The State of the PCAR Banks

The three banks in which the State continues to hold a stake are AIB, BOI and PTSB (collectively the PCAR banks).  Here is a summary of their aggregate balance sheet position for the past five years.

The main changes are pretty clear.  Their aggregate balance sheets have declined by just over €100 billion since the end of 2010.  On the asset side this has mainly been achieved by a reduction is loans due (repayments, write-offs, NAMA transfers and other sales).  The big move on the liability side has been a reduction of €80 billion in the amount owed to the Eurosystem.  Customer deposits are up around €15 billion while debt liabilities are down around €30 billion.

Net equity in the banks is currently around €23 billion with a combined CT1 ratio of 14.5%.  The loan-to-deposit ratio has fallen from 192 per cent to 123 per cent.

Here is their aggregate income statement for the past five years.

As has been widely reported the banks “returned to profitability” in 2014 (well AIB and BOI did at any rate).  The €1.6 billion positive net income was mainly driven by provisioning behaviour which declined from €4.5 billion in 2013 to just €0.3 billion in 2014 with the banks writing back provisions in relation to some elements of their loan books.

Selling banks with €22.6 billion of net equity and €1.6 billion of net income in their most recent year should generate substantial funds but the amounts will be unclear as long as the problem of dealing with non-performing loans (€45.7 billion or 23.3 per cent of gross loans) remains.

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A profit from the BOI bailout?

This morning Bank of Ireland have announced that they indeed to redeem the €1.8 billion of preference shares held by the National Pension Reserve Fund in the bank.  Since the onset of the crisis the State has contributed €5.8 billion to Bank of Ireland.  This comprises:

• €3.5 billion of preference shares in February 2009
• €1.3 billion of ordinary shares in July 2011
• €1.0 billion of contingent capital notes in July 2011

That is a total of €5.8 billion.  And what has been returned?

In April 2010 it was announced that €1.7 billion of the preference shares would be cancelled as part of a swap with ordinary shares in the bank.  That left the €1.8 billion of preference shares in today’s announcement.  As part of the swap the State received around €0.5 billion in warrants for the cancellation of the preference shares.

In July 2011 it was announced that around €1 billion of ordinary shares held by the NPRF would be sold to private investors.  In January 2013, the sale was completed of the €1 billion of contingent capital notes held by the Minister for Finance were sold.

When the €1.8 billion from today’s announcement is received that will bring the total received from asset transaction to €4.3 billion.

There have also been substantial income receipts from Bank of Ireland over the past four years.  These include transaction fees (€0.1 billion), preference share dividends in cash (€0.6 billion), contingent capital interest (€0.2 billion) and various guarantee fees (€1.5 billion).  These total €2.4 billion.

Thus total receipts from Bank of Ireland over the past four years are €6.7 billion which is a surplus of almost €1 billion over the €5.8 billion put in.

It can be seen though that the “profit” only arises with the inclusion of the various guarantee fees and not simply from the financial transactions with Bank of Ireland.  These were a ‘fee for service’ and providing the guarantee was not a costless operation for the State.  Only monies paid to Bank of Ireland are included while costs carried by the State (higher interest rates, reduction/elimination of market confidence) are ignored.  It is probably appropriate to omit the guarantee fees when determining the profit/loss from the State’s financial transactions with Bank of Ireland.

That means we are still nursing a €0.6 billion loss.  However the State still holds a 15 percent equity stake in Bank of Ireland (which will be diluted slightly by today’s announcement if the State does not participate in the rights issue).  With a current market capitalisation of around €8 billion this stake is worth around €1.2 billion.  We may yet turn a profit on the bailout of Bank of Ireland.

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The State of the Banks

The quarterly IMF Reports generated as part of the EU/IMF programme now include an useful table that summarises the state of the “Irish-headquartered banks” (known as “covered” before the withdrawal of the ELG).  The banks included, and their level of state ownership, are:

• Allied Irish Banks (as merged with EBS) – 99.8%
• Bank of Ireland – 15.1%
• Permanent TSB – 99.2%

The most recent review, the eleventh, includes the table aggregating the results of the three banks on page 43. First is the Profit and Loss Account:

One important measure of the state of the banks is pre-provision profits.  For the past few years the banks have not been able to generate enough income to cover their operating expenses.  Regardless of loan losses that is unsustainable.  The March 2011 PCAR projected that the banks would make €3.9 billion of operating profits in the three years from 2011 and 2013.  This was a wild over-estimate. 

