18/6/2014: ECB Assessment of Irish Banks: IMF view

In the previous post, I looked at the IMF report on Irish banks from the point of view of ongoing developments and balance sheet repairs (link here). Now, let's take a look at IMF report from the point of view of the ECB stress tests.

Per IMF: "The ECB’s Comprehensive Assessment and corrective actions where needed are important to reinforce confidence in European banks, including in Ireland (see stress tests parameters described below).

"AIB, BoI, and PTSB all reported capital ratios above the regulatory minima at end 2013. Notwithstanding, a finding of a capital need under the Assessment cannot be precluded, with results due to be announced in October." In effect, here's your warning, Ireland - IMF has no confidence as to the outcome of the tests and this is in line with the risks to the sector still working through banks balance sheets, as highlighted in the previous post.

Never mind, though, as per IMF "Private capital is the first line of recourse and it is welcome that market conditions for European bank equity issuance currently appear relatively favorable."

While IMF seems to think there are plenty of crazies out there willing to bet a house on banks stocks valuations, the IMF is still hedging its bets: "Nonetheless, where private capital is insufficient, public support may be needed, including from a common euro area backstop to protect market confidence and financial stability; the possibility of ESM direct recapitalization should not be excluded."

Which begs a question or two:
1) Will ESM come in ahead of irish taxpayers? Answer - unlikely.
2) If ESM were to come in, will it have seniority over previous taxpayers equity in the banks (in other words, will it destroy whatever recoverable value we have achieved so far)? Answer - likely.

IMF is less gung-ho on the idea of immediate state supports in the worst case scenario: "If the supervisory risk element of the assessment identifies other issues, such as profitability or liquidity, staff considers these should be addressed over time in a manner that contains costs while firmly safeguarding financial stability. This is especially important for PTSB, where staff continues to see risks to its return to adequate profitability over a reasonable horizon in its current form, but approval of its European Commission restructuring plan is on hold pending completion of the Assessment."

Oh… ouch…

A chart to illustrate the pains:

Watch that equity cushion in the above for PTSB and the margin on provisions… No wonder IMF is feeling a bit uneasy. But across all banks, Gross Non-performing Loans are nearly par or in excess of the Provisions + Equity + Sub-Debt.

Now onto stress tests.

Agin per IMF: "Irish banks are currently undergoing the ECB’s Comprehensive Assessment (CA). The five largest banks are included: three Irish headquartered banks (AIB, BoI, PTSB), and the domestic subsidiaries of Merrill Lynch and Royal Bank of Scotland. Based on end 2013 data, the CA comprises:
(i) an Asset Quality Review (AQR);
(ii) a forward looking stress test covering 2014–16; and
(iii) a supervisory assessment of key risks in banks’ balance sheets, including liquidity, leverage, and funding."

First thing to note: the time horizon for tests is exceptionally narrow: 2014-2016, or 36 months, of which (by the time the tests are done, at least 6 months data will be already provided). Does anyone think Irish banks will have full visibility on risks and downsides expiring at 2016 end? Good luck to ye.

"The AQR will audit banks’ banking and trading books. For each bank, at least half of the credit risk weighted assets and at least half of the material portfolios will be covered. For the banking book, the AQR will look at the impairment and loan classification, valuation of collateral, and fair valuation of assets, while core processes, pricing models, and revaluation of Level 3 derivatives will be covered in the trading book review. Compared with the CBI’s BSA in 2013, the AQR for the CA has narrower coverage of the banking book by risk weighted assets (RWA), it does not review banks’ RWA models, but does cover the trading book although such exposures are not large for the domestic retail banks."

What this means is that the forthcoming tests are less robust than the CBI tests, but that assumes CBI tests were robust enough.

IMF provides a handy set of charts summarising stress scenario, baseline scenario for the CA against IMF own projections.

"The CA will apply a common equity tier 1 risk based capital floor of 8 percent for the AQR and the stress test baseline, and 5.5 percent for the adverse scenario, using the relevant transitional definitions. Results will be announced in October. If a capital need is identified, the additional capital will have to be raised within 6 months if the shortfall occurs under the AQR or baseline scenario, or within 9 months if it arises under the stress scenario."

