Will KBC and Ulster Bank’s exits allow remaining Irish lenders to rebuild?

When the European Commission ordered Belgian financial giant KBC Group in late 2009 to sell a number of businesses and shrink its balance sheet as penance for a taxpayer bailout, it was agreed that offloading its Irish and central and eastern European units would be a step too far.

"It could be damaging to financial stability in these [central and eastern European] countries and lending to the real economy if KBC was required to further reduce its presence in the region," the Commission said in documents released months after the decision. "The same is true for KBC's presence in Ireland. "

It was clear at the time that the Republic was in the midst of what would become Europe's worst banking crash. It would see the Government commit €64 billion to save six domestic lenders – albeit temporarily in the case of Anglo Irish Bank and Irish Nationwide Building Society – and a slew of overseas players, including Bank of Scotland, Danske Bank and Rabobank, quit the market.

More than a decade later, KBC has had enough of trying to make a go of the Irish market, and is in talks to sell its almost €9 billion of Irish performing loans and €5 billion deposit book to Bank of Ireland. It came eight weeks after London-based NatWest confirmed what had been an open secret for months: that it was winding down its Ulster Bank unit in the Republic.

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"In a seismic shift, literally in a matter of weeks, we are now down to just three 'main' banks and a host of smaller non-bank players," said Eamonn Hughes, an analyst with Goodbody Stockbrokers. "KBC's quick exit, in hindsight, looks like it always had one eye on the door, but it just never knew how to do it, so Bank of Ireland's approach probably provided the answer to something that it couldn't execute on its own."

The fear among consumer advocates is that consolidation of the banking market, with Permanent TSB (PTSB) and AIB in talks to acquire much of Ulster Bank's €20 billion loan book, will see reduced competition among mainstream banks leading to higher interest rates and other charges.

The departures highlight how difficult it is to generate sustainable profits in a market where banks are required to hold much higher levels of expensive capital against loans than European peers. But the move by the three remaining banks to mop up most of the loans of the exiting lenders will help them rebuild scale after years of muted loan demand – boosting their chances of delivering acceptable returns for investors and ultimately opening an avenue for the Government to sell down its stakes in the three.

And, unlike during the height of the financial crisis, when overseas banks were retreating at haste and domestic lenders didn't have the capital or funding to support the economy, the system currently has too much idle money at a time when lenders are being charged negative rates by the European Central Bank for accepting excess deposits.

Meanwhile, a number of non-bank lenders, like Finance Ireland and Dilosk, say they are ready to play a greater role in the mortgage market as fintechs such as Revolut and N26 are encroaching on the traditional mainstream banking space for everyday payments.

"As banks exit it leaves a void which is being filled by innovators with agile operations because they are the ones who can rapidly fill a niche," said Karl Deeter, founder of OnlineApplication.io, an online mortgage and insurance fintech that's working with most of the biggest home loan brokers and lenders here.

Mr Deeter said that, hot on the heels of Avant Money, owned by Spain's Bankinter, entering Irish mortgages last year with the lowest rate in the market, he is in talks with two other players, ultimately backed by pension fund money, looking to access the Republic through the low-cost broker channel.

“The good news is that things are being replaced by companies that will make lots of services easier, faster, and better for everybody,” he said.

Problem loans

On the face of it, KBC Bank Ireland, with a "digital-first" banking model and only a dozen branches, is the kind of new-age lender that should thrive in the changing landscape – if the legacy of the financial crisis weren't holding it back. More than a decade after the crash, 14 per cent of its loans remain impaired, more than double the market average, albeit driven by KBC using more stringent rules for categorising problem loans than rivals.

Still, KBC Bank Ireland makes the kind of profit returns for its parent that others would kill for. The lender generates a 9 per cent return on its parent's equity investment (RoE) in a normal year, according to Cor Kluis, an analyst with ABN Amro-Oddo BHF in Amsterdam.

By contrast, Bank of Ireland had a RoE of 6.6 per cent in 2019 and had been a ratio of 10 per cent in the long term prior to the Covid-19 pandemic. It will be revisiting its goals later this year. Meanwhile, AIB conceded late last year that it would take a year longer to reach its “North Star” target of achieving a ratio of more than 8 per cent, to 2023. Ulster Bank’s returns stood at 2.3 per cent in 2019, compared to 9.4 per cent for the wider NatWest group.

KBC Group typically generates one of the highest RoEs in Europe, at between 15 and 16 per cent, making the Irish unit an outlier, when the wider sector is grappling with an income squeeze from lower-for-longer interest rates, weak loan demand, and the economic fallout from Covid-19.

Low Irish returns are being driven by the perceived riskiness of Irish mortgages, which requires banks to set aside three times as much expensive capital against a typical home loan compared to the European average, according to analysts. Indeed, Kluis noted that the risk-weighing on KBC Bank Ireland’s loans rose “quite materially” from 58.8 per cent of total loans to 71.1 per cent during the fourth quarter of last year. The higher the weighing, the more capital that needs to be held.

