The top two Irish banks are rooted in the domestic economy but are also heavily exposed to the UK. In fact, a quarter of Irish banks’ credit exposures are directly to borrowers in the UK. “It’s clear that the pressures on Irish banks have much to do with the no-deal Brexit scenario,” said Jennifer Ray, executive director in the financial institutions team of Scope Ratings.

But there are other things going on too. “Margin pressures, especially in the mortgage market where competition has intensified; the return to net provisions rather than net write-backs; and provisions for the tracker mortgage scandal and restitution costs are just some of the issues,” Ray said. “The banks are focused on cost-cutting as their profitability outlook looks somewhat lacklustre in terms of targets being met. Sterling weakness hasn’t helped either given that both banks, especially BoI, have UK earnings streams.”

The Central Bank of Ireland is working on the basis of a 6% decline in Irish economic output two years after a no deal Brexit. That is relatively severe, although less severe than the adverse scenario of the 2018 EBA stress tests, which the country’s two largest banks passed in terms of meeting regulatory capital minimums.

Nonetheless, Irish banks’ heavy exposure to the UK and to domestic SMEs in sectors potentially most exposed to a disorderly Brexit – agriculture, manufacturing, retail trade and tourism – are seen as points of vulnerability. Other areas of concern are the potential for a sharp decline in Irish residential and commercial real estate prices, and the banks’ exposure to global leveraged loan markets.

In its inaugural Financial Stability Review in July, the Central Bank of Ireland cited a larger-than-expected macroeconomic shock in a disorderly Brexit as the main outstanding source of risk to financial stability and the wider economy. “This could arise if the expected negative impact of a disorderly Brexit through trade channels is compounded by a sharp increase in uncertainty and fall in confidence, with knock-on effects to Irish economic activity,” the Bank noted.

Better metrics

It acknowledges, however, that the domestic banking system is much more resilient than in recent years. “On the brighter side, the banks are largely deposit-funded and are at least adequately profitable with clear strategies,” Ray said.

The year-end sector CET1 capital ratio looked reasonable at 17%, while funding is now predominantly sourced from retail deposits rather than more fickle wholesale markets. BoI reported customer deposits of EUR 80.2bn against wholesale funding of EUR 10.2bn at the half-year stage. AIB reported that 75% of its total funding now comes from customer accounts.

Sector NPLs are markedly lower than at the depth of the Irish banking crisis (though still above international standards). “Brexit uncertainty doesn’t help with the NPE outlook. For AIB especially, NPEs are falling more slowly than hoped for,” Ray said.

There continues to be progress, though. Bank of Ireland securitised a non-performing Irish buy-to-let mortgage portfolio in April with a gross book value of EUR 377m, while the sale in August of a EUR 250m portfolio of non-performing Irish BTL mortgages to Cerberus took the group’s NPE ratio below 5%. In its half-yearly earnings report, AIB noted that its NPEs had reduced to 7.5% of gross loans and are on track to reach around 5% by year end.

Despite the progress, the central bank believes vulnerabilities remain. It says Irish retail banks continue to face challenges to the sustainability of their profitability through an economic cycle, which may hamper their ability to compete with international peers for investment. Challenges cited include managing NPLs, sustaining the profitability of corporate and household lending and investing to adapt to a changing operating environment, while containing costs.

“Over time, such challenges to profitability could incentivise banks to take on excessive risk to meet return expectations, leading to an unsustainable pro-cyclical expansion in credit and increasing the risk of additional NPLs in future,” the Bank warned.

Officials also wants to see progress to improve bank resolvability, including through issuance of additional loss-absorbing liabilities. In its half-year earnings report, AIB reported MREL issuance of EUR 3.3bn to-date, adding that is well positioned to meet its expected MREL requirement, with about EUR 5bn still to do to hit its requirement of 28.22% of RWA by 2021.

Bank of Ireland has an MREL target of EUR 13.3bn (26.4% of RWA at December 2016) to be met by 2021. At the half-year 2019 stage, the group MREL ratio was 21.1% based on June 2019 RWAs, leaving modest MREL-eligible issuance of an anticipated EUR 1bn to EUR 2bn, according to the bank’s half-year report.

A sign of potential investor unease around Irish banks emerged on 3 September when Bank of Ireland cancelled a EUR 300m subordinated Tier 2 offering, having gone into marketing and fixed the spread at MS+270bp. Even though the book was covered, investor support looked lacklustre, so the bank opted to pull the deal. The cancellation was broadly attributed to Brexit, but then again there was also talk that pricing had started out too aggressive and investors simply opted to buy elsewhere in a busy market that was concurrently offering more liquid benchmark-sized investment-grade paper.

Market participants say a disorderly Brexit has not been fully priced into Irish government bonds, pointing to some switching out of Irish sovereign paper as a Brexit hedge and a widening of the Ireland-Germany spread in recent weeks. The 10-year Irish government bond auction on September 12 could offer a timely test of sentiment.

Author: Keith Mullin: k.mullin@scopegroup.com