In my view, CET1 at 8% floor is a bit aggressive. The floor should have been around 9-10% for Irish banks (and all other distressed banks), while for stronger banks the floor could be 7-8%. But ECB does not want to differentiate ex ante the banking quality tiers present in the euro area markets. Which is fine, but yields and outcome that strongest banks have implied identical floor as the weakest ones.

So overall, my view is that the IMF is being rightly cautious about the banks prospects under the ECB CA exercise. The Fund is hedging clearly in referencing the possibility for banks failing the tests. Key point is that the IMF - having had access to CBI and Department of Finance data and assessments, cannot rule out the possibility that Irish banks might need additional capital and that this capital may require taxpayers stepping in.

Next up: Households Balance Sheets

18/6/2014: IMF on Irish Banks: Still Sick to the Core, but of course, getting better...

IMF released Staff Report on the First Post-Program Monitoring Discussion for Ireland. Some of the highlights over few posts.

First up: banks.

Per IMF: "Banks’ 2013 financial statements show higher provisions and, although easing funding costs are supporting bank profitability, credit continues to contract." Ugh? Surely not because the banks are lowering rates on existent and new debt? CBI data shows no such moves.

Here is how dramatic was the decline in banks funding costs (all declines down to ECB lower rates, plus Government ratings improving):

"AIB, BoI, and Permanent tsb (PTSB) set aside provisions totaling €2.5 billion in the second half,
reflecting the CBI’s updated guidelines introduced in May 2013 and the CBI’s balance sheet assessment (BSA) finalized at end November, together with allowances for new NPLs."

Coverage ratios of provisions to NPLs increased at all the banks. Which is good for banks balance sheets and forward potential for lending, but bad for current potential. And it is material for the stress tests forthcoming (see next post on this).

"Higher net interest income in  2013 partly offset provisioning to result in a smaller full year overall loss than in 2012. However, new lending remained weak, with credit outstanding to households and non-financial firms contracting 3.7 percent and 6.2 percent y/y, respectively, in April."

Ah, I wrote loads about credit supply problems: here's a note on latest data for credit supply to households http://trueeconomics.blogspot.ie/2014/06/1062014-credit-to-irish-households-q1.html and another one on latest data on credit supply to Irish private sector enterprises: http://trueeconomics.blogspot.ie/2014/06/662014-credit-to-irish-resident.html And the third post coming up today will cover the margins banks charge on loans relative to what they pay on deposits... the margins that act to extract value out of the economy.

And here's IMF's chart summarising the above developments:

All said, banking sector remains one of the core weak points. In assessing downside risks to Fund's forecasts for Ireland, IMF identified 4 key sources of risks. Banks are the fourth: "Bank repair shortfalls. As firms’ internal financing capacity is drawn down, sustaining domestic demand recovery will depend increasingly on a revival of sound lending, where substantial work remains ahead to resolve high NPLs to underpin banks’ lending capacity."

But for all the talk, banks remain sick. Per IMF: "Banks’ NPLs remain very high, at 27 percent of loans at end 2013, in a range of 17–35 percent across the three Irish headquartered banks. Such ratios reduce banks’ potential capacity to lend by hurting profitability, including through higher market funding costs, limiting the supply of collateral for funding, and diverting credit skills. With recovery taking root and property markets improving, banks may see further upside from postponing NPL resolution. But such choices at the individual bank level may not sufficiently internalize the macroeconomic impact of banks collectively leaving NPLs at high levels in terms of barriers to new lending and an inefficient allocation of capital, warranting supervisory pressure on banks to accelerate asset clean up. Reducing uncertainties around the value of banks’ loans will also enhance public debt sustainability by supporting valuations for the government’s bank equity holdings, which it intends to dispose."

