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No green shoots of growth in sight yet for Irish corporates Back  
A deterioration in the quality of loan books has led to the business reconstruction units of banks getting busier writes Jim Ruane.
The six years to the end of 2001 were among the best corporate banks and corporates alike experienced for some considerable time. However, 2002 did not continue in that vein and the domestic environment for Irish corporate bankers is less positive than might have been anticipated 12 months ago. This is mainly because companies today are investing significantly less in fixed assets and working capital than they were.

Irish fortunes are intertwined with those of the major world economies. A year ago there was a general belief that the international economic slowdown would begin to revert to higher growth rates within approximately 12 months. Now, with the 12-month period already gone, the general view is the upturn is still probably nine to 15 months away, notwithstanding the recent 1/2 per cent cut in interest rates by the ECB.

Reflecting this slowdown, there has been a deterioration in the overall quality of loan books. There is an increased incidence of breaches of covenants, for example on agreed net worth requirements or debt/EBITDA ratios. This is triggering renegotiations of debt agreements and consequent re-rating and re-pricing of loans. Not surprisingly, the business reconstruction units of banks are getting busier.

Corporate bankers today use highly sophisticated loan grading tools and many loans have seen a lowering of their ratings over the past 12 months. From a banker’s perspective, this has required higher general provisions against bad debts and in the marketplace there has been a widening of spreads. It is also now universally accepted that both lower quality and longer-term loans will attract appropriate interest premiums.

Inward investment has also been sluggish compared to recent years. The flows are smaller and largely confined to expansion of existing plants. Furthermore, such investments are typically self-financed by cash rich companies.

On the liability side of the balance sheet, there has also been a reduction in funds, with a large number of US companies choosing to repatriate cash in the wake of September 11. This is no surprise, as traditionally the centre takes an increasing control over the periphery in times of uncertainty. Also, the fact that the euro is now well bedded down has made it easier for European companies to improve their cash management by centralising control.

Within Ireland we are beginning to see a shift in the types of business being serviced. There is growing interest in the whole environmental area - ranging from waste disposal to wind energy projects - and continued strong interest in leveraged and management buyouts (MBOs).

Property remains firmly in favour too. The residential development market for our house-builders remains strong; especially the first time buyer market and completions this year are anticipated to be a record 55,000 units.
The key factors sustaining house prices are demographics, interest rate stability and low unemployment.

Demographics, particularly in the Dublin area, will ensure that demand will continue to exceed supply for the near term at least. Ireland’s membership of the single currency has heralded a period of low interest rates, by historical Irish standards, and this is forecast to continue. Similarly, unemployment remains below 5 per cent, the economically accepted figure for full employment, fluctuating between 4.2 per cent and 4.4 per cent. Pay is expected to rise by 7 per cent in 2002, improving affordability and thereby helping to sustain the housing market. However, with improved investor activity leading to increased supply, the residential rental market has softened in the past six months.

There has been a significant softening in the suburban office market and falling rents and rising vacancy rates are now becoming a feature of the city centre. While opportunities still exist in the north and south docklands area, the potential here is highly dependent on investor reaction to the stamp duty increases in the recent Budget. These increases may well accelerate the trend already evident of investors looking to other Eurozone countries, particularly France and Holland, for commercial opportunities.

It is also worth noting that many borrowers, especially property investors and those undertaking MBOs, are looking to the future and locking in at current interest rates for five years and even longer. Indeed, interest rate hedging in general has become an increasingly sought after service.

Unfortunately, the anticipated surge in public infrastructural projects through the much-discussed Public Private Partnership (PPP) route has singularly failed to deliver. The lack of impetus behind such initiatives, at a time when state funding is much tighter and therefore the need for PPPs is at its greatest, is most regrettable. This is in marked contrast to the development of PPPs in other countries, such as the UK, Spain and Portugal.

It is also apparent that, following a surge in overseas investment in recent years by a number of Irish companies, there has been a slowdown in such investment over the past 12 months. This is partly a timing issue, with companies now bedding down earlier investments, but it also possibly reflects a deliberate policy of seeking to keep balance sheets in order in anticipation of more ‘rainy days ‘ ahead. The Enron type accounting scandals of the past 12 to 18 months have played their part, too, in making boards and investors more wary.

The logical quest for business growth in larger overseas markets is not confined to manufacturing companies. Irish corporate bankers, including Bank of Ireland, have recognised the opportunity to expand abroad through leveraging off their people, skill bases and ever-increasing reputations.

At BOI Corporate Banking, for example, we realised that we needed a presence on the ground in key markets to make the most of benefits afforded by operating out of the IFSC. Over the past three years we have opened offices in London and the U.S., hiring local people as well as transferring highly skilled and specialised professional Irish bankers to these offices.

Supported by credit assessment, strategy, finance and loan administration teams in Dublin, these specialists have nurtured niche markets and built reputations in such areas as project finance, cross-border structures, leveraged finance and investment grade blue chip lending. We are moving up the value chain in the process, earning enhanced returns over straightforward ‘participation lending’. Increased overseas activity has played an enormous part in the average 30 per cent a year growth in profits achieved by BOI Corporate Banking over the past five years. We believe that 2003 will be a challenging year and we see no signs of any green shoots of recovery as yet. This will inevitably make life difficult for corporates. Many have only survived so far on the back of cash cushions built up over the better times. The longer the downturn lasts, the more likely it is that these cushions will be absorbed by trading losses. There is also strong evidence that others are only managing to keep their heads above water because interest rates are at historic lows. So it is reasonable to expect that, just as the good times of the past few years hid many of the weaknesses of poorly managed companies, the present climate will expose those weaknesses as never before.

Furthermore, the effective closure of the equity market to fund-raising will inevitably put increased pressure on businesses. From a banker’s perspective that will also mean a further downgrading of the loan book and potentially bigger provisions. The important thing for a banker, after all, is never to be caught taking a banker’s margin for an equity risk.

Over the next 12 months, therefore, the old adage that ‘anyone can manage in good times’ will be put to the test and inevitably some managers will have difficulty. This is particularly true at a time when the demands for good corporate governance - presenting honest accounts in a transparent way - have never been greater.
Against what must sound to be a fairly pessimistic note, it is only fair to acknowledge that there are some positive influences. One of these is the onward march of electronic banking, which is resulting in much better cash management by corporates. At BOI Corporate Banking the number of customers adopting electronic banking has more than doubled over the past two years and e-banking is now used by around 85 per cent of our customers. These multi-banked customers, furthermore, expect their electronic banking service provider to give them full access to all their accounts and to make provisions for payments of all kinds. The result is enhanced treasury management and increased efficiency for both customers and the banks.

Basel II, a new international approach to regulatory capital for banks, is not due to be implemented until 2007, but detailed discussions now taking place on the detail are of considerable importance.

Using economic capital criteria, Basel II will look at measurement of risk based on true experience and levels of security provided, but will also capture off balance sheet activities and make provision for operational risks. Fundamentally, therefore, Basel II has the potential to significantly reduce the capital requirements of many banks, freeing up capital for productive investment and lending. December 2002 was a particularly significant month because it involved individual banks making final submissions.

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