The Department of Finance never intended to become a bank shareholder. Twelve years later, it’s still trying to get rid of its bank shares. 

The department doesn’t want the shares first and foremost because it doesn’t want to be in the banking business. State-managed banks have a poor track record. The Department’s view is that banks should be banks. 

Besides, EU state aid rules prohibit governments from propping up domestic companies. The government’s ownership of the banks falls under those rules. So the government is legally obliged to sell off its bank shares.

Why not just sell the shares, then? Well, selling off the state’s remaining €5.2 billion worth of shares is proving tricky. There are a couple of constraints. 

The first one is politics. It’s bad politics for the government to sell the shares for less than the amount it has already invested. It just sounds bad. 

If the government were to get €28.9 billion back of its €29 billion investment, it would be labelled a bailout. But if the government was to get €29.1 billion, it would be called a successful investment. People would say the banks “repaid every penny”. 

The investing books would say this is a silly way to think about things. What’s done is done. The €29 billion is gone, and there’s no getting it back. The only decision now is whether the state would be better off having the shares or having the money. 

For years, the Department of Finance said it was confident it could recoup the full €29 billion. But in the briefing presented to the Finance Minister this time last year, the Department conceded that, given the banks’ share prices, recouping the full amount was looking “increasingly unlikely” within five years. 

So politics gets in the way somewhat. What else is stopping the Department from just dumping the shares? 

A big one is that the banks, and the system, needs to be strong enough to stand on their own two feet. Each of the individual banks should be able to raise capital, if needed, from the private investors. So if the bank needs funding, or if something goes wrong, the bank should have the ability to tap private investors for support instead of relying on the government.

This is the key point, really. If private investors would be willing to capitalise the banks, then bank shares will be trading at a decent price, and the government should be satisfied that it’s getting value for money on the transaction. 

Yesterday the Department announced it was planning to sell an undisclosed amount of Bank of Ireland shares. The targeted amount is undisclosed so the government can get the best possible price for the shares. Though Paschal Donohoe has said the government still intends to own some shares in the bank at the end of the process. The plan is to sell 15 per cent of the total volume of traded shares every day for the duration of the trading plan.

Why now?

The government owns stakes in AIB, Bank of Ireland and PTSB, but the three are not the same. The government owns only 14 per cent of Bank of Ireland, where it owns 72 per cent of AIB and 75 per cent of PTSB. 

The government invested €4.7 billion in Bank of Ireland between 2009 and 2011. It has since gotten back €6.0 billion in share sales, dividends and fees. So its investment in Bank of Ireland is already in the black, unlike its investments in AIB and PTSB. This makes the politics simpler. 

Bank of Ireland is Ireland’s strongest bank (not saying much!). It trades at around 50 per cent of its book value. What this means is, if you were to buy all the shares, then strip the bank down and sell it for parts (ignoring transaction costs) you’d double your money. (Though this scenario would not be allowed to happen.) By comparison, AIB trades at 44 per cent of book value, and PTSB trades at 26 per cent of book value. 

It doesn’t sound great, and it isn’t. But it’s normal-ish for European banks. European banks are in really bad shape. The Dow Jones Euro Stoxx index of the 25 biggest European banks is close to its all-time lows. Given that the index is 29 years old, that’s quite something.

Why are European banks struggling? The basic business of banks is to borrow short term (deposits) and lend long term (mortgages and business loans). This is profitable because money can be borrowed from depositors at a lower interest rate than it can be lent to mortgage borrowers.

This model has stopped working in the eurozone. Long term rates are nailed to the floor. This makes it very hard for banks to profit from money lending. In other places like the US and UK, long term rates are higher, and banks are more profitable. But not in Europe. 

It’s bad for Irish banks in particular because Irish banks are pure money lenders. The average European bank makes 49 per cent of its profits from stuff other than money lending, where in Ireland the number is closer to 20 per cent. This makes Irish banks super sensitive to moves in interest rates. 

As the chart shows, Bank of Ireland had a disastrous start to 2020, and then started to rally towards the end of the year. At the start of the year the ECB cut interest rates aggressively, and as we've seen Bank of Ireland was particularly vulnerable to this. Since October, long term bond yields in the Eurozone have started to rise, and Bank of Ireland has benefited.

The following chart shows how interest rates have changed in the last year. The pink line shows the yield curve on European AAA bonds in September of 2020, just before the rise in Bank of Ireland's share price. The Blue line shows the yield curve today. As you can see, long term rates have risen. That's good news for European banks' profitability and great news for Irish banks profitability, dependent as they are on money lending.

The other distinctive thing about Bank of Ireland in 2020 is that it was unusually pessimistic about the impact of Covid. As I wrote yesterday

"When Covid-19 hit last year, the banks had to come up with an estimate of how many of their loans would be turned sour. Clearly, this was a difficult job. Bank of Ireland has €134 billion worth of loans. This time last year, it was very difficult to work out how Covid-19 was going to pan out, how long it would take, what the effects on the economy would be, what the effect on bankruptcy would be. 

"Among the big banks, the average write-downs about 0.6 per cent of risk-weighted assets. The Irish banks, by contrast, decided Covid-19 would result in a lot of bankruptcies. AIB wrote down 2.4 per cent of the value of its loan book, and Bank of Ireland wrote down 1.9 per cent. I wrote about it at the time: Either the Irish banks are being extraordinarily cautious, or a wave of defaults is coming. One year on, it's looking like the Irish banks were just being extraordinarily cautious, and a wave of defaults is not coming."

Bank of Ireland's share price started to turn in October and November of 2020. Around then, Central Bank data first began to hint Irish banks weren't about to be submerged by Covid-19 related bankruptcies. Since then, Bank of Ireland has closed a lot of the gap with the European banks. 

In the last eight months, the stars have aligned for Bank of Ireland. Rates are rising, and last year's worst-case scenarios haven't come to pass. The Department of Finance didn't need to be asked twice and is taking its chance to sell down.