Small is beautiful. That is the mantra Ireland’s new government has adopted for restoring the country’s troubled banks and banking system to stability. No more banks than a country of 4 million people really needs, no more massive loans for speculative property developments, no more expansion into foreign markets.
Editor's choice
It is a tough prescription for recovery to which the country's government has been driven by external pressures and by its desperate need to rebuild Ireland’s own credit ratings, which have been pushed to near junk-bond levels by the propping up of its troubled banks.
The restructuring is being driven by a timetable set by the terms of a bailout package agreed with the 'Troika' of the EU, the European Central Bank, and the International Monetary Fund (IMF) – as well as the demands of the bond markets, investors and a public restive for relief from the deep recession into which the country has been plunged.
Too much growth
The crisis has already precipitated a voter uprising that ignominiously turfed out the former Fianna Fail government led by prime minister Brian Cowen, whose September 2008 guarantee of all deposits in failing Irish banks was widely viewed as the cause of the country’s downfall and humiliation – “the blackest day in Ireland since the Civil War broke out”, according to Ireland’s new finance minister Michael Noonan.
“Overall, the Irish banking system grew too large and needs to be significantly downsized,” a briefing paper on Ireland's banks succinctly informed Mr Noonan when he took office in March this year as a member of the new Fine Gael government.
Within three weeks, Mr Noonan had acted on this advice. He announced that the nation’s banking system would be restructured to consist of two 'pillar' banks. Built on the foundations of the existing Bank of Ireland (BOI) and Allied Irish Banks (AIB), the two banks will provide a full range of basic services. Foreign banks are welcome to compete.
Mr Noonan had the freedom to ordain such dramatic change not through dictatorial powers but simply because five of Ireland’s six banks are fully or majority owned by the state, and it is the largest shareholder of the sixth, Bank of Ireland, with a 36% stake. “In essence, our banks will need to be smaller, more focused on core operations, better funded and better capitalised,” says Mr Noonan.
Restrictions in place
Mr Noonan has decreed that not only will there be fewer banks, their business will be more limited. Bank operations will be classified as core and non-core. Non-core assets – “those that do not serve growth on the island of Ireland” – will be sold off over time in a process of deleveraging, reducing their size in a balanced and measured way, not at fire-sale prices.
For BOI, this means the bank will have to shed €30bn-worth of assets by 2013. They include its portfolios of UK mortgages, international 'niche' businesses such as project finance and asset-based lending, and foreign commercial properties. However, BOI will retain its UK Post Office consumer banking franchise, which has 2.3 million customers, as well as its operations throughout both Ireland and Northern Ireland, and limited capital markets business.
For 2010, the bank reported an operating profit of €1bn, before €2bn in impairment charges on financial assets and a €2.2bn loss on the sale of assets to Ireland’s bad bank, the National Asset Management Agency (NAMA), at a 44% discount. With these taken into account, it had a pre-tax loss of €3.5bn.
AIB, which is to be merged with EBS Building Society, will have to sell off €23bn of its joint non-core assets. AIB reported operating income of €2.6bn for 2010; however, including the loss on transfer of assets to NAMA, it had a loss of €3.4bn. EBS reported a loss of €590m.
The long-term future of a fourth bank, Irish Life & Permanent (ILP), which reported an operating loss of €197m for 2010, is still uncertain. Its life insurance and pension business, with €2bn assets under management, is to be sold for €26m to a Swedish group. After the surviving bank has been recapitalised with €4bn, there is speculation that it may be acquired by Bank of Ireland. In the meantime, the deposits of Irish Nationwide Building Society have been transferred to Irish Life and the deposits of Anglo Irish Bank transferred to Allied Irish.
Need for strengthening
The remaining banks will also have to strengthen their capital positions – BOI by €5.2bn, AIB by €13.3bn, and EBS by €1.5bn. These sums were decided following stringent capital and liquidity stress-tests performed for Ireland’s central bank by an outside firm, BlackRock Solutions, and announced on March 31 this year.
BOI will be given time to try to raise capital from private sources. The state will provide the additional capital to the other banks – and to BOI, if needed – using the funds provided by the EU/IMF.
