AIB is a beacon of hope, but there are still problems in Irish banking
International investment in AIB is a positive sign for Irish banking, but huge challenges remain in the sector
The Government's acceptance of a lower-than-hoped-for share price signals that, even after the AIB IPO, Irish banks still have many unresolved problems.
The Irish banks are literally not even half of what they used to be. A decade ago, the six Irish-owned banks had a combined loan book of more than €400bn. By the end of last year, the combined loan book of the three surviving Irish-owned banks - AIB, Bank of Ireland and Permanent TSB - had shrunk to just €161bn.
While no-one could argue that, after the excesses of the Celtic Tiger era, the Irish-owned banks needed to be drastically slimmed down, are we in danger of getting too much of a good thing?
The latest Central Bank statistics reveal that total Irish bank lending is still falling, with a further 2.8pc reduction in lending to Irish households and non-financial companies being recorded in the 12 months to April.
The good news is that while there are some signs that bank lending to Irish households may have finally bottomed out, with the annual rate of decrease now down to a barely noticeable 0.15pc, it's a very different story with lending to non-financial companies, which fell by almost 8pc over the past year. Although some of this latest decrease represents the gradual unwinding of loans dating back to the boom, there is little doubt that most Irish businesses have been finding it extremely difficult to persuade the banks to lend them money.
SMEs (small and medium-sized enterprises), most of which don't have access to other forms of finance, have been particularly badly hit by the shortage of bank lending to businesses. SME lending fell by 2.9pc in 2016 and has more than halved since 2010, when the Central Bank first started to collect this information. Indeed, the Small Firms Association has just surveyed its membership and found that although 72pc intend to invest in their business over the coming year, just 8pc of SFA members are prioritising new lending from banks, according to SFA acting director Linda Barry.
"It's really positive to see a return to that investment mindset," she said. "But the divergence between the number who want to invest and the much lower number who are actually looking at bank credit raises an interesting point about the relationship between small businesses and the banks. Bank finance isn't for everybody, but if people aren't open to that option, then they are really constraining their prospects if they are unwilling to take on debt to finance their growth ambitions."
Small companies are still very cautious about debt and in many cases are still more focused on paying down their commercial and private debt.
"But small firms have to get back to borrowing if we are going to be able to scale our businesses," she said. "We met with all of the banks, including AIB, and their narrative is that they are looking to lend. But the market is not yet fixed, in our view, and there is still a failure going on here. The banks are saying they are looking to lend, yet the perception amongst small businesses has not changed."
Barry said that, in some ways, small Irish firms have never had it so good in terms of the variety of alternative funding options. However, many of these options do not provide the amount needed for large-scale expansion. "But bank lending is still the go-to option for most small businesses, and until that part of the market is functioning, we can't really relax. We have a problem nationally if thousands of small companies across the country are looking at incremental growth, instead of trying to grow by 10pc or 20pc."
Even for those companies that do seek bank finance, there tends to be very little clarity around the timeline and what is to be expected in the process.
"We find members frustrated at being asked for the same documents or the same questions over and over at different parts of the process. Small businesses feel they have lost a lot of the relationship side of banking, without getting a lot of the efficiencies that you could expect to come from greater automation," said Barry.
Nevertheless, she welcomes the flotation of AIB as a positive step forward.
"One of the things that would really help in the Irish situation is more competition. So if people are willing to invest in one of the existing banks, you would hope that there are also people looking at entering the market. That's what we would love to see, and the interest in AIB hopefully does send a positive signal in that regard."
With more than half of all bank lending now consisting of mortgages, the banks have made great play of higher levels of mortgage approvals, up 77pc by value over the past year. The problem with mortgage approvals is that, with only tiny volumes of either new or second-hand homes changing hands, what seems to be happening is that the banks are giving mortgage approval to multiple bidders on the same property.
The fact that this helps push up prices across the market, thus reducing the level of provisions the banks have to hold on their balance sheets against bad loans, is entirely coincidental.
A far more accurate gauge of what is really happening with mortgage lending is actual mortgage drawdowns. The value of new mortgages drawn down rose by 39pc to €1.39bn in the first quarter of 2017.
Central Bank statistics, which show total bank mortgage lending rising by 0.5pc over the past year and by almost 1pc in the first four months of 2017, also indicate that after a decade in the doldrums, the banks' mortgage lending is recovering to something resembling "normal" levels.
Even so, bank lending to Irish households remains at very depressed levels. At the end of April, the banks had €10.1bn more deposits from households than loans to those households on their books. This is an extraordinary situation.
Despite new lending remaining very subdued, both AIB and Bank of Ireland are back in the black, with 2016 pre-tax profits of €1.68bn and €1.07bn respectively. In the absence of lending growth, the two largest Irish-owned banks have squeezed out profits by taking advantage of the absence of competition caused by the exodus of foreign-owned banks to double their net interest margins since 2012.
One of the growing forms of alternative finance is peer-to-peer lending through online lending platforms that allow consumers and small businesses easier and quicker access to loans. Internationally, there is a growing trend for bigger banks such as Barclays, Westpac and Goldman Sachs to hook up with these smaller lenders to provide boutique online lending opportunities. In the UK, Santander has a partnership with online lending platform Funding Circle for smaller loans, which saw £140m (€160m) lent in May alone, while Goldman Sachs also has a new peer-to-peer lending arm called Marcus.com.
One of the key players in the Irish market offering peer-to-peer lending is Linked Finance, whose founder Peter O'Mahony told this newspaper that he is in negotiations with all of the main Irish banks about potential similar partnerships.
