Reducing bank-bust risk could stymie lending capacity of the 'big two' in the good times
AIB and Bank of Ireland will have to set aside more than €1.7bn of extra capital to meet the Central Bank's new capital buffers at a time when overall bank lending is still falling, writes Dan White
Last week the Central Bank unveiled new rules dictating the amount of capital the Irish banks must have on their balance sheets.
The regulations, which are part of the Eurozone's Single Supervisory Mechanism, will have major implications for AIB and Bank of Ireland when they come into force between 2019 and 2021.
The new rules come in two main parts. Initially, at least, the most important is the Other Systemically-Important Institutions regulations. Under O-SII, the Central Bank can order systemically-important banks - that is AIB and Bank of Ireland - to provide up to 2pc of their risk-weighted assets in extra capital.
In the event the Central Bank didn't go quite that far, it could opt for an O-SII buffer of "only" 1.5pc instead. That is still a big number. Emer Lang, banking analyst at Davy Stockbrokers, is forecasting risk-weighted assets of €63bn at AIB and €55bn at Bank of Ireland by the end of 2017 - while over at Goodbody Stockbrokers, banking analyst Eamonn Hughes is pencilling in €60bn at AIB and €53bn at Bank of Ireland.
That would translate into an O-SII buffer of at least €900m for AIB and €800m at Bank of Ireland, a combined total of €1.7bn.
Following a State bailout, which cost the taxpayer a gross €64bn, virtually no one disagrees with the notion the banks must set aside sufficient capital to cope with sudden, unexpected downturns.
However, despite last week's economic good news with the latest CSO figures showing that GDP grew by 7pc in the first nine months of the year, overall bank lending is still shrinking. According to the Central Bank's own statistics, bank lending to Irish non-financial companies fell by a hefty 7.7pc in the year to the end of October, while lending to households fell by 2.5pc over the same period.
This continuing decline in bank lending was the main reason the Central Bank decided to postpone the implementation of the O-SII buffer requirement. It will begin to kick in in 2019, when the two pillar banks will have to set aside 0.5pc of risk-weighted assets, gradually rising to the full 1.5pc by 2021.
The Central Bank also postponed the implementation of the other main capital buffer requirement, the Counter-cyclical Capital Buffer which, unlike O-SII, is supposed to apply to all banks and not just AIB and Bank of Ireland. The initial CCB rate has been set at 0pc.
A 1.5pc O-SII rate and 0pc CCB rate was broadly in line with what the market had been expecting. Investors had already priced in the need to meet the new capital buffers.
In fact, both AIB and Bank of Ireland are carrying far more capital on their balance sheets than they are required to by the Central Bank and the ECB.
Goodbody's Eamonn Hughes estimates AIB will have a 12.5pc capital ratio by the end of this year and Bank of Ireland will have reached this level by the end of 2016. It is this 12pc-12.5pc capital level rather than the regulatory minimum of just 8.5pc that investors are targeting when calculating whether or not a bank has the capacity to pay its shareholders a dividend.
However, while the initial Counter-cyclical Capital Buffer rate has been set at 0pc, there is no guarantee it will stay at that level. The Central Bank has stated it will review the CCB rate on a quarterly basis.
Speaking at the launch of the new capital buffers last week, Central Bank chief economist Gabriel Fagan stated that, when setting the buffer rates, the Central Bank had taken into account "the subdued credit developments in the economy as the non-financial private sector continues to deleverage and the moderation in rates of growth in residential property prices".
Reading between the lines of what Mr Fagan was saying, it's not difficult to conclude that if the current strong economic growth begins to feed through into increased demand for credit, then the Central Bank will move quickly to push up both the CCB rate for all banks and O-SII rate for the larger lenders.
To see where this might be heading one has only to look across the water at what the Bank of England is doing in the UK. There Governor Mark Carney is getting ready to impose a 1pc counter-cyclical buffer rate on all UK banks and a 2.5pc rate on the larger systemically-important lenders.
If similar capital buffer levels were to be imposed in this country - that is, a combined 3.5pc CCB/O-SII rate - then AIB would need up to €2.1bn-€2.2bn of extra capital, while Bank of Ireland would require €1.8bn-€1.9bn, based on Ms Lang's and Mr Hughes' estimates of their likely risk-weighted assets.
On the other hand, the UK is very much an outlier in setting its capital buffer rates. None of the other Eurozone countries has set a non-zero CCB rate while our O-SII is slap bang in the middle of the single currency area average.
While a number of countries including the Netherlands, Estonia and Slovakia have pitched the O-SII rate (including emergency top-ups) as high as 3pc, most other countries have set it much lower.
Of course such onerous capital buffer requirements would only come into force if bank lending started to grow strongly once again.
Last week's economic statistics from the CSO almost certainly means that credit demand will revive sooner rather than later, something that could prompt the introduction of the CCB for all banks and an increase in O-SII for the 'big two'.
While no one wants another bank bailout, the trade-off for reducing the risk of a bank bust in a downturn may be one of increased capital buffers, which will reduce the banks' capacity to lend in the good times.
The thinking behind the capital buffers, which have yet to be tested in a crisis, is that they will provide a war chest from which banks can draw when things go wrong.
Will this trade-off prove to be effective? For Irish taxpayers that is - literally - the €64bn question.
Sunday Indo Business