Here's an interesting bit. We know banks have been slow to deal with Buy-to-Lets, parking bad loans in hope that current debtor will part-fund warehousing of BTL properties (via renting them out) until such time when prices rise and bank can foreclose on these. This strategy clearly maximises banks returns and is happy-times for CBofI, concerned with how good banks look on their 'profitability' side. But it is bad news for the economy, where investors (aka ordinary punters) are bled dry of cash to fund BTLs which will never return any fund they 'invested' in them.

IMF basically tells the CBofI and Irish authorities: you have to force banks deal with these BTLs and smaller CRE loans, i.e. foreclose earlier, not later.

And IMF is onto the task: "In view of improved market conditions, the authorities should press banks to broaden their resolution efforts into impaired CRE loans. Banks hold mostly smaller CRE exposures (below €20 million) that were not transferred to NAMA, yet delinquent CRE loans still account for 40 percent of NPLs. Recent strong IBRC and NAMA deal flow points to potential investor interest—although the nature of the assets differ somewhat—and the banks’ portfolios also have relatively high provisioning cover. Staff therefore recommends that banking supervision press forward the restructuring of these NPLs or their disposal in a manner that achieves sufficient deal flow while avoiding flooding markets. Although one bank is exploring disposal options for its CRE loan portfolio, others prefer loan restructuring to retain potential upside and their customer base."

And a handy chart:

Do notice how weaker provisions cover is delivered on mortgages, while over-provision is a feature of other loans? Priorities… priorities…

SMEs loans are still a huge problem: "SME loan workouts will require ongoing oversight to ensure viability is restored. The two main banks making loans to SMEs report substantial progress in developing workouts for their distressed SME loans, although in practice such workouts will be implemented over some years as restructuring steps by SMEs move forward." Read: the reports are fine, but we won't see full results over some time. Question, unposited by the IMF is: why?

"Recent amendments to the Companies Act facilitating SME less costly examinership procedures are expected to become operational in June, which may be most useful in multi-creditor cases as banks otherwise prefer to conclude workouts outside of the courts."

And finally: mortgages arrears:

"Mortgage resolution should be both timely and durable. …Banks report that by end March they had concluded solutions for over 25 percent of primary dwelling and buy to let loans in arrears for more than 90 days." Never mind the rest?.. Oh, by the way - of 132,217 accounts in arrears in Q1 2014, 39,111 accounts are less than 90 days in arrears. Of all mortgages that were restructured (92,442 accounts) only 53,580 accounts are not in arrears following restructuring. Again, IMF ignores this.

"Targeted audits give the CBI comfort that the solutions underway are durable, but reducing reliance on shortterm modifications paying interest only or less remains important." Interestingly, this is what we - IMHO - have discussed in depth with the IMF team. Irish authorities have seemingly no problem with the banks 'restructuring' mortgages by loading more debt onto households and spreading this debt either over greater duration or offering temporary relief from cash flow pressures of this debt.

How sustainable is this? Well, 'targeted audits' might suggest that a household that owed 100K on a property and was unable to fund it at full rate, can be made sustainable with 110K debt over same property but with 3 years worth of interest-only repayments. I am not so sure. Neither, it appears, is the IMF.

Another thing we discussed with the IMF: "Securing constructive engagement by borrowers remains a key challenge to progress, where extending independent advice to borrowers willing to negotiate with lenders may be helpful."

So far, the CBI has given independent advisers no support whatsoever and given the banks no encouragement to engage with such advisers. IMHO has worked closely with some banks to deliver such advice - and we have a proven track record showing it works. But two 'pillar' banks refuse to engage with us and any other independent advisor on any terms, unless the borrowers pay directly for advice out of their own pockets. Even IMF now sees this to be completely nonsensical.

Last bit: "The Insolvency Service is developing a protocol to standardize loan modifications, which could also help." So IMF now endorses idea of standardised solutions. From 2010 on, when mortgages crisis blew up, I campaigned for the state to impose onto banks standardised resolution products, such as loans modifications parameters, arrears capitalisation and write downs parameters etc. The state refused. We at IMHO briefed the Central Bank on the need for such standardisation. Our submissions were ignored.


Next: ECB Assessment of Irish Banks: IMF view