Yes, we were out of control. But those guys...
Here’s a very simple model that determines bank profitability in markets all over the world. Interest rates and regulation both matter but the overriding driver is market structure.
By Capital Thinking · Issue #833 · View online
When Irish Eyes Are Smiling
Plus: Blackstone, Trustly, Credit Suisse
Marc Rubinstein | Net Interest:
“Time is a great storyteller.” — Irish proverb
“Chinese Premier Zhou Enlai had a famous take on the French Revolution. When asked about its influence, his response was, it’s “too early to say”.1
The same might be true of the global financial crisis.
One of the best books written about it is Crashed by Adam Tooze, published a full ten years after the event. But even that book doesn’t tell you how the story ends.
Right now, in Ireland, a fresh chapter is being written.
In the past couple of weeks, not one but two banks have announced they’re exiting the market. First Ulster Bank, owned by the UK’s NatWest Group and then KBC, owned by the Belgian group, have said they’re out.
Once home to a thriving banking market, Ireland is rapidly converging on a duopoly. If you’re familiar with the idea of the capital cycle – as outlined in the book Capital Returns – it’s an interesting set-up.
Capital cycle analysis focuses on supply rather than demand dynamics in an industry. Instead of trying to project how many long-haul flights will be taken globally in 2022, it looks at changing supply conditions. So in banking, when capital in the industry contracts around just two players, that’s something worth paying attention to.
Today, we take a closer look at what’s going on in Ireland. It’s a small market, sure, but it’s a great case study in boom-bust and what happens next.
The Celtic Tiger
Early in my career I was invited to attend a management offsite with executives of the Irish Permanent bank in a country club near Cork, in south-west Ireland. This was a small bank, founded as The Irish Temperance Permanent Benefit Building Society in the late nineteenth century.
They were interested in my thoughts as an analyst on the prospects for growth in mortgage markets outside Ireland. As it was, except for a foray into the neighbouring UK market, they stayed close to home.
The bank merged with a domestic life insurance company in 1999 and, a couple of years later, the combined group bought the Trustee Savings Bank from the Government of Ireland.
For a few years at least, the domestic focus paid off. Ireland was hot. Economic growth was running at around 7% a year.
Tax incentives, competitive wages and European Union membership drew people in from around the world. Most of all, having signed up to the single currency in 1999, Ireland had access to deeper pools of liquidity and therefore cheaper credit than it had ever had before.
All of this fuelled a boom in real estate markets and Irish Life and Permanent was there to cheer it on.
Having been kindled by positive developments in the general economy, real estate markets soon overshadowed most other sectors, becoming a major driver of the economy themselves.
The construction industry swelled to contribute close to a quarter of GDP as homebuilders rushed to mine new houses.
They built around half as many new homes per year as their peers in the UK were building, despite a population a fifteenth the size. By the mid 2000s, the construction industry employed around one in five of the Irish workforce.
Financing all of this were the banks and they competed aggressively to do it. Domestic banks grew their balance sheets to five times Ireland’s GDP at the peak and foreign banks rushed in.
As well as Irish Life and Permanent, there was Bank of Ireland, Allied Irish Banks (AIB), Ulster Bank, Irish Nationwide, Educational Building Society (EBS) and Anglo Irish. Foreign banks included Danske Bank of Denmark, KBC of Belgium and Bank of Scotland from the UK. The poster child high-growth bank in this period was Anglo Irish Bank. Founded as a small finance business, it focused almost exclusively on real estate lending.
Costs were kept low because the bank didn’t operate a vast branch network. Its business model was to make big-ticket loans to a relatively small group of loyal clients active in the real estate business. Its twenty largest clients made up about half its Irish loan book.
Anglo Irish would process their loans quickly and affirmatively – 95% of loans put in front of the weekly credit committee were approved.
Anglo’s publicly professed mission was to “make our customers richer” and as they grew, Anglo grew.
In the mid 2000s, its loan book was growing at around 40% per year. In 2004, its CEO, Sean Fitzpatrick boasted, “We’re bigger now than Bank of Ireland was in 1998.”
By then he already had 14% of the Irish business banking market; he wanted that to double over the next ten years. The market loved the growth. Anglo’s stock price rose from €2.5 at the beginning of 2002 to €17.5 in mid-2007.
Close to its peak, the company slipped out a share placing which was four times oversubscribed. Its valuation reached over 4 times book value (for context banks today typically trade below 1 times their book value). Other banks pursued a “chase Anglo” strategy.
Bank of Ireland’s CEO told a board meeting in 2005, “we’re going to grow at 30% a year.” AIB opened a unit nicknamed ABA – Anybody but Anglo – charged with poaching Anglo’s largest clients.
Such intense competition led to a loosening of lending standards. Banks introduced interest-only mortgages and lent against 100% of the value of real estate, leaving no room for error.
In 2006, around a sixth of Irish mortgages were made at a loan-to-value ratio of 100% and around a third were made at ratios in excess of 90%.
Former Anglo Irish executives told Michael Lewis, who dedicates a chapter to the Irish banking crisis in his book Boomerang, “yes, we were out of control. But those guys were fucking nuts.”
There weren’t enough deposits in Ireland to fund all this growth and so banks had to borrow abroad. Having been funded entirely by Irish deposits in 1997, by 2008 loan-to-deposit ratios ranged between 130% and 175% for five out of the six major banks in the market; for my friends at Irish Life and Permanent, the ratio was 280%.
The entire stock of Irish bank deposits was being used to fund commercial property loans.
So when funding markets started to wobble in the aftermath of the Lehman collapse, things went awry.
Hedge fund manager John Hempton observes “The most scary thing to invest in is a fast-growing financial.” Irish banks are a case in point.
Marc Rubinstein
Photo credit: Max Bender on Unsplash