As Brian Lenihan's end-of-quarter deadline for bank recapitalisations draws nearer, the negative share-price trend for both AIB and Bank of Ireland is raising questions about the feasibility of either bank mounting a successful rights issue.

As recently as early October, both banks were enjoying the benefits of a global rally in equities which pushed shares to a one-year high as institutional investors anticipated a cash call on the back of Nama. But prices have only tumbled since then as those investors became disillusioned both with continued uncertainty over the future of the Irish banks and the increasing possibility of massive dilution.

Now with the market values of both banks half of what they were just three months ago, market sources are beginning to express pessimism that rights issues can succeed by the means at hand under the circumstances as they are.

"The greater the multiple of market cap the rights issue is, the harder it is to do. The number of shares you need to issue is larger, leading to dilutions," said Oliver Gilvarry, head of research at Dolmen Stockbrokers. Converting the state's preference shares would cause a bigger dilution, he said, leaving investors with less ownership of the company and a greater state stake.

Delay in rights issues

Lloyds ran into this problem late last year when it tried to raise capital to avoid participation in the British government's asset-protection scheme, which would have led to majority state-ownership for the bank. Lloyds originally intended a massive £25bn (€28.7bn) rights issue, but had to scale back its ambitions to £13.5bn since its market value at the time was just £24bn – the initial price and volume was simply overwhelming. Ultimately, the bank raised the remaining capital through a debt swap and by issuing so-called 'contingent convertible notes' – of CoCos – which would absorb losses in a stress scenario.

What worries analysts about AIB and Bank of Ireland is the amount of required capital relative to their market value. At the end of last week, Bank of Ireland was worth €1.4bn while AIB was worth just over €1.1bn. Both those figures are dwarfed by the amount of capital each must raise to cope with the discount Nama will apply to transferred assets, as well as ongoing losses on loans that will stay on the banks' balance sheets. According to Merrion Stockbrokers, AIB will need €4.4bn in new capital – or twice its market cap – while Bank of Ireland will take another €2.8bn to get into the comfort zone demanded by the market. And Merrion's estimates come in at the low end of the range: earlier in the month AIB adviser Morgan Stanley said the two banks would need at least €9bn between them.

But back in September and October 2009, when institutional investors were anticipating rights issues by the Irish banks as Nama made its way through the Dáil, both AIB and Bank of Ireland boasted market caps of more than €3bn each. A rights issue then would have meant far less dilution than is now likely, as share prices have fallen by more than 50% in the interim.

Delays in announcing rights issues together with the required scale of any new equity-raising contributed to Standard & Poor's decision last week to downgrade the Irish banking system as a whole. The ratings agency paid special attention to AIB, which it kept on negative watch, saying it might not be able to execute a recapitalisation to an adequate level in a reasonable timeframe.

"The negative outlook [on AIB] reflects our view that the quantum and timing of equity raised through recapitalisation may not be sufficient to support an 'A-' rating, combined with our expectation of significant losses from the remaining loan book and weak operating income as a result of the challenging economic environment," said Curtin.

With so much other uncertainty still surrounding the Irish banks – Nama discounts, expected level of state ownership, sector consolidation – the system-wide downgrade and negative statements on individual banks by S&P could not have come at a worse time. Several market sources share S&P's concerns about impairments and capital. A failure to source fresh capital from private sources will ultimately force the government to step in with further support on top of the €3.5bn per bank it has already committed in preference shares.

Negative sentiment

Analysts in London told the Sunday Tribune that the Irish banks could struggle to generate interest among big investors because of their small size and continued negative sentiment towards the Irish economy. It will not help either that Bill Gross, who runs the world's biggest mutual fund at Pacific Investment Management (Pimco), said last week that Ireland was part of a "ring of fire" of over-indebted economies that investors should avoid.

Enterprise minister Mary Coughlan last week reiterated the government's wish for private capital to precede state investment, as the government wants to top up the banks rather than lead another full-scale rescue. But institutional investors have begun signalling that they want the government to jump first by converting some or all of its 25% preference share stake in each bank into ordinary shares. The institutions want to see a "direction" of eventual state ownership before committing money of their own, since it is widely expected AIB and Bank of Ireland could at least be part-nationalised.

With prices continuing to fall following the worst week on global stockmarkets in 10 months, with massive pressure on banking shares amid regulatory uncertainty, the size of any theoretical state shareholding is growing. With plenty of other bank rights issues to satisfy investor appetite, institutions might simply choose to stay away from the Irish banks rather than risk dilution or being stuck as minority shareholders in a semi-state company.

"There is a false optimism around the Irish market. Anybody who thinks the crisis is over is deluded," said Paul Somerville, head of private clients at online financial trading company Delta Index. "The flood of rights issues has been extraordinary and the Irish banks could be left high and dry. A rights issue is likely to fail when the time comes."