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Irish bank ratings hold up well in an international context Back  
Irish banks financial profiles compare well with their European and US counterparts, writes Michelle Brennan of Standard & Poor's, although the sector still faces strategic challenges, such as the role of overseas activity, increasing competition and the fear that the rapid rise in credit growth may lead to future financial system problems.
The ratings on the Irish domestic banks compare well with the Top 50 largest banks in Europe, and with the larger U.S. regional banks. Profitability is good on an international basis, although the banks are unlikely to maintain the very high rates of profit growth seen in recent years. Since the mid-1990s, banking sector profitability has been boosted by the buoyant economic backdrop (real GNP grew by an average of 6.5 per cent per year from 1993 to 2002), low bad debt charges, changes in the demographic profile, and operational improvements within the banks. The domestic banking system continues to be characterized by a relatively high level of concentration and ownership stability, even after some control changes. Competition is tightening, however.

The key challenges for the system arise from the small size of the economy (which pushes some banks to seek growth opportunities in other markets), the lower interest margin environment (which encourages a greater focus on productivity), and the transition of the economy back to more sustainable growth rates. Current ratings would absorb a decline in asset quality from the current very strong levels, but a sharp fall in economic performance could cause debt affordability problems given the increased leverage of segments of the household sector.

Domestic asset quality has held up well during the last three years, despite the extreme openness of the economy. This reflects the relative resilience and flexibility of the Irish economy. Although some industries were affected by links with the weaker U.S. corporate environment, public sector expenditure has helped underpin employment levels. Consumer spending has also remained quite high, although moderating, as household incomes have continued to grow. Consumers have taken comfort from continuing low interest rates, and the wealth effect of high property values.

Bad debt charges remain very low for the banks, with most recent problems linked to overseas lending rather than domestic exposures, but Standard & Poor’s remains cautious regarding the potential threats to future asset quality if there are income shocks to parts of the population. The domestic corporate lending portfolios are also relatively highly skewed towards commercial property, which can exhibit volatility.

Domestic credit has grown rapidly in recent years, even allowing for the underlying economic and income growth, and for positive demographic changes. Residential mortgage lending is still growing by about 24 per cent year-on-year. Rapid credit growth, especially when accompanied by high asset price inflation, can be a leading indicator of future financial system problems. For this reason, Standard & Poor’s continues to include Ireland on its list of countries exhibiting potential signs of future financial system stress. Mitigating factors include the structural improvements in the economy over recent years, interest rates that are lower and less volatile than in the pre-EMU period, and the protection afforded by the good profits, loan loss reserves, and satisfactory capital levels of the rated banks.

The creditworthiness of the ‘offshore’ banks, resident in Dublin’s International Financial Services Centre (IFSC), is determined by their parents’ strength rather than trends in the domestic Irish market.

Lending growth still rapid
The increased volume of mortgage borrowing has been the key driver of higher private sector borrowing, which now exceeds the EU average as a percentage of GDP. As a percentage of GDP, domestic credit to the private sector and corporates rose to 110 per cent in 2002, from 89 per cent in 1999. It is estimated to reach 122 per cent of GDP in 2003. Rapid increases in debt are always a cause for caution, although Standard & Poor’s notes the structural changes in the economy, and the increases in average household income. Many households now have more than one salaried income, as female labor force participation rates have caught up with EU levels. To some extent, the increase in debt is a sign of the convergence or ‘catch-up’ of the Irish economy with other OECD economies. The fast pace of change is still a reason for watchfulness, however, as it can give rise to imbalances in the economy. The orderly deceleration in economic growth and house prices that was seen in 2001 was encouraging, but house prices have since rebounded. Some of the recent property price increases do not appear to be underpinned by economic fundamentals, and sit uneasily alongside the slower pace of growth in the economy.

Implications for debt affordability
Increases in private-sector borrowing have been offset partly by higher disposable income, and are supported by demographic trends, but some segments of the private sector are anticipating a continuation of fast income growth when deciding to take out debt. Aggregate household debt affordability measures remain satisfactory but would be affected by an increase in interest rates, even if interest rates do not reach the high levels prevalent before EMU. There is also significant dispersion within the aggregate household position. Many households have benefited materially from higher incomes and the increase in house prices over the last decade, and either no longer have mortgage debt outstanding or else have mortgages that are low relative to income levels.

