Why are banks leaving Ireland?

Ulster Bank are going and now KBC too?

Yes, that's right. Together, they had a share in excess of 20% of the Irish mortgage market but now both are leaving. Ulster Bank leaving had been on the cards for a long time. However, KBC's departure has come as more of a surprise for many people. Their leaving is a loss and reduces choice for buyers and switchers.

What happens to mortgages and loans they originated?

Ulster Bank's €20billion loan book looks to be going to AIB and Permanent TSB. Meanwhile KBC have been in discussions with Bank of Ireland about its €9billion performing loan book. KBC will be looking to sell its €1.4billion non-performing loan book elsewhere.

But I keep reading that Irish mortgage rates are the highest in Europe. Banks are making a load of money here. Why would they leave?

Yes, it is true that Irish mortgage rates are the second highest in the Eurozone. At the time of writing, the wighted average interest rate on new mortgages is 2.78%. This compares to the Eurozone average of 1.27%.

And why does this extra margin not keep the banks here ?

There have been a few reasons cited for the banks struggling. Extra regulation, negative interest rates and the costs of digital transformation weigh heavily on all banks. But what is it specifically in Ireland that is driving banks away? It is true that the process around repossessing property is much more difficult in Ireland than in many other countries. However, this has always been the case.

In fact, the reasons why banks are leaving is given by a recent report commissioned by BPFI to be higher capital charges incurred with granting mortgage loans in Ireland.

How do the capital charges work?

In general, a bank is required to hold capital against mortgage loans that it grants to customers. Of course, the main business of a bank that is traditionally understood by people is that of receiving money from depositors and taking this money and lending it on as mortgage loans. The margin between the two rates forms the profitability of the bank. But the banks needs to hold some money in case these mortgage loans go sour. It cannot pledge depositor's money so the bank has to pledge its own capital. This capital is generally expensive for banks and they need to borrow it on the capital markets. However, the bank needs a buffer of capital to prevent it from being overwhelmed in case the loans go sour.

And who decides how much capital the banks hold?

That is an excellent question ! The basic principle on how much capital to hold is a simple one. The riskier the loan, the more capital needs to be held. When a loan is granted to a large company or a sovereign that has a credit rating from Moody's, Standard & Poor's or Fitch, the rules on how much capital to hold can be very specific. However, how much capital needs to be set aside on a mortgage loan to Mr and Mrs O'Brien for a three-bedroom semi in Skerries, where 15% of a deposit is put down? For these questions, banks have some discretion in how much capital they put down. Banks develop their own "internal models" for these purposes.

Hmmmmmm, internal models.

Yes, the problem with internal models is that there will always be pressure to set aside a little bit less capital to make the lending profits look a little better. However, this creates a problem of banks being undercapitalised when loans go sour. And of course the great financial crisis showed us how unprepared banks were for the collapse of their loan books.

Who is policing these internal models?

The ultimate regulator for European banks is the ECB. The ECB has long been concerned about banks internal models. Starting in 2016, they started a Targeted Review of Internal Models (TRIM). This was done in conjunction with the national regulators - for Ireland, the Central Bank of Ireland. This involved site-visits and an in-house examination of the internal models.

I feel like we are getting to a punchline here.

Yes. One of the big inputs into the internal models is the probability of loss on a loan. For a mortgage loan, one of the loss drivers is a drop in property values such that the property value falls below the size of the mortgage loan - negative equity. This leaves the bank exposed. To assess the probability of the property value falling to such an extent, one of the key inputs to the internal models is a history of prices. And this is where Ireland is getting punished. Because we have seen such a dramatic property collapse in the recent past, the probability of it happening again is seen as higher in these internal models. This means higher capital and less profitability for the banks. It also means higher mortgage rates for consumers.

The BPFI report found, as an example, that capital requirements for Irish banks are three times higher than in Austria or Belgium on a loan with similar LTV (loan size to property value) and actually better LTI (loan size to income of mortgage applicants) metrics.

What does it mean ?

Anyone who has been through the mortgage origination process now versus how it was before the crisis knows that the difference is night and day. The Central Bank limits on lending (3.5 times income etc ...) feed into this too. So there is an argument to say that consumers are being doubly punished now.

The lending criteria is conservative so consumers cannot afford the properties they would have been able to afford in the past. However, the conservative lending is not reflected in lower mortgage rates. Actually, the opposite is true. Consumers are now paying the mortgage rates that reflect a bank lending into the wild west of Ireland's property market that existed fifteen years ago. And now it means less lenders for consumers to choose from. Something is not right here.

Have you any good news for me?

As always the market adapts to changes. Whilst the capital charges are a headwind for banks, there is an advantage to non-bank lenders. The set of mortgage lenders in Ireland has changed markedly over the last years. Lenders like Dilosk, Finance Ireland and Avant have entered the market. Whilst these onerous capital charges continue, expect this trend to continue. Speak to us at AM Financial - we have access to all the lenders in the broker space.