The high capital levels of the Irish banks has been praised by commentators, politicians and academics when considering the impact of COVID-19 on the Irish banking sector. It provides stability and reassurance and indicates that what happened in the last financial crisis will not be repeated. However capital requirements that are too high can have negative implications. These have been highlighted in a recent Banking & Payments Federation Ireland (BPFI) report and by Ulster Bank’s decision to exit the Irish market.
The BPFI report is based on data gathered from the five main Irish banks, the European Central Bank and the European Banking Authority. The research underlying the report covered 12 million data points across 613,000 mortgage accounts worth €83 billion.
The report was commissioned to:
Understand the factors behind higher average capital requirements, ie the amount of capital that banks need to hold against each loan to deal with unexpected loss, and
Compare average capital requirements across different countries in the EU
The report revealed that risk weighting asset (RWA) density on mortgage loans in Ireland is significantly higher than the average for comparable European countries. Different risk weighting is applied to assets based on their risk profile. The RWA shows how a bank’s assets are adjusted for risks associated with its assets.
According to the report, Irish mortgage RWA was 37% on a pro forma basis at the end of 2019. This is in contrast to the European average of circa 13.3%. This means that Irish banks have to hold more capital than other EU countries in case of unexpected losses. The report calculates this as being a circa €2.5 billion additional equity requirement on the €83 billion of Irish mortgages in the surveyed pool. It has been reported elsewhere that Ulster Bank's RWA for all loans is currently approximately 28% - that is more than double the EU average and is significantly higher than its UK shareholder NatWest’s RWA. It is estimated that because of this, Ulster Bank has approximately €2 billion of excess capital tied up in its Irish operations.
The BPFI analysis considered the implications of good and bad mortgages. The good loan book was classified as mortgages that never had a credit impaired status. The bad loan book was classified as mortgages that were impaired at the time of the survey or previously. This highlighted that even the best performing mortgages in Ireland have a significantly higher RWA density than good performing loans in other parts of Europe. It also demonstrated that even a low proportion of bad mortgages has a serious detrimental effect on a bank’s overall RWA density and the disposal of bad mortgages is more effective for a bank’s overall capital requirements than repairing loans. This has also driven the continued stream of NPL sales, notwithstanding adverse political and media commentary.
The impact of using historical data from crisis years when calculating future unexpected losses for Irish mortgages and issues with loan enforcement in Ireland are both listed as drivers of the differential between Ireland and other European countries’ RWA density. Interestingly, the report revealed that Irish banks on average will receive 11% recovery of outstanding liability when engaged in a court process in respect of a defaulted residential mortgage loan. This is the second lowest recovery rate in Europe and is considerably less than the EU average of 46%. It contrasts starkly with Luxembourg and the Netherlands where 90% recovery is obtained.
The BPFI report and Ulster Bank’s exit from the Irish market demonstrate the challenges faced by the Irish banking sector. NatWest cited not being able to generate long term sustainable returns as the main reason for exiting the Irish market and at the Joint Committee on Finance, Public Expenditure and Reform, and Taoiseach on 23 February 2021, representatives from Ulster Bank referred to the BPFI report and noted that the higher than average RWAs in Ireland impacts on shareholders’ returns.
Appropriate capital requirements and RWA density levels are vital to ensure the resilience of the Irish banking sector but there are challenges if the levels are too high and these challenges can have a massive impact on customers and lending activity as:
Irish banks need more capital to underwrite mortgages which results in higher costs of mortgages
Increased capital requirements reduces lending activity: in a paper published by the European Systemic Risk Board it was found that a 1% increase in capital requirements reduces lending by up to 8%
Banks are forced to consider if it is sustainable to operate in the Irish market, and
The lack of competition in the market distorts prices and reduces product variety.
At the 23 February 2021 Joint Committee meeting referred to above, it was suggested that the Central Bank of Ireland and European Central Bank should be asked to prepare a report on Irish banks’ capital difficulties. It was also stated that a wider discussion is required regarding the structural problems faced by the Irish banking sector. Further engagement on this topic should be welcomed by Irish banks, businesses and consumers.