AIB was meant to have been thoroughly scrubbed and disinfected prior to its return to public markets in December 2017.

In the run up to the flotation it cut 3,000 jobs and reduced bad loans from €29 billion to €8.6 billion. A fresh start. 

But AIB is stuck with its past. In the 2019 results, released on Friday, after tax profit was down two thirds to €364 million. Much of the drop is explained by a combined €582 million worth of provisions for dealing with the tracker mortgage fallout. The Central Bank confirmed the scale of the tracker problem two months after AIB’s flotation, and it has dogged the bank ever since. It has hit AIB harder than its big rival, Bank of Ireland. 

The tracker scandal isn’t AIB’s only legacy problem. Like Bank of Ireland, it’s labouring under stringent ECB rules which limit the amount of profit shareholders can make from each loan. The ECB rules stem from losses by the Irish banks from 2009-2013.

Between the tracker scandal and the backward-looking ECB rules, AIB is stuck. The flotation has not been a clean break.

AIB shares were down 3.8 per cent on Friday and down 66 per cent since it floated at the very end of 2017. In that time, Bank of Ireland is down 55 per cent and the Eurostoxx Banks Index, which is made up of the biggest European banks, is down 50 per cent. 

AIB, like the rest of the banking industry in Europe, is in a bad place.

The way to judge banks’ profitability is return on equity (RoE). For a bank to survive in the long run, its RoE needs to be above roughly 10 per cent. AIB’s RoE for 2019 was 3.4 per cent. Stripping out exceptional costs related to the tracker scandal, RoE was 7.2 per cent. This compares to 6.8 per cent for Bank of Ireland or 6.1 per cent for European banks in 2018. 

AIB, like the rest of the banking industry in Europe, is in a bad place. The government still owns 71 per cent of it, €3.6 billion worth. So we’re all in it together.

1,500 jobs to go

As with Bank of Ireland, four big factors determine AIB’s RoE: costs, prevailing interest rates, capital rules, and the demand for loans in the economy. To those four, AIB must add the tracker mortgage liability.

Last year, the tracker scandal cost AIB €582 million – in the context of a €364 million after-tax profit. It has to pay restitution costs of €416 million, €78 million in fines, €48 million in termination benefits and €40 million losses from disposal of loan portfolios. CEO Colin Hunt is hoping this is the end of it: “Ideally we’d like to close this chapter of the bank’s history in 2020”.

Of the important factors above, only one of them — costs — are directly within AIB’s control. As we’ve seen, before the flotation AIB worked hard to cut its costs. It shed 3,000 jobs. That got its cost to income ratio (operating expenses divided by operating income, which is made up of things like interest income and fees) down to 53 per cent in 2018.

In the 2019 costs crept up (as income fell), so that the 2019 cost to income ratio rose to 56 per cent. AIB today announced a plan to cut five per cent of its workforce, or 1,500 people, over the next three years to get costs back under control. 

AIB CEO Colin Hunt says the bank shed 500 jobs in the second half of 2019 through natural attrition and voluntary redundancies; he intends to keep that up for a further three years, losing 500 workers per year. On the type of jobs to go, he says about half will go from areas in the bank which are dealing with legacy issues. The ultimate goal is to get headcount below 9,000.

The bank is also to freeze pension payments to more than 4,000 former employees. In its annual report, it said its decision was based on “the group’s financial circumstances and ability to pay, the views of the trustees, the group’s commercial interests and any competing obligations to the state”.

Though costs rose last year, AIB’s 56 per cent cost to income ratio nonetheless compares well with Bank of Ireland (63 per cent), and with the eurozone average (66 per cent). The ECB is pressuring eurozone banks to get their cost to income in line with US and Nordic banks, which are around 55-57 per cent. 

Interest rates – how high is too high?

Costs are within AIB’s control. Interest rates are not. Interest rates are set by the market, under the influence of the ECB. 

Net interest margin is a key number for a bank. It shows the difference between what it pays for loans on the market and what it can charge for them. 

AIB’s net interest margin shrunk slightly from 2.47 per cent in 2018 to 2.37 per cent in 2019. This is better than Bank of Ireland’s (2.14 per cent) and much better than the eurozone average (1.44 per cent). Though it’s still much less than American banks make (3.4 per cent). 

