The banking sector has been no stranger to dramatic developments in recent years.
Indeed, the past 15 months have not been without their fair share of twists, which were reflected in the annual results of the main banks which were published over the last few weeks.
As 2022 kicked off, the industry was still grappling with the shock decisions by Ulster Bank and KBC to quit the Irish market.
The outbreak of war in Ukraine presented challenges to the economy that had the potential to cause significant difficulty for financial services providers.
And the global economy was still readjusting after the disruption caused by the pandemic.
As the year progressed, it was starting to dawn that the inflationary environment brought about by that recalibration of the economy – and exacerbated by the war – was not going to be as ‘transient’ as had been hoped.
Difficulty turned to opportunity for banks as the European Central Bank followed its global counterparts in embarking on a rate hiking cycle, the likes of which had not been seen in decades.
This was the standout figure in all the banks’ results with AIB recording a 20% jump in net interest income, Bank of Ireland, 12%, and Permanent TSB reported the measure up 16%.
It’s a metric that has been quite challenged in recent years as ECB interest rates sat at rock bottom.
Banks try to strike a balance between the amount of interest that they take in on money that they have lent to borrowers and that which they have to pay out in interest to depositors.
From 2014 up until the middle of last year, excess deposits were essentially costing the banks as they had to pay the ECB to park their money in Frankfurt.
As the era of negative interest rates showed no sign of ending, some banks started to pass that cost on to their wealthier depositors, as well as large corporate deposits.
But all of that has changed since July with the ECB hiking rates by three percentage points – with more to come – bringing the deposit rate to 2.5% today.
Savers are not getting anything like that return with rates ranging from close to zero to 1% at best. There are some limited offers of over 1% if a lump sum is locked away for a few years.
However, the banks are crammed with deposits, and have been since the Covid-19 pandemic super-charged a habit that Irish people were already very adept at.
The banks, it appears, do not need to entice people to put money on deposit with them and, until they do, they will likely hold off on offering any inducements.
Plus, deposits are flooding in from customers who are moving from the exiting banks, making interest a bountiful source of income for the remaining banks in the market in the years ahead.
Pressure will likely mount from consumer groups and the political arena, but the banks will hold off on rewarding savers for as long as they can.
This is the other side of the rates equation and the yield that the banks have been generating on their deposits has meant that they haven’t had to pass the full extent of rate increases onto their mortgage customers.
Unlike their European banking counterparts, which appeared to have moved quite swiftly in response to rate hikes, the main pillar banks here have been raising their fixed rate offerings gradually.
AIB raised its variable rates after the ECB last hiked rates in early February, but apart from that, variable rates have stayed static in the other banks – albeit at fairly elevated levels relative to the now-defunct zero rate environment.
Tracker rate mortgage holders automatically get the full brunt of every rate increase – that’s the nature of the product – prompting a debate about whether some should look at locking into a fixed rate for a period.
Mortgage rates surged in January, according to Central Bank figures published this week, bringing the average interest rate being charged on new mortgage arrangements here to its highest in three years.
However, having had among the highest mortgage interest rates in Europe prior to the current rate hiking cycle, we now have the third lowest after France and Malta.
It indicates that, even with two lenders departing, the remaining banks are keen to remain somewhat competitive on the mortgage front – while shoring up their margins from deposits and other sources of income.
But make no mistake, borrowing money is getting more expensive and lenders are increasingly pulling longer-term fixed products – which had only made a meaningful appearance in recent years – from the market.
Irish borrowers on the whole have tended to lock into short term fixed rate arrangements that expire in three or five years.
They – as well as their variable rate counterparts – are heading into a vastly changed and more expensive rates regime for the foreseeable future.
Profits and dividends
Together with an outlook for an economy that’s weathering very well in the context of a war on the continent and a cost of living crisis, the new rates environment has prompted a revision of banks’ prospects for the year ahead.
Having reported a near 20% increase in profit after tax for 2022, AIB chief executive Colin Hunt told analysts on Wednesday that the bank expected to “materially exceed” its own profitability target this year.
Bank of Ireland – which grew net interest income by 12% last year – expects to match that performance this year.
And Permanent TSB, which reported a pre-tax profit of €267 million following a loss in 2021, expects interest income to grow further as a result of higher rates but also the acquisition of portfolios from departing Ulster Bank.
Both AIB and Bank of Ireland announced substantial share buybacks and shareholder dividends last week.
And the banks have been given leeway to reward staff with bonuses of up to €20,000.
