AIB and Bank of Ireland will be even more cautious after EU stress tests
Many people were unpleasantly surprised to read on Saturday morning that Ireland's two pillar banks had performed among the worst of 51 lenders assessed in the European Banking Authority's stress tests.
It wasn't so much that we all believed everything was wonderful at Bank of Ireland and AIB. No, it is just that we had been told during the week by both banks how well capitalised they were.
The news might have given some people the impression of enduring underlying problems at these banks which they should be worried about. The reality is not nearly as harsh as that, but nevertheless the poor showing in the stress tests will have some consequences.
Bank of Ireland and AIB have both come a very long way in turning around their businesses and balance sheets since the depths of the financial crisis. They are both back to profitability, with stronger capital levels and growth in lending to consumers and businesses.
The problem is the sheer scale of the crisis in their loan books back in 2011 leaves them with legacy loan issues. Both banks have been tackling their problem loans and have cut the number of problem loans they carry from well over 20pc to around 10pc.
The stress tests only took a snapshot based on how they looked at a moment in time, namely last December. In reality the momentum at both banks for a long time now has been towards reducing the number of legacy problem loans they have.
AIB is in the process of returning €1.8bn to the state and is clearly comfortable with its balance sheet and capital levels to be able to do this. So is the European Banking Authority which is allowing the deal to go ahead.
The Irish banks are well capitalised and capable of handling a downturn. The banks in the stress tests that performed better than AIB and Bank of Ireland, did not have to deal with anything like the scale of crisis the Irish banks did.
RBS in the UK did have a similar meltdown in 2008 but it didn't perform well in these tests either.
The stress tests examined the impact a severe economic shock would have on their businesses. They were of limited use anyway, given that they didn't examine the impact that prolonged low interest rates across Europe after Brexit might have on the banks. This is a more likely scenario. Equally, the stress tests were aimed at assuring the investment community across Europe that the EU's big banks are actually doing fine. They didn't mind if the real dogs of the show were the likes of two Irish banks and RBS which blew itself up so badly in 2008 it had to be bailed out by the British taxpayer.
An Italian bank had to feature badly and so Monte dei Paschi did. In reality Italy's banks are in a lot more trouble than these stress tests convey. Greek and Portugese banks didn't even feature in the tests at all. They were not included on the grounds that none of them was big enough. That doesn't mean they aren't big enough to run into severe problems.
Either way there are likely to be some implications for Bank of Ireland and AIB arising from these tests. Firstly, the banks are probably in a better and more resilient position than is portrayed in the tests. Their balance sheets are improving along with the Irish economy and as they work through legacy debt issues.
But when it comes to bank share prices and investment, market sentiment is important. Bank of Ireland shares have already been hit by the news and traded down to 17.3c when the market opened on Monday morning after the weekend stress tests results had been digested.
It has been suggested that the stress test outcome would further delay the refloat of AIB. This is unlikely, given that it had already been delayed because of market sentiment around banking anyway. The Government had initially aimed to sell off around 25pc of AIB some time this year.
It has already been put back to 2017 and stress test results won't affect the timing of that as much as the wider stock market environment next year.
The State will still receive its €1.8bn from AIB. The impact of the tests arises more in relation to future payouts to the State in dividends. AIB is back in profit but it will be under some pressure to retain more of the benefits of that profit within the company.
The best way for AIB to further bolster its capital is to steadily grow profits and hold on to them. This could reduce the amount of money the state gets back in the short term in dividends.
The other big question is how the stress test outcome could influence the risk appetite of the banks. They are back lending again after the scars of the crisis but they remain incredibly cautious. The have rebuilt their profitability by squeezing existing customers on interest rates and cutting costs.
They have also been able to write-back losses they thought would occur but haven't.
They have not rebuilt their profitability by growing their asset base through solid new lending. New lending is picking up but only very slowly.
The banks have become adept at screwing their best customers and simply not lending to anybody else.
This situation could tighten even more on the back of these tests.
Even AIB, which has cut its standard variable mortgage interest rates several times, continues to charge SME customers very heavily for business loans. SME loans in Ireland are among the most expensive in Europe.
Bank of Ireland is the same, and it hasn't even cut its standard variable mortgage rates.
Irish banks will be encouraged even more now to stick to that model of milking the solid customer base and shutting the doors to others.
In their defence the banks will argue that the appetite for debt is still not really there and modest new lending is as much down to lack of appetite as banks saying no.
Bank of Ireland has improved its volume of new lending but in the current climate banks will not want to ramp that up too much because of the amount of capital they will need to set aside for each loan.
It is extraordinary to think that it could be 2018 or even 2019 before AIB pays a dividend - ten to 11 years after the banking crash began.
As the Bank of Ireland share price languishes around the 17c level, shareholders, including the State, can't help but think of the 27c per share billionaire investor Wilbur Ross bagged two years ago when he sold out of the bank.
Fairfax sold shares in 2015 for 35c per share. Foresight or what!