To understand Bank of Ireland’s 2021 results, released yesterday, it makes sense to go back to August of 2020. 

August of 2020 was Bank of Ireland’s first set of interim results since the onset of Covid. It’s easily forgotten what a stressful and uncertain time it was for financial markets. Investors were seriously weighing up the chance of a financial meltdown. Banks were trying to figure out how what percentage of their outstanding loans would ever be repaid.

Bank and AIB took a super aggressive approach. In August, they wrote down 1.9 and 2.4 per cent of their loan books, respectively. That put them way out of line with the rest of the European and world banking industry. In other words, they judged that more of their loans were going to go bad as a result of the pandemic than other banks. Later that year, each bank wrote down the value of even more loans. The following chart shows the extent of the write-downs in 2020.

Why did the Irish banks write down so aggressively? One theory is that their hands were tied by the models they use internally to model risk. Those models are strongly informed by the previous crash. Another is that they wanted to get the losses out of the way as soon as possible, so they could focus on their main priority of returning capital to investors. 

18 months later, we can understand the 2020 write-downs a bit better. In 2020, Bank of Ireland wrote down €1.1 billion worth of assets. Then, halfway through 2021, it wrote back €163 million (ie, it reconsidered its earlier write down). And in yesterday’s results, it wrote back a further €194 million. 

The other big news from yesterday’s results was Bank of Ireland announcing a plan to return capital to shareholders. The bank plans to return €104 million – €54 million as a cash dividend and €50 million as a buy back. For the long-suffering shareholders of Bank of Ireland, this day was a long time coming. It will be Bank of Ireland’s third dividend since 2008, and its first since 2018.

John Cronin of Goodbody called it a “landmark moment”. The 2020 write-down makes more sense now. Especially in concert with the government’s decision to divest shares in 2021, which opened the political space to return cash to investors. 

In its most important metric, Bank of Ireland is strong

Because banks have such huge balance sheets, they’re not judged simply by their earnings. They’re judged instead by their earnings as a percentage of the amount of capital tied up to generate those profits. The number in question is return on tangible equity (RoTE). RoTE is the key number for assessing the health of a bank. 

As the following chart shows, Bank of Ireland boosted its RoTE a lot in 2021. The number took a dive in 2020 as a result of the write-downs, then more than recovered in 2021. I’ve taken the liberty of calculating an alternative RoTE without the write back in 2021, to give a sense of Bank of Ireland’s sustainable RoTE going forward from here.

Regardless of whether you use 12.7 per cent or 10.2 per cent, Bank of Ireland's RoTE compares well. The average for European regional banks in 2021 was 6.2 per cent, according to data from Prof Aswath Damodaran.

Relentless cost-cutting

How did Bank of Ireland boost the RoTE ratio? RoTE is earnings over tangible equity. One of the most important things it has done to improve earnings is to cut costs. Between 2017 and 2021, the company has cut costs by €254 million per year. This it has done by cutting headcount through redundancy programmes, and by closing branches. 

The cost to income ratio is another important metric for banks. It separates out the costs that go into running a bank, like staff and overheads, from other important costs like funding costs. 

Bank of Ireland's cost to income ratio is now 58 per cent. This is much better than a few years before, and it compares well to the European average of 64 per cent. 

And the bank isn't done cutting costs. It guided in its presentation yesterday that further cuts should be expected in 2022 and 2023.

The Irish borrower has come through for Bank of Ireland

Since 2008, the big issue with Irish banks has been non-performing loans. The banks have worked hard to get bad loans off their books (which is where the securitises and vulture funds come in). Non-performing exposures, as they're called, are down to 5.5 per cent of the total loan book, from 11.4 per cent in 2016. There's no sign of an uptick as a result of the pandemic.

That's an improvement, but still above the European average of 2 per cent. 

The biggest surprise: a jump in capital 

Bank capital is important to regulators because it protects the bank from going bust. It's important to investors because, to the extent that a bank has spare capital over and above its regulatory requirements, it can be used for different desirable things. It could be used to fund buybacks and dividends, or to reinvest in the business. 

Bank of Ireland surprised investors yesterday with its level of capital. It has 16 per cent what's called CET1 fully loaded capital. That's a good bit more than it needs. It gives the bank latitude to do different things.

How did the Bank get its hands on this capital? A combination of higher earnings, and two credit risk transactions during the year got riskier loans off its books. 

Not much progress on interest rates — but perhaps more to come this year

The other big thing that determines a bank's profitability, apart from cost, is the difference between what it charges lenders and what it offers depositors. This is called the net interest margin. When net interest margins are high, it's a good time to be a money lender. 

Unfortunately for the European financial system, it has not been a good time to be a moneylender for about 14 years. This is because interest rates are low. 

The following chart shows Bank of Ireland's net interest margin. Not much to see there. 

But what is interesting is that in the last few months, interest rates across Europe started to rise. This was a sign that maybe, the European economy was starting to power up again, and interest rate rises might be on the cards. The following chart shows the average 10-year yield curves for all bonds in the eurozone. The pink curve is from September 2020; the blue one is from two weeks ago. As you can see, rates are starting to rise.

This was good news for European banks in general and Irish banks in particular, who do more moneylending than most banks. But the war in Ukraine could pose a serious problem here. If the EU goes the whole hog and sanctions Russian oil and gas — something not currently on the cards — we could be looking at a recession, and consequently lower interest rates. The final shakedown between output, inflation and interest rates would be hard to predict from here. But it wouldn't benefit the likes of Bank of Ireland.