To improve their liquidity, the banks will also have to reduce their loan-to-deposit ratios to 122.5% by 2013, by disposing of €73bn in non-core assets. In December 2010, loan-to-deposit ratios of the four banks ranged from 166% (AIB) to 248% (ILP), which amply demonstrates the size of the task they face.
The stress-test results were endorsed by the Troika. In a statement, it called them “a major step toward restoring the Irish banking system to health”. The reactions of rating agencies were less positive. Moody’s issued a downgrade, noting the banks would continue to face significant short-term funding pressures and an uncertain operating environment. It said asset quality and earnings were likely to remain extremely weak, and the deleveraging process could increase asset quality and earnings pressures.
Fitch placed the banks on “ratings watch negative”, noting that its action reflected its ratings of the country itself. Indeed, since the former prime minister's bank guarantee, the state’s and banks’ credit ratings have become inextricably intertwined, tending to move in the same direction.
Standard & Poor's called the stress-tests a “credible first step” toward rebuilding investor confidence, but warned it would take the Irish banking system many years to rebuild the creditworthiness enjoyed by its European peers.
A watershed moment?
Both BOI and AIB declined to comment on the stress-tests. However, Pat Farrell, chief executive of the Irish Banking Federation, calls them a “watershed” in restoring confidence in the country's banking system. “The capital levels of the guaranteed banks will be well in excess of the 10.5% [core Tier 1] that is the internationally accepted target – by a multiple of two or more in some cases,” he says.
Mr Farrell agrees that the Irish economy in the 'Celtic Tiger' years probably was overbanked, with six domestic institutions and several foreign banks that showed up to take advantage of the boom. He believes the fierce competition for customers may have prompted some of the unwise lending to developers.
He insists that the surviving banks will be more than savings-and-loan type operations. “This is still a sophisticated economy with a significant export sector,” says Mr Farrell.
In addition to banks’ retail business, Mr Farrell points out that small and medium-sized businesses will continue to need loans, foreign currency transactions and export and import finance. Irish corporations will still require investment banking, merger and acquisition financing and syndicated loan services.
Banking expertise is not lacking in Ireland, according to Mr Farrell, with leadership drawn from both Irish and foreign candidates, though a €500,000 legal cap on salaries does not help.
“There is nobody who is not working very long hours on a very consistent basis, and that goes from top to bottom,” he says. Senior managers now have to find ways to simultaneously manage restructuring, deleveraging, interactions with various government agencies, direct submissions to the European Commission for approval of restructuring plans, as well as their normal duties.
Attracting investment
A key question is whether, after all these painful steps, the banks will be able to attract foreign investment. Philip Lane, an economist at Trinity College Dublin, believes foreign investors may be interested after the Irish government has completed the first wave of restructuring. “The dominant issue is the sovereign debt side and whether it will be repaid in full. No foreign investor will get involved in the restructuring because the bank debt is guaranteed by the sovereign,” he says.
Ben May, a UK-based analyst with independent research consultancy Capital Economics, is similarly cautious. In his view, while the stress-test results are somewhat encouraging, it is difficult to say with confidence what shape the banking system is in because the true scale of its problems has been consistently underestimated.
“We think Ireland will go through a fairly long period of stagnation with a possible risk of deflation that could cause the public debt to rise higher. We don’t think default in Ireland is probable, but there’s a possibility it could happen if the government is forced to pump in more money,” he says.
One consortium of US investors, WL Ross & Co along with the Carlyle Group and led by Dublin-based Cardinal Capital Group, did make a bid for EBS. However, at the last minute the new government rejected the offer as “not sufficiently commercially attractive”. Mr Lane believes the government preferred to deal with EBS as part of the overall restructuring of the banking system.
Private equity interest?
While there was some interest by private equity in Ireland’s banks last year, that has faded in 2011, according to Libby Garvey, a partner in Dublin law firm Matheson Ormsby Prentice’s banking department. She notes that the banks face other problems, including withdrawals of deposits by large corporates.
Central bank data bears this out: Irish private sector deposits in Irish banks fell by an average annual rate of 7.4% for the last three months of 2010, primarily due to withdrawals by other financial intermediaries, insurance and pension funds. During the same period, deposits by the non-resident private sector fell at a rate of 22.3%.