“And this for a mostly residential mortgage book, which is quite a surprising RWA [risk-weighted assets] which is required by the regulator,” he said, concluding that the plan to exit the Irish market was a “rational decision”.

Billy Kane, chief executive of Finance Ireland, a non-bank lender that entered the mortgage market in 2019, said: "There's already very little appetite for any large European or international bank to come into the market, because we're a small economy. But the capital demands here are making things worse."

Meanwhile, despite having a minuscule branch network, and relatively small workforce of about 1,300 employees – compared to about 2,400 in both PTSB and Ulster Bank – KBC Bank Ireland’s running costs were more than 80 per cent of income. The holy grail for retail banks is to have a ratio of 50 per cent.

“What was probably the final straw for KBC was that before Ulster Bank’s exit, it had a 12.6 per cent mortgage market share, neck and neck with Ulster Bank on circa 13 per cent and not too far behind Permanent TSB on 16 per cent. But with Ulster Bank’s exit, its gap with PTSB would widen,” said Hughes.

Strategic review

Founded in 1973 as Irish Intercontinental Bank (IIB) by Paddy Mc Evoy, a Jesuit-educated Dubliner who had previously worked for Bank of Ireland, the company was taken over by KBC five years later. When the property bubble burst in 2008, it accounted for about one in 10 Irish mortgages being drawn down in the market. The bank ultimately needed a €1.4 billion bailout from its parent as mortgage defaults spiralled.

The Belgians carried out a strategic review into the Irish operation in 2016 and early 2017, concluding that it should remain in a recovering economy.

However, sources said that KBC Group CEO Johan Thijs would later privately express regret over the decision.

They said that comments by Thijs on an analysts call in late 2019 where he rounded on the Central Bank of Ireland over its continued focus on the tracker mortgage scandal – the public fallout from which would force him to issue a grovelling apology – were more about the regulator’s general approach, rather than the ultimate cost of the tracker investigation.

The Central Bank fined KBC Bank Ireland €18.3 million last September for its role in the scandal, concluding that the lender devised a strategy to move borrowers off cheap loans and “persistently” resisted as regulators pushed it to admit its failings.

On the margins, the board of KBC Group in Brussels would have been reminded of how Irish mortgage lending can be construed as unsecured lending when, in late 2018, its Dublin headquarters and two branches were subject to arson attacks after it moved to repossess a farm in Co Roscommon, almost a decade after it took proceedings to try and recover money that was owed.

“Nobody wants to see people losing their homes. But there has to be a balance between a secured and an unsecured loan,” said Kane. “When we go out raising funding for residential mortgages, we’re always asked how long it takes to get hold of a house if a borrower stops paying. The answer is: how long is a piece of string.”

While non-bank lenders don’t have to hold capital against loans like banks, the risks inherent in Irish mortgages means that they have to pay higher rates for funding raised in the mortgage-backed bond market than in most other European countries, he said.

A senior Irish banking executive said: “KBC didn’t join the original rush out of the market after the crash. They take a very considered approach to everything. You can be sure that the decision to leave must have been very compelling.”

Approach

Bank of Ireland, led by CEO Francesca McDonagh, made an approach to KBC in February on a potential deal, after learning late last year that the Belgians were reviewing their ongoing presence in Ireland, according to sources.

Kluis estimates KBC Group will be able to extract about €1 billion of capital trapped in the Republic through the sale of its loans and deposits. Combined with the €410 million of dividends that KBC Bank Ireland has returned to Brussels since 2017, it would see the parent recouping the unit’s entire €1.4 billion crisis-era rescue bill.

Keefe Bruyette & Woods (KBW) banking analyst Daragh Quinn has raised his earnings forecasts for AIB and Bank of Ireland as they prepare to take on parts of the departing banks' loan books. He now sees the increased scale of the banks pushing their profits towards their RoE targets. This could go some way towards Irish bank shares, trading at a little over half the estimated value of their assets, narrowing the discount at which they are trading, relative to European peers – and providing an opportunity for the Government to sell down its equity stakes.

Quinn is holding off raising his projections for a potentially more transformational deal between PTSB and Ulster Bank – which will likely require PTSB to raise additional capital – given that these talks have yet to deliver an outline for a potential transaction.

Crucially, according to Hughes, the capacity of the banking system to lend has not changed as a result of the decisions of Ulster Bank and KBC to quit the market.

“In aggregate, Ulster Bank and KBC had €30 billion of loans but excess deposits at AIB, Bank of Ireland and PTSB are €41 billion, so these three banks have ample liquidity to support the market,” he said. “Indeed, historically, the retail banking model worked to a loan-to-deposit ratio of 110-115 per cent [compared to 82 per cent at the end of 2020], so the existing players in our view have capacity nearer €60 billion–€70 billion to lend, which is two times the loans of the departing banks.”