Monday 19 August 2019

Dark clouds gather over Irish banking sector

Results from AIB, Bank of Ireland and Permanent TSB suggest falling interest rates and economic headwinds pose major challenges, writes Dan White

For the banks and their shareholders, it is a case of battening down the hatches and hoping that interest rates start to climb again sooner rather than later
For the banks and their shareholders, it is a case of battening down the hatches and hoping that interest rates start to climb again sooner rather than later

Just when it seemed as if things were beginning to return to normal for the Irish banks, they get clobbered by a combination of falling interest rates and global economic uncertainty. All three of the Irish-owned banks have now reported their half-year results. They do not paint a pretty picture. Despite Ireland enjoying the fastest economic growth in the eurozone, with employment at record levels, someone forgot to tell the banks, with every one of them reporting a fall in profits for the first six months of 2019.

First out of the traps on July 25 was Permanent TSB. Its pre-tax profits more than halved to €28m from €57m in the first half of 2018. Even when loan impairment charges were excluded, underlying profits were still down by 44pc, to €32m.

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AIB was next up the following day. It too unveiled a disappointing set of interims, with pre-tax profits plunging by 43pc, from €762m to €436m. Even when loan impairment charges (a €9m writedown in the first half of 2019 compared with a €142m write-back in the first half of last year) were taken into account, underlying profits fell by 29pc.

Bank of Ireland made it third time unlucky last Monday when it released its interim results, with pre-tax profits down by 30pc, to €315m. However, when loan impairment charges (a €77m writedown in the first half of 2019 compared with an €81m write-back in the first half of 2018) were excluded, underlying profits actually rose by almost 9pc, from €345m to €375m.

The rapid turnaround in impairment charges at both of the major banks, from major write-backs in the first half of 2018 to significant writedowns in the first six months of this year, must call into question the wisdom of the banks' recent loan write-backs.

Why are the banks finding it so difficult to increase profits, despite our strong economic growth? Banks traditionally took in money from depositors and then lent it to borrowers. They made their money on the spread between what they paid their depositors and received from their borrowers in interest. Unfortunately, with interest rates having been at unprecedented low levels for over a decade, that model has broken down.

Throw in the huge volume of legacy bad loans that the Irish banks have had to work their way through since the 2008 crash, and they are finding it virtually impossible to grow their loan books profitably.

This trend continued in the first half. AIB's total loans to customers stood at €61.1bn at the end of June. This was up only €213m, just 0.3pc on its total loans to customers at the end of December 2018, and a 2pc increase on the €59.9bn total at the end of June 2018.

It was a similar story at Bank of Ireland, where total loans to customers increased by just 1.3pc to €77.4bn in the first six months of 2019, and by a mere 1pc over the past 12 months.

It is the increase, or rather the lack of one, in total customer lending that bank shareholders need to focus on, rather than the figures for the rise in new lending bruited about by both of the major Irish-owned banks.

For what they are worth, AIB says that its new lending increased by 8pc to €6bn in the first half.

New lending of €7.7bn at Bank of Ireland was unchanged on the first half of 2018, and down by 6pc on the €8.2bn of new lending recorded in the second half of last year.

What these figures tell us is that new lending at both AIB and Bank of Ireland is struggling to keep pace with the sale of legacy bad loans and repayments on existing good loans.

At least AIB and Bank of Ireland are achieving, admittedly minuscule, growth in their loan books, which is more than can be said for Permanent TSB. Its loan book shrunk by a further €82m, about 0.5pc, to €15.8bn, in the first half. With a loan book now only a quarter of the size of AIB's and just a fifth of Bank of Ireland's, it is difficult to see the group surviving much longer as an independent, stand-alone bank.

Falling profits and virtually flat lending have hit the share prices of all the Irish banks. The AIB share price has fallen by a quarter over the past year, while the Bank of Ireland price is down by over a third over the same period. Worst of the lot has been Permanent TSB, whose share price has plunged by 40pc over the past 12 months.