More recent borrowers have much heavier debt burdens. Recent simulations by the Central Bank of Ireland, using national household budget data, suggest that a modest rise in interest rates would result in a significant share of newly mortgaged households with substantial repayment burdens.

Standard & Poor’s believes that other disposable income shocks could have a similar effect. Standard & Poor’s therefore expects that a less buoyant economic environment will lead to a pick-up in household bad debts from the current extremely low levels but believes that these will be concentrated in segments of borrowers, and that the overall effect should be manageable given the balance sheet strength, and profitability, of the banks.

The domestic banks’ current ratings factor in a slowdown in the level of economic activity, and could absorb an increase in domestic bad debt charges from their very low levels today. The banks remain exposed in the event that there is a sharper economic slowdown and a hard downward correction in house prices but Standard & Poor’s central expectation is that the economy will show a relatively ‘soft landing’.

Solid industry structure but some challenges
The relatively stable industry structure provides a solid base for the Irish financial services groups. Challenges for the banks include:
• An upturn in competitive pressures;
• The continued need for investment in systems, distribution channels, and innovative products;
• Successful implementation of measures to improve productivity, without damaging customer franchises; and
• Careful management of diversification strategies.

Bank profitability still compares well internationally, but competition and low interest rates are pressuring margins. As a result of their international expansion, Irish banks are exposed to the economic and competitive conditions in other countries, notably the U.K., the U.S., and Poland. The deceleration in the economic environment in Ireland has some positive effects on the banks, however, by reducing the recent pressure on funding and other resources. Many institutions are also taking actions to improve their operating efficiencies, thus better positioning themselves for less benign economic conditions. Intensifying demands for shareholder value may push banks to reduce core capital bases, however, a factor that may constrain ratings.

The Irish banks that have negative outlooks assigned to their ratings have so because of pressures facing their parents (except for Irish Life & Permanent PLC (IL&P: A+Negative/A-1) where the negative outlook reflects the challenging market equity environment for life companies such as its subsidiary Irish Life Assurance PLC (Irish Life: A+Negative/—)). The positive outlook on Allied Irish Banks PLC (AIB: A/Positive/A-1) reflects the actions that the bank is taking to recover from the impacts of the fraud that hit its Allfirst subsidiary in 2002.

Competition likely to strengthen
The results of the Irish Competition Authority’s study of competition in the provision of certain banking services will not be known for some time. Any policy response cannot be predicted, but the study is likely to heighten customer awareness of alternative product providers, and of differing terms and conditions. This will reinforce the competitive pressures in the market, as may the increased emphasis given to consumer awareness and competition by the new regulator, the Irish Financial Services Regulatory Authority (IFSRA).

The strategic quandary of overseas expansion
The issue of diversification remains a major challenge for the Irish banks. Although the Irish banking market exhibits attractive profitability, it is likely to grow more slowly in the future, and is of small absolute size. (The Irish economy is less than one-third the size of The Netherlands’ economy.)

Several of the banks have looked overseas to find additional growth opportunities, with variable success. It is difficult to transfer competitive advantage to overseas operations, and they can be a source of additional risk rather than true risk diversification. The dilemma is that it is often difficult to achieve high quality earnings from overseas activity but expansion into other markets could still help reduce concentration risk.

Role of IFSRA
The integration of a wide range of supervisory activities is an operational challenge for IFSRA, but its system-wide oversight should over time lead to a stronger supervisory environment.
Unified supervision could lower the risks of regulatory arbitrage and contagion. IFSRA is paying close attention to international developments in the field of effective supervision, as it looks to bed down its operational model. Standard & Poor’s believes that work in the financial stability area is strengthening. Co-operation between the macro- and micro-prudential activities has deepened.

This article is an extract from Standard & Poor’s 2003 ‘Bank Industry Risk Analysis: Ireland’. For a copy of the full article, please contact the author: michelle_brennan@standardandpoors.com or Hayley Dawson on (44) 20-7847-7230: hayley_dawson@standardandpoors.com

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