Compared to the first half of 2012, the banks managed to slightly increase their net interest margin (from 1.6% of total average assets, TAA, to 2.1% of TAA).  A small turnaround in trading gains and a reduction in operating expenses from €2.1 billion in H1 2012 to €1.8 billion in H1 2013 resulted in pre-provision profits swinging around from –€0.7 billion to +€0.1 billion.  This is still well shy of what was envisaged under the PCAR.

Although the banks returned a small aggregate pre-provision profit in H2 2013 continued loan loss provisions mean that net income remains negative.  If the level of non-performing loans (NPLs) continues to rise the banks will have to continue provisioning for losses which will continue to be a drag on the P&L account.

Next up is the balance sheet where we will ultimately see the effect of these provisions.

The balance sheets of the banks are getting smaller.  Total assets dropped €40 billion over the year, falling from €322 billion last year to €288 billion at the end of June this year.  Only ‘securities and derivatives’ showed an increase on the asset side, possibly down to valuation effects. All other asset categories fell with net loans dropping by €22 billion.

On the liability side the bulk of the reduction was seen in the money ‘due to Eurosytem’ which fell by nearly 50% over the year.  The other drop was in ‘Debt and derivatives’.  Both interbank deposits and customer deposits rose over the year.  The €3.6 billion rise in customer deposits must be tempered against the fact that government deposits in the covered banks increased by around €10 billion over the year as the NTNA placed around half of the €25 billion cash reserve that has been accumulated with them.

The net equity in the banks (difference between assets and liabilities) was just over €20 billion.  The value of the liabilities is easy to determine; the value of the assets is less immutable. 

As shown, the banks had €65 billion of debt securities at the end of H1 2013.  These are mainly NAMA bonds, Irish government bonds and bonds from each other.  “Oh what a tangled web we weave, when we practice to deceive” (Walter Scott).

The loan books of the banks continue to both decline and deteriorate.  As good loans are paid off the relative size of the defaulting loans increases.  This is a chart on SME lending up to the end of 2012 from the Central Bank’s Macro-Financial Review.

The proportion of impaired loans has risen to around 25% but the amount of lending outstanding has fallen from €60 billion to €43 billion.   For Q1 2011, 15% of €60 billion is €9 billion; for Q4 2012, 25% of €43 billion is €11 billion.  The proportion of impaired loans has increased far more than the amount of impaired loans.  This is not the case in the mortgage market where the level of loan reduction is lower and the increase in impaired loans is faster.  The question of whether the ultimate losses will be above those set out in the 2011 PCAR is still uncertain.

Finally, the IMF include some “memorandum items” that give some further insight into the balance sheet and profit & loss account.

We see that the banks have a gross loan book of €213.5 billion.  The balance sheet value of €186 billion is as a result of the €28 billion of loan loss provisions that have been set against the loan books.  Non-performing loans in the banks grew another €5 billion over the year but that provisions as a percentage of NPLs is almost 50%.

The second half shows that the banks’ Core tier 1 capital ratio fell from 16% to 14% over the year and is still above regulatory requirements.  Operating losses eating cash and provision reducing the value of loan assets will have eroded the banks’ capital.  A relapse to pre-provision losses and further provisioning on bad loans will erode this further. 

This will arise because additional loans go sour or because they banks may not have set aside enough to cover existing non-performing loans (NPLs).  For example, AIB may not have been conservative enough with provisions against its Irish residential mortgages.  We have seen that AIB has made a provision equal to 34% of its non-performing mortgages, as against 44% for Bank of Ireland and 48% for Permanent TSB.  The banks do have slightly different methods of measuring ‘non-performing’ which may be a factor in the provisions they set aside.

So what is the overall state of the banks? Will they pass the forthcoming stress test?  It is likely that the Irish banks will pass the stress test.  Reports suggest that the ECB will require a 7% CT1 ratio in the stress test with a 1% surcharge for “systemically relevant” banks.

The ECB wants to unearth potential risks hidden in banks' balance sheets before banking supervision is centralised under its roof from November 2014 as part of a broader plan for closer European integration to head off future financial crises.

To do that it plans to run an asset quality review (AQR) early next year, for which it will reveal details on Wednesday.

Two sources familiar with the matter told Reuters on Tuesday that the central bank will ask banks to fulfil an 8 percent capital buffer in its review.

The buffer will require a core tier one capital ratio of risk-weighted assets of 7 percent, as foreseen in the final 2019 stage of the Basel III regulatory framework, plus a 1 percent surcharge for systemically relevant banks.

Could the results show that the Irish banks will drop below this level?  It’s possible but unlikely.  The Irish banks must strengthen their operating profitability and will have to continue making provisions against bad loans (but at a much reduced rate) but a drop below the level set out in the ECB stress test is unlikely. 

