Wounded bank structure will need more than a few quick patch-ups
It must be acknowledged that high variable rates are a symptom of deeper problems in the system, writes Colm McCarthy
Published 22/05/2016 | 02:30
Ireland's retail banking system comprises the patched-up remnants of the dysfunctional and swollen structure which arose during the bubble. There were spectacular collapses, every single bank had to be rescued, some remain in majority public ownership, several disappeared and a well-functioning system has yet to re-emerge. As is true in many countries, the banks remain burdened with non-performing loans and there are reservations about balance sheet quality. Customers complain about credit availability and cost and there is an evident lack of competition. There continues to be an over-concentration on housing finance.
The Fianna Fail Bill empowering the Central Bank to cap certain mortgage lending rates is an understandable response to borrower concerns and may succeed in reaching the statute book. It will please mortgage borrowers but will hardly appeal to the Central Bank which has not sought these powers, may decline to exercise them and cannot be forced to do so.
Variable rates on mortgage loans in Ireland are about 1.5pc higher than the average in eurozone countries, and in some cases the excess is even greater. Banks which owe their survival to the taxpayer are reporting profits, promising to resume dividends and able to afford pay increases and pension fund top-ups. Borrower discontent is hardly a surprise.
The problem with variable rates reflects the structure of the banking system which emerged after the crash and rescue. The survivor banks have scrambled to rebuild net interest margin, the excess of what borrowers pay over the cost of bank funding. A highly competitive, indeed excessively competitive, mortgage market has been replaced by a small handful of lenders willing to offer mortgages and in a position to expand margins at the expense of captive legacy borrowers.
There are just five active mortgage lenders, AIB, Bank of Ireland, Permanent TSB, Ulster and KBC. The latter is reviewing its involvement and could exit, following the departures of National Irish, Bank of Scotland (Ireland), Irish Nationwide, Educational and others. Just over half of the performing Irish mortgage loans are at variable rates, ranging from 3.5pc to 4.5pc and even higher, but the remainder are trackers charging 1pc or thereabouts and they lose money for the banks. Trackers, which locked the banks into long-term lending at tight margins, are no longer profitable and are no longer offered. The banks cannot borrow cheaply enough, even with deposit rates near zero.
The lending rate on trackers was set at a modest margin, around 1pc in most cases, over the ECB's main lending rate at a time when banks could borrow wholesale funds at roughly the ECB's figure. This rate has been reduced steadily through the crisis and is now zero.
But the Irish banks have been paying well above the ECB's rate for wholesale funds and are stuck (the margin on trackers is contractually fixed) with the huge book of tracker mortgages issued in the years 2004 to 2008. They made an unhedged bet on the indefinite availability of cheap financing and they lost (or rather, the taxpayers lost).
The resulting hole in their annual revenue has been filled through their ability to expand margins at the expense of captive borrowers, principally variable-rate mortgage borrowers. The ability to expand margins reflects the weakness of competition in the post-crash marketplace.
Irish banks are not substantial lenders to small business - their principal activity consists of mortgage lending and lending to housebuilders and holders of residential land. For AIB and Bank of Ireland, about two-thirds of lending activity is related to housing, for Permanent TSB an even greater portion. Some of this (the trackers) is unavoidably loss-making. Margins on lending to farmers and SMEs have also been edged upwards but the expansion in spreads on variable-rate mortgages is the principal driver of the profit recovery, more than compensating for the losses on trackers.
Bank profits would fall substantially, or in some cases disappear, if variable rates were cut severely. The banks have been rescued through a huge, once-off bailout by taxpayers. They are being rescued every day through a further and continuing subsidisation of their loss-making tracker loans by other borrowers, notably those on variable rates.
A well-functioning market competition, or the threat of competitive entry, would discipline the lenders against overdoing it, since borrowers can switch. But there is limited competition and the weakness of, in particular, the UK banking system has dissuaded potential entrants. The Central Bank is caught in a dilemma and the Government in a conflict of interest.
The Central Bank is doubtless pleased to see the banks restored to profitability, since profits (unless dissipated in dividends) help to rebuild capital. Healthier banks are able to borrow on better terms and are less likely to go wallop again. But the Central Bank has responsibilities to bank customers, too, and cannot be unaware of the cross-subsidisation going on in the mortgage market.
The Government owns a large slice of the banking system and hopes to recover some of the bailout costs through selling off bank shares. Profitable banks able to pay dividends are reassuring for shareholders, and the Government is the biggest shareholder. Awkwardly, the variable-rate borrowers are voters, and their interests diverge from those of the Government as shareholder. It is hardly an accident that the highest variable rate is charged by the bank in which the Government has the smallest stake.
There is a second conflict of interest for the political system. Mortgages are secured loans, collateralised through the lender's right to repossession. Without this security, housing finance would be much more expensive - check out the interest rate on personal or small business loans to see the difference! Politicians of all parties are sympathetic to the plight of underwater mortgage borrowers, and have been chipping away at the entitlement of banks to repossess.
As a matter of social policy this is perfectly understandable, but it has consequences. One consequence is that the appropriate lending rate goes up, not down, when the collateral value of the loan security is diminished. A draconian regime of instant eviction for non-payment with no sensitivity shown for delinquent borrowers is the one likely to offer the lowest borrowing rates.
It would be nice to have a competitive, profitable, well-capitalised banking system charging low rates to borrowers, paying decent returns to savers, slow to realise collateral from defaulters, yielding generous dividends and offering high returns to departing shareholders. We had a banking system which looked like this for a while and you know what happened next. It is not possible to whistle up these conflicting features by political fiat in the wounded structure of post-crash Irish banking.
The Fianna Fail Bill will now go through a deliberative process in the Oireachtas, presumably the first task of a new committee on banking and finance. This committee will need to acknowledge that high variable rates are a symptom of deeper problems in Irish banking and to address the longer-term structural issues.
Brendan Walsh, formerly the chairman of UCD's economics department, passed away suddenly last Thursday at the age of 76. Brendan was the outstanding Irish economist of his generation, a gifted teacher, prolific researcher and contributor to public policy, and a wonderful colleague. Ni fheicimid a leitheid aris