In a piece of complex financial engineering, US banks were securitising mortgage books and selling them to other banks. The problem was many of these mortgages belonged to the subprime sector, in other words, less credit-worthy individuals who struggled to service their mortgages. When the US property market turned in 2007, chaos ensued. Banks stopped lending to each other because of uncertainty over who was carrying toxic assets. The consequences for the Irish banking system were disastrous. Irish banks had become reliant on the wholesale money markets to fund their day-to-day activities. When the liquidity dried up in the wholesale money markets, Irish banks could not fund themselves. The situation became acute following the bankruptcy of Lehman Brothers on Sep 14, 2008.
Hence the government guarantee of the banking system later that month. The government believed Irish banks just had liquidity issues. In fact they were completely insolvent. The cost of bailing out the banking system forced the government to seek a bailout in Nov 2010.
That brings us to where we are today. So far it has cost the State €64bn in bailing out the domestic banks. There was roughly €34bn put into Anglo Irish Bank and Irish Nationwide, which is now the Irish Bank Resolution Corporation. The remaining €30bn was pumped into AIB, Bank of Ireland, and Irish Life & Permanent.
In Mar 2011, the Central Bank conducted stress tests of the banks to establish how much more capital would be needed in the event of worse case scenarios unfolding in the property sector and economy. They showed that banks had to raise a further €24bn in capital to act as a buffer against further potential losses. Another round of stress tests is scheduled for later this year. Only when the next set of stress tests are completed will it be known whether the banks are sufficiently capitalised. There are doubts that this is the case.
One area of concern is that the property market deteriorates even further and there is another wave of losses lurking in the banks’ mortgage books. According to a senior source in one of the pillar banks, another sector that could be concealing massive losses is the SME sector, particularly retailers.
Retailers became an attractive punt for banks during the boom years because they have property assets and buoyant cashflows. Many retailers took advantage and took on significant levels of debt. Now the property assets are worth roughly 50%-60% of what they were during peak conditions and business dropped off considerably since the downturn. Many retailers are struggling to service loans.
But if there are no more major losses in the banks and they are in a position where they can start looking to the future again, there are still many challenges looming. Banks grew too big during the boom years. Now they must go through a process of deleveraging, which means shrinking their balance sheets. This can be done by selling loan books and offloading non-core business divisions. Banks have deleveraging targets they must meet every year. But, in this environment, there is no incentive to exceed these targets because the prices banks get for their loan books and assets remain flat. This puts the economy in a huge bind.
As long as banks are deleveraging, they will not be lending — no matter what they claim. Irish banks have static deposit books. Consequently the only way they can delever is by selling assets. There is no incentive to increase their loan books. A corporate financier familiar with the situation says banks might claim they are in business and providing loans, but what they are mostly doing is rolling over existing loan facilities for companies. Very little new business is being underwritten. Whereas in the past, businesses could get loans with maturities of about five years or longer, banks are now extending rollover facilities for roughly two years. This makes it very hard for companies to plan for the future, which means it is weighing on potential investment and depressing growth.
It won’t get better any time soon. In the past, Irish banks had access to an almost endless supply of cheap money in the wholesale money markets. That will not be there in the future. Deposits, as well as other forms of financing, will become much more expensive. As a result, banks will have to charge an interest rate higher than they pay for the cost of funding. Everything from the cost of mortgages to car loans, to loans to small businesses will be much more expensive.
Of course, the multibillion-dollar question is the complexion of the Irish banking system in the future. Ulster Bank has obviously had its troubles following its recent technical difficulties. This has prompted speculation that its parent Royal Bank of Scotland may offload it. A senior Dublin-based corporate financier claims it will still be Ulster Bank in 18 months but it won’t be owned by RBS. “It will be an attractive proposition for a Spanish bank like Santander. It doesn’t have the same legacy issues like AIB because it is not State-owned, but it has the infrastructure.”
Given that technology costs will be the biggest form of capital expenditure in the future, it might make sense for the pillar banks to share back-office technology costs.
AIB and Permanent TSB are both State-owned. They both have to cut costs and return to profitability which means charging more for their financial products, including mortgages. They are likely to meet stiff political resistance. The way is clear for Bank of Ireland to dominate market share over the next few years.
But one thing is for sure: The forthcoming trial of former Anglo Irish Bank executives will ensure the damage caused to the wider economy by the banking system will remain an open sore for agood while longer.
