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Battered financial sector regains forward momentum

Ireland’s banking sector has ridden the return of risk appetite to global capital markets after the summer of 2012 with great skill. Irish covered, senior and Coco bonds have all been launched over the last nine months — quite an achievement considering what the country has been through over the past five years. But as Philip Moore reports, capital remains a key concern, as does profitability.

“Every line in the income statement and key performance metrics were better in the second half of 2012,” says Bank of Ireland (BoI) in an upbeat presentation delivered to investors in February.

It’s a statement that is true enough, but it is one that analysts say needs to be put in some perspective. Income is rising, but is still modest. Net interest margins are up, but from a deep trough. Impairment charges are falling, but from a vertiginous height. The loan-to-deposit ratio is declining, but also from an unsustainably lofty level. 

The direction of travel, however, is clear enough, and the recovery from a very low base has been reflected in the performance of BoI’s share price this year, which by early June had risen by 49%. That’s not bad for a bank which Goldman Sachs expects to post a loss this year and next, exiguous earnings per share of €0.01 in 2015 and no dividend for the foreseeable future.

Aside from reflecting the return of risk appetite to global capital markets after the summer of 2012, the support that BoI has enjoyed from equity and — increasingly — from debt investors is a recognition of the progress that has been made by the Irish banking industry in the last two years. 

“The rescue funding made available to Ireland required the central bank to implement a wholesale restructuring of the banking system,” says Ben Davey, co-head of FIG EMEA at Barclays, who was one of the team advising the Irish authorities on the rehabilitation of the industry in 2011. The restructuring plan drawn up by the central bank and its advisers, says Davey, identified three core objectives. The two leading banks, Allied Irish Banks (AIB) and BoI, have clearly achieved two of these goals, and are making palpable progress towards delivering on the third.

“The first priority was a significant deleveraging of the banking system, with specific targets set for AIB and BoI,” says Davey. This process is clearly advancing well ahead of schedule, with AIB reporting that 89% of its deleveraging target for the end of 2013 had already been achieved by December 2012. Last year, AIB reported a decline in its risk-weighted assets (RWAs) of 15%, from €84.3bn to €71.4bn.

BoI, meanwhile, completed €10.6bn of asset divestments in 2012, which it says “exceeded targets, below assumed cost and ahead of schedule”, and reduced its RWAs by €10bn, from €67bn to €57bn.

“The second objective was the delivery of a loan-to-deposit ratio of 122.5% by the end of 2013,” says Davey. BoI reports that it is on target to reach its loan-to-deposit (LTD) ratio of 120% by 2014, having reduced the ratio from 175% in December 2010 to 123% at the end of 2012. AIB, meanwhile, brought its LTD ratio down from 169% to 115% over the same period. 

There are, of course, two sides to the LTD story, with the banks required by the government to observe lending targets as well as bolster their retail deposits. AIB, which is 99% owned by the government, reports that in 2012 it was ahead of schedule on mortgage and SME lending. In mortgage lending, it was 50% ahead of its target last year, which has encouraged it to double its target for 2013. Loan approvals in the SME area reached €4.8bn in 2012, compared with a target of €3.5bn.

BoI, meanwhile, also beat its lending target last year. Its loans to SMEs grew by 16% in 2012, and it forecasts a further 12% increase in 2013.

Jury out on profitability

“The third target for the two big banks was a restructuring of their operations and a downsizing of the cost base, with a view to achieving high single-digit or low double-digit returns on equity within three to five years,” says Davey. 

It is too early to ascertain how far the banks have come down the road to profitability. “We are seeing a stabilisation but not yet a reversal of mortgage arrears,” says Christy Hajiloizou, credit analyst at Barclays in London. “Impairment charges are still at an elevated level, but are trending in the right direction.”

Per Høg Jensen, head of financial origination, debt capital markets, at Danske Bank in Copenhagen, points to the problem of tracker home loans, for example, which carry a fixed margin above the ECB lending rate, as a drag on profitability. These represent more than half of all Irish mortgages — about 40% of GDP — and “currently generate a near-zero, or even negative, net interest margin for the banks,” according to Standard & Poor’s.

Recent initiatives such as a proposal for a law that will make repossessions more straightforward should help arrears level off, says Denzil De Bie, director, financial institutions, at Fitch Ratings in London. “It’s unlikely that we’ll see clean banks in the next couple of years,” he says. “But by 2015-16 we may see banks start to make sustainable profits.”

Discontinuation of ELG

Another key step towards normalisation was taken at the end of February, when it was announced that the Eligible Liabilities Guarantee (ELG) Scheme would be discontinued as from March 28. At Barclays, Davey says the scheme was the subject of some controversy when it was introduced in December 2009, and that its discontinuation was an important milestone for the banks for two reasons. 

