Some politicians have labelled bank profits “obscene” and maintain it is “utterly offensive” for Irish banks not to pay higher rates to depositors. Are these assertions supported by the data?
Deposit rates are undoubtedly low in Ireland at present, as indeed they are across the euro area. In recent research, the Central Bank of Ireland compared the deposit rates paid by Irish banks with those paid by euro area banks.
It found that “interest rates on household overnight deposits rose to 0.07 per cent in June 2023″, some 0.16 per cent less than the 0.23 per cent annual average paid by euro area banks.
It also commented that “interest rates on new household deposits with agreed maturity rose to 2.12% in June in Ireland” noting the “equivalent rate in the euro area was 2.70 per cent”. In an earlier report, the Central Bank highlighted that “overnight deposits, which include current accounts ... account for 94 per cent of outstanding household deposits”.
The rate of interest paid by banks for deposits is largely a function of the banks’ need for such funding. In the period 2009-12, when Irish banking had a loan-to-deposit ratio as high as 180 per cent, competition for deposits was intense and Irish banks paid the highest rates in the euro area.
However, over the past 10 years, banks have continued to accumulate deposits even as their loan books shrank. The loan-to-deposit ratio has declined towards 70 per cent and competition for deposits is modest. Indeed, this increase in deposits has been a mixed blessing for banks: for most of the period 2016-22, Irish banks incurred a cost of 0.5 per cent to place their excess deposits with the Central Bank but did not pass this cost on to retail customers.
The International Monetary Fund notes the key reason for the higher risk-weighting [of Irish banks] ‘remains the inability of financial institutions to predictably and efficiently enforce mortgage security on primary dwelling homes’
The Central Bank also noted: “The weighted average interest rate on new Irish mortgage agreements at end-June 2023 was 4.04 per cent... The equivalent euro area average [was] 3.79 per cent. As at end-June, the rate in Ireland exceeded the euro area average by 25 basis points.”
It also calculated that the average interest rate charged by Irish banks for mortgages secured on private dwelling houses was 3.36 per cent, compared to the 4.06% average charged by non-banks.
Risky business
Banking is a risky business and Irish banking particularly so. The riskiness of bank lending is measured by the risk-weighting of a bank’s loans. Research by the Department of Finance and Banking & Payments Federation Ireland highlight the greater risks to which Irish banks are exposed.
For example, the risk-weight of Irish mortgages was found to be 2.8 times higher in Ireland than the euro area average. The International Monetary Fund notes the key reason for the higher risk-weighting “remains the inability of financial institutions to predictably and efficiently enforce mortgage security on primary dwelling homes”.
Thus, Irish banks need a higher interest margin than their euro area counterparts to pay for the extra capital required to undertake lending and absorb the higher losses from mortgage default. This is even more necessary as Irish banks earn a far lower percentage of their income from fees than other euro area banks.
Shareholders will expect a return on their investment commensurate with the risks they face. Investors in banks, which are especially exposed to the economic cycle, will typically require returns of 7 to 10 per cent more than they would earn by investing in 10-year Government bonds, which is 10 to 13 per cent in the current interest rate environment.
If banks are to provide the appropriate return to shareholders over time, it seems reasonable to expect they will deliver greater profits in the current benign climate to compensate for the reduced or negative earnings during the next downturn. The weighted average return which the shareholders earned on their investment was a rather modest 4 per cent, well below the market required rate of return.
Banking is a capital-intensive business. Irish banking needs to deliver profits of €3 billion annually through the economic cycle to remunerate the €26 billion of capital required to support it
The Central Bank reported that before this year, Irish banks’ return on equity had been in the bottom quartile of euro area banks over many years. And euro area banks themselves have long been insufficiently profitable.
Despite the recent stronger performance, Irish bank shares are still trading at discounts of 20 per cent to 50 per cent of book value, though this is much better than the situation in mid-2020 when all three Irish banks were trading at 70 per cent below book value. There’s no doubt that many years of sub-par returns finally convinced the parents of Ulster Bank and KBC that their capital would be better deployed in other countries.
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Banking is a capital-intensive business. Irish banking needs to deliver profits of €3 billion annually through the economic cycle to remunerate the €26 billion of capital required to support it. It will require higher returns when the economy is strong, as it is currently, to cushion the losses when Covid, or the next downturn, emerges. It is in the national interest that Irish banks are adequately profitable, particularly as the Irish taxpayer owns 62 per cent of the shares in Permanent TSB and 47 per cent of those in AIB.
It seems inappropriate to consider intervening in the market when Irish banking has finally reported strong results for the first time in five years.
Banking relies on confidence: suggesting that the Government intervene in the banking market at present may well prove counterproductive, as Giorgia Meloni discovered.
Brian O’Kelly is professor of finance at Dublin City University
