AIB and Bank of Ireland’s trading updates this week weren’t as dramatic as their half-year results. 

Half-year results were all about Covid. In their half-year results, both banks said Covid had significantly hit the value of their loan book. Bank of Ireland wrote down its loans by €937 million and AIB by €1.2 billion.

The banks took a lot of the pain upfront at the half-year. So this week’s results are less about Covid than about the coming years.

The third-quarter results didn’t look too bad on the surface. Each bank had a pickup in activity, each bank has tonnes of surplus capital. One is cutting costs boldly, another is making noises about cost cuts before the end of the year.

So why then do Irish banks continue to lag way behind European stocks and European banks? 

There are two ways of thinking about it. I don’t know which is right. Both are plausible. Both might be right.

Option A

One way of looking it is to focus on how much money the banks make on loans. Money lending is, after all, their main business. 

Banks make more money when interest rates are high – aka when the yield curve is steep. This means they can borrow at low-interest rates and lend at high interest rates. A simple and effective business model. 

As the following chart shows, interest rates have fallen in the last ten years. And the pandemic has pushed down interest rates further. This goes some way to explaining why eurozone banks in general are having a bad 2020. The pandemic is pushing down interest rates, which shrinks their profits from money lending.

By this view, the reason Irish banks have done particularly poorly is that they make more of their money money-lending than other eurozone banks. That makes them more highly exposed to interest rates than the rest (I wrote about this over the summer). 

Option B

The interest rate story is simple and straightforward. But is it true? As John Authers pointed out during the week, the relationship between bank stocks and interest rates isn’t what it once was. Bank stocks seem to move only loosely in relation to interest rates. 

If low-interest rates aren’t to blame for bank stocks’ performance, then what? Authers says the market might be more worried about dodgy loan books than falling profits from money lending. 

When companies can’t repay their loans, the banks have to write down the value of the loans, which drags down their profits.

The following chart shows the change in bank stock prices versus the change in high yield credit spreads. High yield credit is a proxy for banks’ asset quality because it’s made up of risky loans to companies. If high yield credit spreads are going up, the market thinks its more likely some companies are going to go bust. If risky companies go bust, banks’ loanbooks will need to be written down. And according to credit benchmark, a consultancy, there’s been a sharp rise in concern over corporate solvency in the last six months. 

Change in high yield spreads (light pink) versus the S&P 500 banks index (dark pink)

How does the dodgy loan book theory of bank shares apply to AIB and Bank of Ireland? Well, they took massive write-downs in their half-year results:

In their trading updates this week, AIB and Bank of Ireland didn’t signal much by way of write-downs beyond what they had already signalled. Bank of Ireland said it had no “material increase in loan losses since June 2020.” AIB announced another €100 million, on top of the €1.2 billion already announced. 

The Irish banks’ approach to write-downs is notably different from the rest of Europe. The whole of the eurozone banking system was permitted to offer a consequence-free six month payments holiday to borrowers. More than €360 billion of loans have been subject to payments breaks across the system. 

But where the Irish banks went ahead and wrote down a good chunk of those loans, as the chart above shows, other banks have decided to play for time. UniCredit, which is Italy’s biggest bank, has said it’ll wait until next year before deciding what to write down. Lloyds said in the next few months it’ll “get a clearer picture of the underlying situation”. 

So the Irish banks are outliers. Either their loanbook is unusually messy, or they’re unusually up-front and cautious about writedowns. 

The latter looks more likely to me. Irish banks’ risk models are much more sensitive than those in Europe, a consequence of Ireland’s horrific 2008-12 period. Which in turn led to aggressive write downs in the second quarter. If that theory is correct, Irish and European banks’ writedowns should converge over the next year.

So the pandemic is hurting banks in two ways. It lowers interest rates, which lowers the amount of money banks can make lending money to their sound borrowers. And it puts some borrowers out of business, which means the banks have to write down the value of their loans. 

The only lever to pull

As AIB CEO Colin Hunt said in August, the banks are singularly focused on growing their return on tangible equity, which is a variant of return on equity. “It’s our north star”, he said.

To boost return on tangible equity, the banks, of course, want higher interest rates and fewer delinquent loans. What else boosts RoTE?

There are three other things that can help: costs, capital requirements and loan volumes. Two are largely outside the banks’ control: capital requirements aren’t going anywhere and loan volumes are a function of the overall economy. 

That leaves costs. Bank of Ireland has decided this is the right time to dramatically cut costs. In its trading update it announced 1,700 jobs are to be cut, which it says is equivalent to 14 per cent of total staff costs. Operating costs — which don’t yet include the job cuts — are four per cent lower this year than last. 

AIB by comparison saw no change in operating costs this year, though it did flag a change to the “future shape of the business” before the end of the year. That sounds like cost cuts. 

Another problem for eurozone banks is the ECB is asking them to freeze dividends until January. The ECB wants as much capital in the system as possible, until Covid settles down.  Irish banks should benefit more than most from the end of the dividend freeze. They’re abundantly well capitalised this time around. A shortage of capital is one problem they do not have.