From the perspective of the Irish borrower, interest rates in Ireland are too high. When you take cash back offers and charges into account, the average interest rate on mortgages is 3 per cent in Ireland compared to 2.1 per cent in Europe. I calculated earlier this week that an Irish borrower pays three times more interest over the course of a loan on a normal mortgage than a German one. 

Why are rates higher here? The banks claim it’s about capital requirements, which are higher in Ireland. That accounts for about half of the difference. The other half of it looks to come from a lack of competition in the Irish market.

AIB is a big beneficiary of all that. But nonetheless, it doesn’t necessarily mean customers are being gouged. The European banks are deathly sick. So they’re not the best comparator. At a net interest margin of 1.44 per cent they can’t write loans profitably. Better to compare AIB’s net interest margins to the healthy and competitive US banks. And interest rates on mortgages are lower here than they are in the US.

Trapped capital

If AIB’s net interest margins are relatively healthy, and its costs are low, why is it struggling? Why is its return on equity stuck at 7.2 per cent (excluding exceptionals)?

This is where capital requirements come in. I wrote at length about how capital requirements weigh the Irish banks down earlier this week. So I won’t get into it here. But suffice to say ECB rules, intended to de-risk the banking system, have made it much harder for Irish banks to make money. 

CFO Donal Galvin didn’t hold out much hope risk weightings would be reduced in the next three years.

The ECB’s capital requirements are meant to reflect the riskiness of the various banks’ balance sheets. But the Irish banks have cleaned up their balance sheets quite a lot without any reward from the ECB. AIB reduced non performing loans from 9.6 per cent in 2018 to 5.4 per cent last year. Colin Hunt said of non performing loans today, “the bulk of the lift is behind us. We’re in shouting distance of the long term level that’s sustainable to us and to our customers.”

CFO Donal Galvin didn’t hold out much hope risk weightings would be reduced in the next three years. He said other European banks, under review from the ECB, have not tended to have their risk weightings reduced.

For now, stuck with it

AIB is targeting eight per cent RoE over the next three years. Remember, its RoE right now is 3.4 per cent, or 7.2 per cent excluding exceptionals. 

I asked Donal Galvin how AIB was going to get to 8 per cent, given falling interest rates and the generally miserable landscape for European banks. His plan is to get costs low, as we’ve seen, and to keep steadily growing the loan book by single digits every year. The company is hoping the long-awaited residential construction boom drives more borrowing. 

The government owns 71 per cent of AIB, €3.6 billion worth. It has a tricky job on its hands. It’s not easy to sell down a 71 per cent stake in a multi billion euro bank. Even if there are buyers out there interested, the government has to sell its stake down slowly in order not to disrupt the market. 

The bigger problem is that, right now, buyers aren’t interested. AIB trades at 0.4 times book value — ie the net value of its assets.

When a company is trading at less than 1 times book value, it means one of two things. The first is that the market thinks the assets aren’t worth what AIB is saying. This is unlikely, given how much work has been put into clearing up AIB’s balance sheet, and the strength of the Irish economy. 

The second possibility much more likely: the market thinks AIB is earning a negative return on its assets. We know AIB’s RoE is below its cost of equity, ie the minimum threshold needed by investors. So the price to book ratio is saying AIB is not worth the book price of its net assets, since it’s earning such a tiny return on them.

AIB needs to grow RoE in a tough environment for banks. It’s in a tight corner, but no tighter than any other European bank.

This is not just an AIB problem, by the way. It’s a Bank of Ireland and PTSB and European banking problem. Investors have no appetite for bank stocks because the returns on offer are so low. 

There’s not much for the government to do. It can only sit on its hands and wait for RoEs to pick up, which will lift the price to book ratio and the stock price.

Until then AIB is proposing an ordinary dividend of 8¢ per share, sharply down from 17¢ last year. That will be worth €217 million to the exchequer.

For ordinary investors, the same calculation applies. AIB needs to grow RoE in a tough environment for banks. It’s in a tight corner, but no tighter than any other European bank. And for now, it at least offers a forward yield of 4.3 per cent.