Luck of the Bank of Ireland

It is well known that the major Irish banks ended up in even worse shape than their UK counterparts following the 2008-09 crash. The cause, while familiar, was a uniquely reckless property investment boom that led to permanently unused offices on Dublin’s quayside and prize racehorses abandoned in the countryside by their bankrupt owners. The clean-up process after this disastrous episode involved the Irish government taking stakes in banks, and the mass-transfer of questionable assets from bank balance sheets into a specially created body called National Asset Management Agency (NAMA).

What has flown a little under the radar in recent years, is the fact that the reconstruction process for the Irish banking sector has now largely ended. This means an institution like Bank of Ireland (BIRG), one of the country’s Big Four banks, with a secondary listing on the London Stock Exchange, can now be considered on its own merits, and with less reference to events that occurred more than a decade ago.

Indeed, this chapter arguably closed for good on 23 September, when the Irish government announced the sale of its remaining stake in the bank – an outcome that investors in NatWest (NWG), nationalised when it traded as RBS, can look forward in hope. Symbolically, this makes BoI the first major state-rescued bank in Ireland to emerge from the long shadow of the great financial crisis and points to what has turned out to be a successful strategy on the part of the Irish government to stabilise and return the sector to sustainable growth. Looking at the returns for NAMA, which has gradually realised a profit on the assets that were transferred to its balance sheet, tells its own story about BoI’s vastly improved financial health. 

The agency's returns on the loans acquired from the major Irish banks already showed in 2011 that BoI was in a much better position than its main competitors (see table), with far fewer loans transferred to the agency – and at a slimmer discount – than either Allied Irish (AIBG) or Anglo-Irish.

This meant its road to recovery was considerably easier than for its sister institutions, a point reflected in BoI’s improved performance as interest rates in the eurozone begin to rise. All banks are now benefiting from higher margins as the difference between interest on loans and customers’ savings boosts bank earnings.

At its third-quarter trading update, BoI said that its net interest income would grow by between 6 and 7 per cent this year. That implies that the bank’s net interest margin should do considerably better than the 1.86 per cent achieved in 2021 and suggests that BoI is on course to generate at least €2.3bn (£2bn) of interest income this year. The interest rate effect could be even greater for 2023, with analysts at Berenberg forecasting a rise interest income of 22 per cent – although market uncertainties on when and how interest rates are likely to peak present a significant caveat.

Overheads also look to be under control, despite inflationary pressures. Management expects the trend that led to a 1 per cent drop in costs in the first half to continue. Since 2017, the lowering of headcount by 10 per cent and the digitisation of the business has stripped out about €250mn of underlying fixed costs, and puts BoI on the road to a 60 per cent cost-to-income ratio that compares favourably to UK-based peers.

The return of the Celtic Tiger?

Of course, whether BoI prospers in the medium will depend on the state of the underlying Irish economy. On this score, Ireland is set to grow faster than both the eurozone’s large economies and the UK, if forecasts this year from the European Commission (EC) stack up. Ireland is expected to post a 7.9 per cent growth rate this year and 3.2 per cent in 2023.

The EC’s commentary also highlights how much Ireland’s economy has changed since the crash. Property had been a prime driver of economic growth in the first Celtic Tiger period, but this time, the emphasis is firmly on experts of high-end medical devices, business services and pharmaceuticals. Wage growth continues, albeit at a slower pace than inflation, and employment is still at high levels. Against that backdrop, BoI should do well from both business banking – it has a big niche in SME businesses – and relatively low levels of loan defaults related to the broader loan book. The loan book, ex-UK, is expected to be weighted towards mortgages in Ireland where demand has been just behind available housing stock.

There is a sense that having endured some of the toughest austerity measures in Europe as a condition of the country’s bailout, Ireland is again starting to leverage its position within the eurozone as a low-tax, highly skilled economy with a banking system that is fit for purpose again. In other words, it is starting to resemble the UK economy prior to the Brexit vote in 2016 – if you want an English-speaking growth story (with great pubs) then Ireland is probably the first choice for investors keen on unrestricted access to the eurozone. Added to this, BoI’s recent history has earned it a deserved reputation for relative competence. The lack of overhang from a government stake and the comparatively few assets that it had to deposit with NAMA reflect an institution with smarter banking DNA.

The bear points with BoI are as much more macro-related. One unknown is how deep a housing rout Ireland might face, even within the shelter of the euro. Evidence from a similar smaller economy such as Sweden are not encouraging, given the Nordic nation is currently experiencing its worst housing slump since the 1990s with peak prices down by 14 per cent. Should that scenario play out in Ireland, then BoI, and the other Irish banks will have to make larger provisions for bad loans, though with risk weighted capital hovering at over 13.5 per cent, the bank is far better capitalised than at any time its recent history. Dividends for Irish banks have been thin over the past few years, with the emphasis firmly on rebuilding capital, but that might be about to change with higher interest income.

The shares earnings are relatively expensive for the sector at 10 times forward earnings, but BoI's straightforward story – no awkward hybrid structure, government stake, or strained geographic split – and relative competence makes their 20 per cent discount to tangible net assets a little harsh. With the dividend set to grow over the next two years, BoI looks a solid addition to an income portfolio and the shares have already outpaced those of UK banks.