“First, it represented a very real cost to the banks,” says Davey. That much is clear enough from their accounts. BoI, for one, paid €388m of fees on its ELG-covered liabilities of €26bn in 2012. “Second, it was a signal to the market that they are making progress towards operating as viable entities and without the state guarantee,” adds Davey.

Regaining market access

Before the discontinuation of the ELG scheme, however, Ireland’s leading banks had already re-established their presence in the capital market, starting in the covered bond space in late 2012. “The covered bond market was the right place for the banks to begin the regeneration of the Irish credit market, given that the collateral had largely been restructured,” says Mark Geller, head of European financial institutions syndicate at Barclays. 

Chris Agathangelou, head of financial debt syndicate at Nomura, says an indication of the strengthening credit profile of the Irish banks was that BoI was able to return to the market in advance of the sovereign. “In a normal environment you would expect the sovereign to come first,” he says. “BoI came ahead of schedule, and should be commended for its flexibility.”

BoI’s capital market rehabilitation began in November 2012, with an €1bn three year asset covered security (ACS), which was its first in non-government guaranteed format for three years. Led by Citi, Morgan Stanley, Nomura, RBS and UBS, the BoI issue was a spectacularly successful re-opener of the market for the Irish banking sector, harnessing demand of €2.5bn for a deal priced at 270bp over swaps, which was the tight end of guidance. “BoI’s covered bond, which traded through the government’s curve in the secondary market, was a phenomenal success,” says Agathangelou.

BoI’s return to the ACS market also opened the door for AIB to issue later the same month for the first time since 2007, with a €500m three year trade led by Deutsche, HSBC, JP Morgan and UBS. Demand of €2.3bn allowed AIB to price at the same spread as BoI’s icebreaker. That was perhaps surprising, given AIB’s lower rating and weaker credit profile, but again pointed to the magnitude of the change in investor sentiment towards Ireland. 

BoI followed up on its return to the covered bond market in December with a €250m 10 year lower tier two transaction, which was the first subordinated debt issue from an Irish bank since before the Lehman crisis, and was four times subscribed. “BoI has implemented its capital strategy very well,” says Agathangelou. “The majority of the tier two deal was pre-placed, and opening the book for the remainder of the trade was an interesting strategy because it created price tension, which accounted for its exceptional performance in the secondary market.”

The lower tier two trade paved the way for BoI to complete a secondary placement in January of €1bn of tier two convertible contingent capital (Coco) bonds which had initially been placed with the government as part of the bank’s recapitalisation. Led by Davy, Deutsche and UBS, the BoI Coco offered a coupon of 10% and generated an order book of close to €5bn.

Bankers say that the Coco was an important breakthrough for BoI. “It has also rallied very aggressively in the secondary market, eventually trading with a yield below 8% before the recent market sell-off, which is a powerful statement about investor appetite,” says David Sismey, head of FIG origination in EMEA at Goldman Sachs.

Good news story

The highly successful 10 year deal from the National Treasury Management Agency (NTMA) in March presented the Irish banking sector with its next gold-plated opportunity to continue rebuilding its credentials in the capital market. BoI grasped the opportunity, extending and repricing its covered bond curve by issuing a €500m five year deal via Deutsche, Morgan Stanley, Natixis and RBS. BoI was able to build a book of €2.25bn and price at 190bp over swaps, well below original guidance and 80bp inside the pricing on its shorter dated deal in November. 

That spoke volumes less about the progress made by the Irish banking sector in the space of just four months, and more about the warm glow that all things Irish were enjoying in the aftermath of the NTMA’s sparkling 10 year trade. “Ireland has become a good news story, investors have become comfortable with Irish sovereign risk, and banks are clearly benefiting as a result,” says De Bie at Fitch.

The most recent landmark was passed at the end of May, when BoI printed the first senior unsecured issue from an Irish bank since before the financial crisis. This was a three year €500m transaction led by BNP Paribas, Deutsche Bank, Morgan Stanley and RBS, priced at 220bp over mid-swaps. While the size of the order book, which reached €1.25bn, did not pull up any trees, it allowed for pricing to be set at the narrow end of guidance of between 220bp and 225bp, and for the majority of the bonds (87%) to be placed with real money accounts. Distribution was well diversified across Europe, with Germany taking 18%, Italy 17%, and the UK and France, 15% each. 

“BoI’s senior issue was very successful in that it was well oversubscribed and priced within guidance,” says Danske’s Jensen. “The three year maturity was well chosen because the depth of liquidity is always greater at the shorter end of the curve. I’m sure BoI could have issued further out on the curve, but the three year maturity minimised the cost and execution risk.”