This steep fall in the share prices of the Irish banks is bad news for Finance Minister Paschal Donohoe, as he attempts to frame October's Budget, which is likely to be the last one before a probable general election in the spring or early summer of 2020.

The fall in share prices over the past year has knocked almost €2bn off the State's 71pc shareholding in AIB, almost €350m off its 14pc Bank of Ireland stake, and more than €200m from its 75pc PTSB shareholding.

On the basis that friends in distress make misery less, it should be pointed out that it is not just the Irish banks who have seen their share prices fall over the past year.

The Euro Stoxx index of the 26 leading eurozone banks, which includes Bank of Ireland, but not AIB, has fallen by more than 25pc. One of the worst performers has been Deutsche Bank, Germany's largest bank, whose share price fell to an all-time low in May and is still trading at less than 8pc of the 2007 peak.

A year ago, it seemed as if the worst was over for the Irish banks and that they were finally on the road back to normality.

Profits were rising, loan growth looked set to resume and their stock of bad loans was falling rapidly. What went wrong?

Twelve months ago, the US Federal Reserve was two and a half years into a cycle of interest rate increases, with the prospect of more rate rises to come.

On this side of the Atlantic, the ECB was holding out the prospect of interest rate increases in the second half of 2019. For banks, this held out at least the possibility of a return to a more normal interest rate environment.

A year later, things are looking very different. Under pressure from president Donald Trump and a slowing global economy, Fed chairman Jerome Powell has been forced into a humiliating climbdown, with the US central bank cutting rates for the first time in more than a decade last month.

Meanwhile, the ECB, which only stopped buying bonds, via quantitative easing (QE), at the end of last year, is also getting ready to perform a U-turn. Any prospect of an ECB rate increase in the short to medium term has vanished, with a further blast of QE, which will push down long-term interest rates, now very much on the cards.

More QE will push interest rates even further into negative territory. AIB and Bank of Ireland already charge negative interest rates for big deposits from large corporate customers. While the two big banks have been able to make negative interest rates stick for such customers, the obstacles, both regulatory and political, to imposing negative rates on retail deposits are probably insurmountable.

"The interest rate environment has changed very violently and very rapidly," observes one bank-watcher. "The banks are not designed for a low interest rate environment."

So what can the banks do when faced with negative interest rates? "The banks are facing headwinds on [interest] rates. They must tackle their costs," says Goodbody Stockbrokers banking analyst Eamonn Hughes.

Bank of Ireland reduced its operating costs by €30m in the first half and cut its cost/income ratio from 68pc to 65pc. However, AIB's cost/income ratio crept up from 51pc to 54pc in the first half.

With interest rates unlikely to rise significantly in the short to medium term, the banks will have no choice but to focus ruthlessly on costs. Bank of Ireland is targeting a cost/income ratio of 50pc by 2021.

Cost reductions of this scale can only be achieved by closing more branches and moving an ever-increasing proportion of Bank of Ireland's business to digital services.

With the State still the majority shareholder in both AIB and PTSB, and a significant Bank of Ireland stakeholder, any branch closures will have to be skilfully navigated if the banks are to avoid the reefs of political controversy.

Following the publication of the interim results, analysts have cut their earnings forecasts for both AIB and Bank of Ireland.

Davy's Stephen Lyons is pencilling in a "low-single-digit" reduction to both his 2020 and 2021 forecasts for AIB, and is also pencilling in a "high-single-digit" reduction for Bank of Ireland.

Meanwhile, Goodbody's Hughes reckons that 2021 earnings at Bank of Ireland will now be 7pc-8pc lower than had previously been expected.

About the only good news in the bank interims was the continuing reduction in non-performing loans.

These stood at just 5.3pc at Bank of Ireland and 7.5pc at AIB. Both banks are now on track to get non-performing loans under the 5pc level considered normal by banking analysts by the end of the year.

For the banks and their shareholders, it is a case of battening down the hatches and hoping that interest rates start to climb again sooner rather than later.

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