What could cause the Irish banks’ capital ratios to drop below 8% (in aggregate)?  A further write down in the value of their assets of around €10 billion would probably do it.  This could happen for a number of reasons:

• If a further €20 billion of loans become non-performing, the current provisioning rate (c. 50%) would knock €10 billion off the book value of the loans.
• If there was an increase in the provisioning rate against current NPLs from 50% to 66%.  Equivalently, if losses on existing NPLs are crystallised at a level above those currently provided for.
• If the book value of loss-making, low-interest ‘tracker’ mortgages was reduced (unlikely to be €10 billion though)
• If the book value of other assets such as Irish government bonds or NAMA bonds was reduced (again unlikely to be €10 billion).

Of course further operating losses and possible changes to the items eligible as Core Tier One Capital will also have a role to play.  The above list are fairly pessimistic scenarios and even if they were to play out (and they are possible) they would still bring the aggregate capital ratio across the banks to around 8% – which is the threshold set by the ECB. 

Under the conditions set out by the ECB no additional capital would be required.  As noted above, the 2011 PCAR was designed around keeping the capital ratios above 10.5% in the base case (and a buffer above that was also provided for). 

If something like the above does play out and the capital ratios in the banks do drop to below 8% where will the money come from to make up the gap?  The shareholder is mainly the State and the amount of subordinated debt in the banks is relatively small (and any write down there would hit the State which holds €1.4 billion of sub-debt between AIB and PTSB).  Similarly there aren’t many senior bonds in issue from the banks.  So where to next?  A depositor haircut a la the botched Cypriot example?

That is very very unlikely in Ireland.  The worst of the banks are now off the stage (Anglo, INBS and Bank of Scotland(Ireland)); the remaining banks are not going to be shutdown.  As projected here the “Irish headquartered banks” probably have around €10 billion of headroom before more capital is required (to stay above the 8% level).  This will be eroded but it will take even larger problems again to generate a hole that has to be filled.  A hole of any substantial size is unlikely but not impossible. 

If it comes to it is there a “National backstop” available?  Yes, the NTMA have accumulated a cash reserve of more than €25 billion.  Using that to recapitalise the banks is an unlikely scenario but the backstop is there.  The Irish banks will pass the ECB stress (and maybe we should be doing more stringent tests of our own) but passing a stress test is not a sign that a bank is healthy.  It just means it’s unlikely to die.  Even when the banks do pass the ECB’s test cleaning up the delinquent loan-book shown on the balance sheet above is a long way from being completed.

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Recapitalising the Banks

The issue of further capital for the banks has attracted some attention in recent days.  Prof. Brian Lucey had a piece in Saturday’s Irish Examiner and yesterday’s Sunday Business Post led with the headline ‘IMF warns of new €16bn black hole in Irish banks’.

The issue in the SBP piece is actually about the contingent liabilities of the State rather than the banks and the IMF have actually been making the same point for at least a year.  Here is a quote from the IMF’s fifth review issued this time last year with the same 10% of GDP (€16 billion) contingency.

Recognition of contingent liabilities would constitute a one-off increase in the level of debt. Ireland’s contingent fiscal liabilities relate to the covered banks, the IBRC, and NAMA. There is no expectation of losses from these entities as the covered banks have been recapitalized under PCAR 2011, the IBRC meets capital adequacy requirements, and NAMA received assets at heavy discounts—averaging 58 percent—to protect its viability. Under the standard scenario, the assumption of 10 percent of GDP in contingent liabilities by the Irish government would raise the debt-to-GDP ratio to 124 percent in 2012 and cause it to peak at 129 percent in the following year, but starting from 2014 debt would start to decline steadily, reaching 123 percent by 2016. However, the debt trajectory would be higher if the higher debt level resulted in higher interest rates on new market funding.

Although the level and composition of the contingent liabilities have changed over the year (NAMA Bonds, ELG guarantees, ELA Guarantees), and are subject to further change because of the IBRC liquidation, the IMF have not adjusted the 10% of GDP contingency in their scenario analysis.  It is not clear that they have given this issue much consideration recently.

In fact if we go all the way back to the IMF’s first review (May 2011) we find this graph in the annex on public debt sustainability (page 41).

And even before November 2010, the IMF included a ‘one-time 10% of GDP contingent liabilities shock’ in their debt sustainability analysis.  Check out page 37 of the Article IV Report on Ireland published in June 2009.

So the IMF is not warning of a ‘new €16 billion black hole in the Irish banks’ but the broader question still stands:  will the Irish banks need more capital?  Maybe or maybe not.  When Craig Beaumont, the IMF Mission Chief to Ireland was asked as part of the conference call on the publication of their latest report on Ireland (the ninth review) he was non-committal as can be seen below the fold.

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