In less than a fortnight, the bond had widened by about 100bp, but bankers say this was a function of a sharp reversal in general market sentiment, rather than a reflection of BoI’s credit profile or of the pricing of its senior issue. 

The deterioration in market sentiment in recent weeks throws a question mark over the next likely step in the continued re-establishment of Ireland’s leading banks as borrowers across the capital structure. 

Bankers believe, however, that there is no reason why AIB should be unable to follow BoI into the senior unsecured market. “Although the early June market sell-off has stalled new issues for now, there is no doubt that AIB could fund in senior, and that both BoI and AIB could issue five year debt once the broader market stabilises,” says Sismey at Goldman Sachs. “For both banks, funding is now a question of price, not market access.”

Sismey does not believe bail-in risk would unnerve holders of senior debt in Irish bonds. “Even for some of Europe’s weaker banks, the credit curve has been flat enough between three and 10 years to suggest that investors believe that by the time senior debt becomes bail-inable, banks will have sufficient buffers in place between equity and subordinated debt that the risk of senior being bailed in will be minimal,” he says.

Nick Dent, head of EMEA syndicate at Nomura, says that one of the keys to the Irish banks’ successful return to the market has been the careful planning, timing and sizing of the transactions. “Because they have been under no funding pressure, the banks have been able to limit the size of their issues, always leaving investors hungry for more,” he says. “This has had the twin effect of supporting their secondary market performance and preparing the ground for subsequent transactions.”

Ireland’s banks should continue to benefit from relative scarcity value. As Sismey at Goldman Sachs points out, one of the technical reasons for why transactions such as the BoI senior unsecured trade were so well supported in the primary market is the general expectation that issuance volumes will be modest. 

Perspective needed

None of this is to suggest that Ireland’s banks don’t face a number of very formidable challenges, some of which are making equity investors jittery. Reports published this month by Goldman Sachs and Fitch were credited by the Irish press for prompting a fall in share prices in the banking sector, but both should be seen in perspective. Goldman Sachs’ ‘sell’ call on BoI shares came after they had outperformed their European peers by a wide margin.

Fitch’s update expressed the caution shared by all rating agencies about the capital requirements likely to be dictated by the Prudential Capital Assessment Review (PCAR), originally drawn up in 2011 on a Basel II basis. “Since then,” Fitch says, “capital expectations of market participants have increased in terms of both quantity and quality. Fitch believes that the 2014 PCAR may revise the stress assumptions and requirements to align more closely with Basel III. As Irish banks’ capital ratios continue to be eroded and a return to profitability only appears feasible in the longer term, further capital may be required before the banks can contemplate a future independent of state support.”

Nigel Greenwood, analyst at Standard & Poor’s, shares this caution. “Although we have seen mildly positive developments on the funding side, our main concern is that the banks’ capital is weak on a Basel III basis according to our metrics, which continues to be a constraint on their ratings,” he says.

Credit analysts agree that the next PCAR stress tests, expected in the last quarter of 2013 or early 2014, are the next critical landmark for the Irish banks, and possibly a key determinant on Ireland’s readiness to exit the Troika programme. “The next stress tests will probably establish a new core tier one target ratio in line with Basel III,” says Hajiloizou at Barclays. “This will be at least 7%, although I wouldn’t be surprised if Ireland requires a slightly higher ratio for its banks than the EU minimum level.”

Hajiloizou says that as of the end of March 2013, AIB and BoI had core tier one under Basel II of 15% and 13.8% respectively. Their last reported fully-loaded Basel III ratios, meanwhile, were 9.7% and 8.5% , including the government’s preference shares. “There will be some capital erosion from continuing loan losses, which could be partially offset by further RWA reductions, but most importantly ratios will remain well above the 10.5% minimum requirements set by the PCAR in 2011,” she says. “A Basel III core tier one pass rate under the stress tests of up to 8% or 9% would put them under renewed pressure. The banks will need to find ways to bolster capital levels to meet new rules, like all European banks.”

The return of foreign banks?

Barclays’ Davey says that although downside risks remain, the brighter prospects for Ireland’s economy and banking industry raise the prospect of foreign banks re-evaluating the opportunity presented by the country. “Pre-crisis, foreign banks represented about a third of the banking system,” he says. “During the crisis, it was assumed they would wind down and exit. But given how strongly the economy is rebounding, it may be that one or two of these banks review their strategies.”

Owen Callan, senior analyst, fixed income strategy at Danske Bank in Dublin agrees. “If a foreign bank were to come into this market in a meaningful way it would be a massive boost to confidence,” he says. That would certainly be the case if a buyer could be found for Ulster Bank, which has 135 branches in the Republic and which its parent, RBS, is eager to offload.  

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