It all amounts to quite a dramatic turnaround in the fortune of banks in the past year, prompting an upgrade to the outlook among analysts.
“Irish banks no longer trade at the value end of European banks,” Davy Financial Analysts Diarmaid Sheridan and Antonio Duarte commented in a recent note.
“In our view, progression of earnings and returns still looks undervalued.”
They added that the fee income boost that will arise from the continued transfer of portfolios and custom from Ulster Bank and KBC to the other banks may have been underestimated.
“We do not believe this is fully appreciated and while it might not be initially as meaningful as loan book acquisitions, it will provide good opportunities to fuel further franchise growth in the coming years,” they speculated.
However, that is not to say that the banking landscape is without its challenges.
Having clawed back substantial provisions set aside for possible bad loans arising from the pandemic – which on the whole never materialised to any great extent – the banks are being prudent again, setting aside cash to deal with potential defaults arising from higher mortgage costs and the cost-of-living squeeze.
AIB made a very large provision for potential bad loans during the pandemic and was still writing some of that back in the first half of last year.
A new provision of €316 million was made in the second half of the year, which the bank’s CEO was said was precautionary.
“That wasn’t driven by an actual credit experience. It was driven by our expectation of the evolution of the economy. It takes into account higher inflation and the impact of higher interest rates on the economy,” Colin Hunt told RTÉ News this week.
Bank of Ireland, having released €194 million of mainly Covid-related provisions in 2021, booked an impairment charge of €187 million last year – also a precautionary move.
One area of particular vulnerability that may be emerging for the banking sector, however, is in the commercial property sector.
Both AIB and Bank of Ireland expect values in this corner of real estate to fall this year but believe any re-evaluation will be manageable.
“I think that a valuation challenge may well be ahead for the sector, but I don’t expect material impairments on foot of it,” AIB’s Mr Hunt said.
His counterpart at Bank of Ireland, Myles O’Grady, described the commercial real estate sector as “an area of some concern” for the system.
The commentary followed a report in the Business Post this week that Ireland’s largest life insurer, Irish Life, had introduced a six-month notice period for withdrawal requests from a property fund, citing an increase in the level of customer withdrawals.
It’s a somewhat concerning development for an industry that is getting back on its feet after a very challenging decade and a half.
The move by US regulators to take over Silicon Valley Bank on Friday, prompting a sudden drop in share prices for US and European banks as concerns grew around the health of their bond portfolios, demonstrates how quickly the mood around banking can change.
For personal banking customers, the biggest challenge in the years ahead will be the rising interest rate environment, which a very significant cohort of borrowers will have had no past experience of.
According to figures from mortgage broker, Doddl, about €12 billion of mortgages here will roll off fixed rates in the coming years into a higher rate environment.
In some cases, a typical borrower with a €250,000 mortgage will end up paying an additional €6,000 a year in interest, it calculates.
Although the banks conduct stress tests on borrowers’ ability to contend with higher rates, for some it will really squeeze finances that are already under pressure from higher costs.
That may contribute to a surge in borrowers getting into difficulty with their repayments.
What’s more, the landscape is likely to be less competitive with fewer banks to chose from after the exit of KBC and Ulster Bank from the market.
Some of the so-called non-bank lenders – which drove quite a bit of healthy competition in lending in recent years – have effectively been priced out of the market as they are dependent on the money markets to fund their activities and money is prohibitively expensive to source right now.
On the lending front, that leaves essentially the three pillar banks and Avant, backed by the Spanish lender, Bankinter, and credited with driving much of the competition in the market in recent years.
The credit union movement – which has the scope to lend and is keen to – has about 1% of the market.
From a day to day banking perspective, the recent move by fintech company Revolut to roll out Irish Ibans to customers in the Republic is one that the banks will no doubt be watching closely.
It claims to have around 2 million customers here who use the app mainly to transfer money.
Given that it now offers a fairly comprehensive online banking service, many users could be tempted to cut out the ‘main street’ banks and conduct their entire banking operations online with the likes of Revolut, N26 or Bunq.
The banks will be hoping that customers will show the level of inertia that they traditionally have and will stay put – or even move to them, as they have in great numbers in recent months.
Notwithstanding that potential digital threat – which is more longer term – the immediate outlook for the banks here is very favourable. After several challenging years, they will be hoping to make the most of it.
However, the Ukraine war continues, inflation is still putting finances under pressure, and recession – although unlikely in the immediate future – is not completely out of the question.
The climate around banking could change very suddenly.