"AIB, Bank of Ireland and Ulster Bank have all been in contact and we are having discussions with them all. There are no concrete proposals, but we are very confident that at some stage, we will have a relationship with one or more.
"The Santander model is exactly what we are interested in, wherein there is a certain size of loan that when AIB or Bank of Ireland review their operation cost, they realise they can't make money on originating such a loan. We have found that we can originate even the smallest loan and still make it profitable."
The ideal relationship, according to O'Mahony, would be a referral model, where Linked Finance would run a platform on the bank's behalf.
"So a customer would come in to AIB in Tralee, for example, looking to borrow €35,000 to buy a tractor. So instead of having to process it and send it to head office for credit review, it would be logged on our online platform and we would get back to the customer in four hours. The loan could either be originated from our resources or from the bank."
Such partnerships are becoming a key part of the business for banks, he said.
"If AIB, for example, were to have a platform for direct lending, it cuts out so many costs for loan origination and loan servicing," he said. "That is the main benefit for the banks and why we feel the banks will be doing it in the future. If you look at every other western market, there is somebody doing it, so I think it is inevitable. Ireland is generally three to five years behind the UK, and all the big UK banks - Barclays, RBS, NatWest and Santander - are already doing it, so I think it is only a matter of time for AIB and, potentially, Bank of Ireland."
O'Mahony believes that the Irish banks necessarily had to be very cautious because of the impact impaired loans had on capital ratios, reserves and their ability to lend.
"As things are improving, they will have more capital there that they can lend against," he said - something that is likely to be particularly true for AIB post-flotation.
"If the banks start to become faster and more dynamic with lending, that benefits us all, because the economy will benefit. Small business owners need money quickly, and we in Linked Finance would believe that as a small lender in the market, we are very nimble and can work very fast and approve a loan in just three or four hours. The Central Bank recently said that the banks are struggling to get back in seven or eight weeks."
But O'Mahony said that things may be changing, particularly at AIB.
"We have noticed in AIB that they now have a whole innovation department and they have brought back Irish expats who are perhaps there to bring back learning from overseas," he said. "There definitely seems to be a mindset that investment in fintech is going to be a sensible approach for the future."
While AIB and Bank of Ireland are in much better shape than they were back in the dog days of 2010 and 2011, they are still far from fully restored to health. At the end of 2016, AIB still had €9.1bn of impaired loans on its balance sheet. While this was down from almost €29bn at the end of 2013, it was still the equivalent of nearly 14pc of its total loan book.
The problem-loan situation at Bank of Ireland was not quite as bad, but was still pretty awful, with €7.9bn of non-performing loans, 10pc of the total loan book, at the end of 2016, compared with €17.1bn at the end of 2013.
It would be churlish not to acknowledge the success of both AIB and Bank of Ireland in tackling problem loans. Unfortunately, there may be less to the reduction in problem loans at both of the main Irish-owned banks than meets the eye.
With more than half of their loan books consisting of home loans, the Central Bank's mortgage arrears statistics provide a fairly accurate picture of how the major banks are dealing with problem loans.
Banks operating in Ireland, including AIB and Bank of Ireland, had a total of €22.8bn of restructured mortgages on their books at the end of March, of which €16.9bn were no longer in arrears. So far, so good. However, when one looks at the nature of these restructured mortgages, a less encouraging picture appears.
At least €16.4bn of these restructured mortgages, 72pc of the total, were temporary measures such as interest only, arrears capitalisation or term extensions. Basically, extend and pretend.
It may seem counter-intuitive, but over-stretched borrowers are far more vulnerable to interest rate increases when rates are low, as they are now, than when they are high. This is because even a 1pc interest rate rise, say from 1pc to 2pc, when rates are low represents a far greater proportionate increase in the borrower's monthly loan repayment than a similar rate rise, say from 10pc to 11pc, when rates are high.
With the ECB cautioning that its current ultra-low interest rates are not a permanent fixture, many economists are now expecting a rate rise from Frankfurt either late next year or early in 2019. How many restructured mortgages will unravel when interest rates start to go back up, and what will the impact of this be on the Irish banks?
As far as David Hall of the Irish Mortgage Holders' Association is concerned, when it comes to the overall impaired home loans problem, the country is at a crucial crossroads. The banks, he said, have three choices. They can repossess a much greater number of houses, they can sell the loans to vulture funds, or they can look to an alternative proposal.
Hall is currently awaiting word from AIB about just such an alternative proposal that he is pushing, which would see housing associations buying troubled loans to allow people to stay in their homes.
"It's a highly radical proposal in a very conservative system. But I genuinely believe that there is a clear and present danger around what is going to happen next in all of this. Whatever chance you have with the State owning 100pc of AIB, a large commercial entity coming in as a shareholder may very well look for the button to be pushed very fast on this issue."
As far as AIB and Bank of Ireland are concerned, it would seem, that is a problem for another day. They are now profitable, and their loan books stopped shrinking in the first quarter of this year.
It's a different story at the other Irish-owned bank, Permanent TSB. It recorded a pre-tax loss of €266m in 2016. While it claims that it is now profitable, with just 10pc of the new mortgage market, does the Permo have a future as a stand-alone bank?
Even the two larger Irish banks are still in the early stages of their recovery. To paraphrase the 2002 Fianna Fail manifesto, while they have done a lot to address their problems, there remains a lot more for them to do.
Sunday Indo Business