By the end of 2009 Ulster Bank and Bank of Scotland Ireland (BoSI), the two biggest foreign banks operating in Ireland, had received capital injections from their UK parents of more than €6bn to cope with mounting loan losses in the Irish market.
It is useful to keep Ulster and BoSI in mind when considering how much money AIB and Bank of Ireland will ultimately need to deal with their own capital deficits. The two big domestic banks have a combined €264bn in outstanding loans, nearly three times that of their British-owned competitors, according to the most recent figures from 2009. Yet AIB and Bank of Ireland have been recapitalised by only €7bn so far – less than 2.7% of total loans and just slightly more in absolute terms than their much-smaller peers.
By contrast, Ulster and BoSI have taken capital support equal to 6.5% of their combined loan books of €92bn, indicating a very high level of bad debts. Despite being the smaller of the two, BoSI needed comparatively more support than Ulster, taking a cumulative €3.45bn from its owner, Lloyds, up to the end of last year. That equates to more than 10% of its loans. Ulster had received €2.6bn, or 4.3%, from RBS, which is majority-owned by the UK government.
RBS and Lloyds have been putting capital into their Irish subsidiaries as the need arises. It is likely that still more capital will be helicoptered in as mortgage delinquencies, SME failures and property developer defaults continue to rise.
Are the domestic banks so much better off? A number of factors would suggest that they are not. In fact, if AIB and Bank of Ireland had been recapitalised at the same rate as Ulster and BoSI, the bill so far would amount to €17bn. On a crude read-across basis, the two major Irish banks should need at least €10bn in fresh capital.
Banking analysts both in Dublin and abroad have been pencilling in fairly large estimates for the banks' post-Nama capital needs since last summer. In August, JP Morgan put AIB and Bank of Ireland among the four European banks most exposed to the need for fresh capital, estimating AIB would need €6.8bn while Bank of Ireland would have to raise €4.7bn. Locally, Merrion Stockbrokers has been the most bearish, predicting AIB will have a post-Nama capital requirement of €4.4bn and Bank of Ireland €2.8bn to bring them up to the 8% core capital ratio that is becoming the de-facto norm for commercial banks. US investment bank Morgan Stanley, an adviser to AIB, said earlier this month the two would need €9bn between them.
None of these estimates, however, take into account a key issue lurking in the background: the proposed reforms coming out of the Basel committee on banking supervision at the Bank of International Settlements in Switzerland – the agenda-setting bank for central banks. If accepted and implemented by national regulators, these so-called Basel III reforms would seriously tighten the rules for how banks calculate core capital, throwing current estimates into doubt. For example, deferred tax assets, unrealised losses, minority interests and pension-fund liabilities might all be deducted in whole or in part from core capital, meaning banks would need a lot more shareholders' equity than before.
According to analysis by Swiss bank UBS, which looked at the most recent accounts, Bank of Ireland would take a €2.7bn hit while AIB would lose €2.4bn if each had to remove pension liabilities and deferred tax from their capital calculations. Both banks would then have a mountain to climb to build up enough capital to achieve a cushion acceptable to the markets.
On the bright side, the asset picture for AIB and Bank of Ireland is not really as bad as it is for Ulster and BoSI. BoSI, especially, chased business during the bubble as it sought to grab share in a competitive market and therefore has a far less seasoned mortgage book than either of the big two. Both Ulster and BoSI were deeply involved in lending to developers too, but neither (so far) has the benefit of Nama.
At the very least Nama, through the magic of long-term economic value, will put a cap on the development loan losses of the participating institutions.
Of course, because they will not be part of Nama, the foreign-owned banks have less of an incentive to drip-feed their losses. Their losses, though significant, are not big enough to sink their giant parent banks in the UK. AIB and Bank of Ireland, by contrast, have every reason to hold back on booking losses until Nama clarifies the landscape. If capital is going to be a bigger issue for the big two than has so far been estimated, what are the options for raising it?
Asset disposals are the obvious first step, as the banks have signalled. AIB is really the only candidate here, as it owns a 23% stake in profitable US regional bank M&T (see panel) and a majority of Polish bank BZWBK. The combined capital value of these two holdings has risen by €840m to more than €2bn in the last few months as result of the global rally in equities, according to Davy estimates.
Converting debt to equity is another viable option, one which both banks used last summer to raise about €1bn in loss-absorbing capital each. Bank of Ireland is considering another debt buyback to raise €500m, according to reports last week.
The final two ports of call are, of course, rights issues to shareholders and the government. Market sources have suggested the banks are preparing to announce rights issues by March – just after the Nama transfers start – to comply with Brian Lenihan's wish to sort out the capital concerns at the banks before the end of the first quarter.
But investor appetite may be lacking, especially considering other European banks have been mopping up demand since September. If AIB and Bank of Ireland sustain their current share prices, there might be just enough headroom for the deep discounts they will need for a successful cash call.
Yet with the possibility of the government having to convert preference shares into ordinary shares to compensate for stopped coupon payments (at the behest of the EU), dilution is a concern for investors. Everybody wants to avoid majority state ownership, but it certainly cannot be ruled out at the levels of capital needed.
running on M&T
AIB will almost certainly have to sell its 24% stake in M&T, the New York-headquartered US regional lender, to help bolster its capital reserves and satisfy EU competition demands.
But that pill got a bit harder to swallow last Wednesday when M&T surprised markets by posting a better-than-expected fourth-quarter profit of $137m – a 21% increase on last year – as write-offs and credit impairments fell.
This improvement in profitability coincided with a steady rise in the bank's share prices in recent months as part of the 25% stock market rally in the US, which has substantially improved the value of AIB's stake in the bank.
All of which must put AIB managing director Colm Doherty in two minds: on the one hand, disposing of M&T quickly will yield a vital once-off capital improvement for the group; on the other hand, losing M&T's contribution to AIB's bottom line is a blow to the group's long-term profitability.