Economists define sunk costs as a cost that has already been incurred and cannot be recovered. When thinking about the Irish government’s shareholdings in the pillar banks, it may be useful to start think about the initial outlays as sunk costs. In my view, there is little chance that the government will recover its initial investment in the banking system.

The collapse in net interest margins and the prospect of an extended period of financial repression mean that banks will find it exceptionally difficult to make profits over the medium term. Consequently, it is timely to begin a discussion about whether and how the government should sell its shareholding in the pillar banks.

The effects of the Covid-19 pandemic will be felt for a long time. The pandemic has led to huge increases in government debt, large interest rate reductions from central banks and the resumption of quantitative easing policies, which reduce bond yields. Even before the pandemic, ECB President Christine Lagarde implored governments to issue more debt and raise spending on infrastructure projects. Lagarde’s implicit message was that the ECB would keep interest rates at incredibly low levels across the yield curve, meaning that governments would be able to borrow money at low levels for a long period of time.

The pandemic’s effects with respect to government debt are notable in the sense that governments have been forced to borrow way more than they expected. Interest rates on government debt have collapsed, meaning that governments can issue debt cheaply, but the corollary of this is that owners of bonds will face significant declines in interest payments for at least the next ten years, if not longer. Traditional owners of bonds are of course banks, and retail banks in particular. Treasurers of all retail banks have a problem in that a large part of their net interest margins (NIM) have collapsed. This is not due to bond coupons alone. Because the ECB’s refinancing rate is now 0%, it means that loan rates have also steadily compressed. The ECB’s lending surveys have noted a compression in loan rates for the SME sector in recent years. This is not a bad thing, in the sense that it should raise overall levels of economic output, but it does make banks less profitable.

Regulation has also played a serious role in reducing profitability in the banking sector. A number of large European banks no longer offer personal loans, because the combination of heavy regulation costs and low interest rates mean that it is not worth their while to engage in this business. So, if you need 10k for a new kitchen or a car loan, you can’t go to traditional lenders. Of course, this has led to a reduction in revenues, which has clear consequences for profitability.

Retail banks then have the issue of deposit rate charges. In the good old days, banks took deposits and paid maybe 3 per cent to depositors, then made loans at say 6 per cent, and pocketed the difference (this was known as the 363 model – borrow at 3, lend at 6 and be on the golf course at 3!). In a sense, deposits were a great revenue generating asset for banks (though they are classified as a liability in an accounting sense). However, because the ECB now has a negative deposit rate of -0.5%, it means that banks are charged for any deposits that they leave with the ECB. This is a really significant issue, because negative deposit rate charges fundamentally change the way that banks think about deposits. For example, banks now have to pay an annual levy which is determined by the size of their balance sheet at the end of the year – meaning that banks are now keen to reduce deposits. The irony is that because interest rates are so low, some depositors are now over-saving to compensate for lost interest income. Where does this over saving go? It goes into savings accounts. Irish banks are now sitting on over €110 billion of deposits, meaning that deposit rate charges alone cost Irish banks literally hundreds of millions of euro each year.

Readers will counter with the fact that Irish mortgage rates are way higher than other eurozone jurisdictions, which indeed they are. However, one must also note that Irish banks face significant difficulties in terms of gaining security on assets when loans go sour. A case in point is to look at non-performing mortgages at Irish banks, which remain at incredibly elevated levels, more than ten years after the 2008/9 financial crisis. Around ten thousand homes have been repossessed during this period, which is a small number relative to the number of outstanding non-performing mortgages. If banks cannot retain security on loans then this has to be compensated for with higher loan rates. So, although there is a lack of competition in the Irish mortgage market, it is not the only factor keeping loan rates at elevated levels.

To make a long story short, the huge compression in net interest margins has led to a massive reduction in banking profitability. Banks have started to pass on these costs to their customers, especially corporate customers, but for the moment most retail depositors have been spared.  Even if the ECB does away with deposit rate charges, loan rates are unlikely to rise anytime soon. Lagarde and co. have implicitly told investors to expect a long and drawn out period of financial repression, so why should investors own the primary means of implementing that same financial repression?

It is instructive to listen to the Bank of Japan in this context. For nearly two decades, the BoJ was worried that inflation was too low, and it tried all manner of monetary policy innovations- QE, yield curve control, negative deposit rates etc. Listening to the BoJ these days the concern is less about inflation but more and more about financial stability, meaning that it is concerned about the profitability and stability of the domestic banking system. That is clearly the road we are headed on.

Bank stakes and low hanging fruit

The other issue for the government is that there is an increasing level of competition from abroad, but this is focussed on areas of low hanging fruit. Online currency exchanges have reduced the profitability of the pillar banks and new entrants to the banking sector will not face the legacy costs that the pillar banks do. Additionally, with the rise of online cost-free trading venues, one has to wonder why one of the pillar banks would even consider buying one of the large Irish stockbrokers. The outlook here is hardly stellar. Little by little, fintech ventures will try and take market share from the pillar banks. You don’t need to be a genius to figure out where this is going. Retail banks will become less profitable over time and will be left with large legacy costs. Why would you want to own them?

The government currently owns around 14% of Bank of Ireland and it owns around 75% of AIB. Each bank has a market cap of 3.3bn and 4.8bn respectively, meaning the value of the government holdings is in the region of 4.1bn. This leaves out the PTSB shareholding, but you get the picture. Assuming the government was able to sell these stakes for around 4.1 bn (on a good day), this would illustrate a large loss compared to the initial cost to the tax payer, but it might make more sense to do this sooner rather than later.

Alternative histories and counterfactuals

Imagine the government had sold its shareholdings at any point over the last 5 years and invested the proceeds in a standard S&P tracker fund. The chart below shows the kind of returns that would have been made, rather than holding on in the increasingly vain hope that bank shareholdings will come good. The opportunity cost of maintaining the state’s investments in the pillar banks is clearly enormous.

A different way of looking at this issue would be to consider the counterfactual. Would the government buy stakes in the pillar banks today, if it did not already own them? The answer is a resounding no. They are not sufficiently profitable and there are surely better investments to be had.  I t makes sense to at least begin the conversation about whether it makes sense to sell down the state’s holdings in the banking sector and where to redeploy that capital. Putting money into a blended approach focussing on growth and value stocks (excluding banks) looks a reasonable bet to my mind. At a minimum, it cannot be a worse investment than leaving money invested in Irish bank shares.

Timing

Coming into 2021, markets are likely to be in an ebullient mood. The combination of pent-up consumer demand, monetary and fiscal stimulus and economic recovery will underpin risky assets. Assumptions about banks’ provisions for bad loans are likely to be revised lower, with the result that bank share prices seem cheap, and therefore they may rally somewhat. The government should use this window of opportunity to begin offloading its shareholdings in the pillar banks. This will have to be done slowly, over time and allowing for certain periods when it cannot sell due to black out periods ahead of quarterly results, but it will have to be done sooner or later.