Ms Garvey attributes this to a certain extent to the banks’ inability to comply with customer corporate guidelines regarding their deposit accounts and other banking business as bank ratings slip. “The downgrades are creating their own problems, along with the difficulty of raising funds. In some cases potentially forcing large corporates to migrate to non-Irish institutions that can meet minimum rating requirements for their deposit banks,” she adds.
As the cost of raising money rises, banks are also losing money on tracker mortgages. Furthermore, even if banks have the funds to lend, they have fewer takers, some Irish corporates are weakening in the harsh economic climate unless they have an international business, says Ms Garvey.
Lack of activity
John Cotter, director of University College Dublin’s Centre for Financial Markets, shares many of these concerns. “Five years ago,” he says, “the banks were the most active organisations in the economy. Now, even if they wanted to be active, the people are not there.” Mr Cotter cites the 15% level of unemployment and rising rates of emigration, especially of entrepreneurs, among the risk factors for banks.
“The question now is whether [banks] will be underperforming because people don’t want to borrow. Their ability to trade off their loan books will be diminished,” he adds.
A central problem for the banks is the uncertainty as to whether the real-estate market has hit rock bottom yet. The residential property market continues to fall as do commercial property values. If the decline continues, Mr Cotter warns, it could lead to a further reduction in the value of banks’ loan portfolios.
It is not only Irish banks that are affected. UK-based Lloyds Banking Group and Royal Bank of Scotland – both owned by UK taxpayers – have experienced operating losses due to their Irish portfolios. Lloyds' 2010 annual report predicted a further 10% slide in Irish commercial real-estate prices.
Bearing the burden
As economic conditions worsen for households, the rest of the private sector and the state, demands have grown for other stakeholders, not just taxpayers, to bear the burden of shoring up the banks. Subordinated bondholders – specifically protected by the guarantee – are the primary target.
In December, holders of €1.6bn of subordinated bonds in Anglo Irish Bank agreed to swap them for new bonds at 20% of the original value of the bonds, or about €300m. The bank, widely regarded as the poster child for what was wrong with the country's banking system, was nationalised in January 2009, and now serves purely as a work-out vehicle for its bad loans. The outcome of a court case will decide whether subordinate bondholders of other banks can be forced to take similar hits.
How did matters come to this? Three major reports examining what happened were commissioned by the Cowen government. The most recent, made public on April 19, was prepared by Peter Nyberg, a former senior official in Finland’s finance department, and blamed all involved.
Mr Nyberg diagnosed “a national speculative mania in Ireland during the period, centred on the property market.” In this environment, both domestic and foreign banks often exhibited “herding” behavior, copying each other’s practices, with some more focused on growth targets than credit standards, and “little apparent realisation of the attendant risks”.
Within institutions – including bank boards, regulators, the finance department, and even external auditors – “groupthink” prevailed, the report found, with few voices strongly urging caution or uttering a warning. Even international institutions such as the IMF and EU were only “modestly critical and even complimentary”.
The report merely crystallised what had long been known. Not surprisingly, banks will have to adjust to a slew of far-reaching new laws and regulations aimed at combating the lax lending and corporate governance failures that precipitated the crisis. A wide range of criminal, accounting and civil investigations are under way. In some cases, bank boards and management teams have been dismissed and replaced.
New rules
The country's central bank has published a stringent new code of practice for banks and insurers, and the Irish Stock Exchange adopted new rules on corporate governance. A Credit Institutions (Stablisation) Act was rushed through, giving the central bank power to take control of banks, appoint managers and run them, as well as authority to liquidate credit institutions in certain circumstances. Credit unions will be more closely regulated.
The central bank is also implementing new 'fitness and probity' standards for financial services sector employees, and all board directors will be measured against them. The Department of Finance is creating a pool of potential bank directors with relevant experience who must also pass the fitness and probity test. And Mr Noonan says he plans additional changes to tighten oversight.
There’s an enormous amount at stake for Ireland – and Europe – in getting things right. As for Mr Cotter, progress to him would be if, in five years time, economic growth had returned to 2% or 3%, unemployment had fallen to 7% to 8%, the economy had moved away from the boom-bust cycle to a stable process of growth, and most people enjoyed a good quality of life.
“Our problem at the moment is whether we can turn the ship Ireland around and achieve that,” he says.
