Irish banking sector faces five challenges
Mr Matthew Elderfield, Deputy Governor of the Central Bank of Ireland addressing the Association of Compliance Officers in Ireland, University College Cork said it is essential for breaking the damaging link between a distressed banking system and weak public finances.
And it is important for economic recovery that the banks are once again in a position to lend to small businesses and homeowners. But despite the considerable effort that has gone in to recapitalising, shrinking, restructuring and otherwise reforming the banking system, the process is by no means complete and significant challenges remain.
While the banks have transferred their troubled commercial property loans to NAMA (and are selling down their non-core portfolios), they retain their legacy portfolio of mortgage, SME and other assets which have a high level of arrears, impairment and embedded losses. A lot of work has been undertaken to assess the quality of these assets and to ensure both that adequate capital is held against them and that adequate accounting provisions are held (following new guidance from the Central Bank). So, a much greater level of capital has been set aside against the risk of loss and higher levels of prudent provisions are now in place.
However, more work remains to be done in order to develop a more precise and clear picture of the performance and degree of embedded losses in these portfolios. This is the first challenge. Efforts to date have involved, in the first instance, a top down estimate of portfolio losses and, more recently with the assistance of Blackrock (a consultant used by the Central
Bank), a bottom-up loan by loan loss forecast exercise based on conservative modeling assumptions. But there is a remaining task: a case-bycase re-underwriting, involving where possible recovery and where necessary restructuring, of troubled loans.
This is crucially important for a number of reasons. While the banks still have uncertainty about the granular performance of their loan portfolios, they will be unsure of the exact capital buffer that is in place and the extent to which they have adequate capital for extreme loss developments. To my mind, this encourages an attitude of hoarding capital and provides disincentives to lending. At the end of the summer, there was much debate around a widely reported Central Bank analysis of lending to the small business sector, where we found that loan rejection rates were significantly higher than other EU jurisdictions, excepting Greece, and which to our mind pointed to supply constraints in the banking sector (in addition to problems over credit quality). Uncertainty about the current loan book and the exact losses that will crystallise (and therefore consume capital) are likely a factor in constraining lending.
Absent an exercise of even further recapitalisation, the best option is more specificity and understanding of the performance of the legacy loan portfolios - and an exercise in facing up to losses and modifying loans as necessary.
The banks' mortgage portfolios are a case in point and have involved close attention by the Central Bank. At this event last year, I explained how we were initiating a project to require mortgage arrears resolution strategies from all lenders in Ireland. We received these in November of last year and provided feedback to the banks, highlighting the need for more effort on a number of fronts. One major area of concern was the lack of operational capacity in the banks to deal with customers in arrears so we required senior management to commit to a step change improvement in that capacity. The plans we received showed significant improvement and we are continuing to monitor progress closely.
We also pressed the banks to work harder to develop specialist strategies for their buy to let portfolios. And, crucially, we insisted that the banks develop a broader range of techniques to deal with loans in arrears, drawing on the ideas of the so-called Keane group. In a slight simplification of the position, the banks were relying heavily on the provision of interest only arrangements or the capitalisation of interest arrears, even though these techniques were clearly unsuitable for a sizeable group of customers with unsustainable mortgages as a result of a severe reduction in income. The banks were required to identify a broader range of techniques, including loan modification arrangements such a split mortgages and the introduction of mortgage to rent schemes, and to pilot these during Q3 of this year.
These pilots are now mostly concluded (although are dragging on in one or two cases) and the banks are now in starting the process of rolling out the new arrangements more widely.