Wednesday 19 September 2018

Banks face a tougher climate as the Central Bank flexes its muscles

Governor Philip Lane’s Central Bank has indicated that the ‘rainy day’ demand on Irish banks will be repeated
Governor Philip Lane’s Central Bank has indicated that the ‘rainy day’ demand on Irish banks will be repeated

Donal O'Donovan and Gavin McLoughlin

Shares in AIB and Permanent TSB fell sharply in early trading yesterday, before recovering, as investors absorbed the impact of the Central Bank's decision on Thursday to significantly toughen capital requirements.

Shares in AIB and Permanent TSB fell sharply in early trading yesterday, before recovering, as investors absorbed the impact of the Central Bank's decision on Thursday to significantly toughen capital requirements.

The move to crank up a so-called countercyclical capital buffer (CCYB) for the first time is a clear signal that regulators see financial risk building up in the Irish economy.

Insisting that banks retain more capital capable of absorbing losses in a downturn could limit lenders' ability to pay dividends to shareholders - including the State - and may also constrain lending growth or other forms of expansion, such as acquisitions.

The move - and in particular a clear indication from regulators that it will be repeated if necessary - will hamper banks' ability to reward shareholders by way of special dividends and buy-backs funded from lenders' return to profit.

The potential for special dividends from AIB in particular is something many in the market have been watching since the run-up to its partial stock market flotation just over a year ago.

"They've raised it (CCYB) by quite a large amount, so that is a surprise given the state of the economy," said Owen Callan, an analyst at Investec in Dublin.

"It limits what excess capital banks have so they may have to look at their plans for that excess capital, whether it would have been dividends, M&A or other issues."

The CCYB is calculated as a share of each bank's Irish risk-weighted exposures, a standard measure of the value of lending that accounts for the risk of defaults. It was set at 1pc with the potential to go to 2.5pc.

The Central Bank also indicated that it sees the new 1pc level as normal - so the CCYB can be ratcheted back from that in the event of a downturn, or up if the recovery fires further ahead.

The idea is to help avoid a repeat of the crash, when the economic recovery was slowed because banks' balance sheets were so beaten up they couldn't make new, good, loans.

This week's move to tighten the capital requirement was expected, but not the scale of it, analysts said yesterday.

They'd anticipated a gradual increase to the 1pc requirement.

Even so, none of the main banks is expected to have to tap investors for additional funds to meet the new target.

The chief economist at Davy Stockbrokers, Conall Mac Coille, said the move does not mean the Central Bank thinks the economy is in immediate danger of overheating. "The Central Bank was very keen to say they were doing this early in the cycle," he said.

Davy's view is that the move direct to 1pc represented a particularly conservative stance by the Central Bank.

It noted that lending into the Irish economy remains subdued - with credit to households and businesses still in contraction as repayments outpace new lending.

In its announcement, the Central Bank referred to the pace of economic growth in Ireland - measured in terms of gross domestic product - and rising commercial property and house prices.

Potentially more controversial, the Central Bank said €7.3bn of new mortgage lending in 2017 was close to its "structural economic value" and growing rapidly.

Davy's Mac Coille said the 29,000 new mortgage loans in 2017 was in fact the lowest figure since 1987, without even adjusting for population growth. The pace of new mortgage lending is picking up, but from an historically low - even problematic - level, he said.

"Levels of debt in the economy are still falling, Ireland is not getting out of control on that score.

"Banks are having to work just to stand still, and we're almost at a point where there are more deposits than loans in the Irish banking sector," he said.

The CCYB tool brought into force by the Central Bank will raise the cost of funding for banks, and so for the mortgage market, though marginally, Conall Mac Coille added.

That's potentially bad news for consumers here, where mortgage costs are by some way the highest in the euro area.

However, banks' shrinking balance sheets, and the relative scarcity of borrowers, has sparked a recent intensification of competition that will limit the impact.

The Central Bank's indication that it expects to raise the CCYB even further over time will ultimately have an effect in terms of credit tightening - restricting the flow of lending into the real economy. Ireland introduced the potential to use CCYB in 2016, as one of a number of measures that also included the much better known macro-prudential mortgages measures - lending restrictions imposed on the banks based on the size of homebuyers' income and down payments.

Other countries, including the UK's Bank of England, have brought in similar measures since the financial crisis.

Here, the Central Bank said the impact of its first deployment of the CCYB would be relatively small on both the banks and the wider economy.

The three main domestically-owned banks, in which taxpayers retain stakes collectively valued in excess of €10bn - Bank of Ireland, AIB and Permanent TSB - all comfortably hold more capital than the minimum required by regulators.

Yesterday, shares in AIB were down 2.20pc at €4.732 each at lunchtime yesterday, recovering to trade at €4.80 each in late trading. Permanent TSB shares fell sharply very early yesterday, down 2.14pc at €1.92 shortly after the market opened to swing to a gain for the day.

Bank of Ireland shares held up better, ending the session at €6.72 each, close to the previous close.

Bank of Ireland's significant UK lending business means it's the least affected of the main Irish banks, and it outperformed on the day.

The Central Bank had signalled in May that it was considering following a number of other European countries in setting a positive CCYB rate, saying the arguments to do so early in the economic cycle were "compelling".

Irish Independent

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