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Stage set for consolidation in Irish banking
Sunday, October 05, 2008 By David Clerkin, Markets Correspondent
The government bailout of the Irish banking sector should act as a catalyst for a wave of mergers and takeovers not seen in Ireland since the 1960s.

That was the anaesthetic. Now it’s time for the surgery. Last week’s dramatic government intervention has numbed the pain for the Irish banking sector for the time being, propping up the Irish institutions that were about to fail under the cover of an unlimited guarantee for all six Irish-run banks and building societies.

But it has not changed the bleak truth facing Irish bankers: billions of euro lent to commercial property developers simply will not be paid back. How these losses are handled will dictate the future shape of the Irish banking sector.

The bailout has come at a cost that will be unacceptable to those who feel the bad boys of Irish banking should have been allowed to go under. But the move has also created the conditions for an orderly process of consolidation.

This is likely to see the country’s weaker institutions taken out in favour of those with a viable long-term future.

Finance minister Brian Lenihan spoke last week of the need for ‘‘reform’’ of the Irish banking sector in light of the new guarantee mechanism. Lenihan’s lack of detail so far on any aspect of how the government guarantee will work has served to deflect attention from what details there are in the legislation that was so hastily cobbled together last week.

But there is much to chew on in the new law. While much of the focus last week was on the guarantee, other provisions will create a framework for the government to be a key player in takeovers of Irish banks and building societies when the industry clean-up begins.

The legislation grants Lenihan powers to provide ‘‘financial support’’ to institutions, but does not limit this to guarantees.

Lenihan, if he chooses, would also be free to provide direct loans to any of the six banks and building societies, or exchange assets with them, in cases that he deems necessary to preserve the stability of the Irish financial system.

Other aspects of the new act will allow Lenihan to bypass competition laws if a bank or building society is the subject of a takeover. While offering a guarantee to each institution was a revolutionary step, the consequences of the provisions dealing with approving takeovers and providing direct loans to institutions could be equally far-reaching.

Lenihan made much of the fact that the six institutions had been given the government guarantee on the basis that, unlike foreign-owned banks operating here, they had nowhere else to go if they were in need of support.

Recent experience in Britain could provide a clue to the Irish government’s future intentions regarding the banking sector here. The credit crunch has already forced Gordon Brown’s government into intervening in the case of three banks - Northern Rock, HBOS and Bradford & Bingley - with a different strategy each time.

In Northern Rock’s case, Brown appeared to have little option but to choose a straight nationalisation of the bank. When HBOS got into difficulties, he instigated a process that resulted in Lloyds TSB agreeing to take over its rival with the government’s blessing, even at the expense of competition concerns due to the market share that the enlarged entity would control.

Bradford & Bingley’s demise, meanwhile, resulted in a part-public and part-private solution, where the government nationalised the loan book and sold off the bank’s assets to a private sector bidder, Spain’s Banco Santander, to help offset the Treasury’s pain.

But having exposed the Irish taxpayer to a contingent liability of up to €400 billion - a figure that could bal loon if depositors and foreign banks switch large amounts of money into Irish banks to avail of the new guarantee - the ticking bad-debt bomb means the Irish government is unlikely to have the comfort of sitting back and congratulating itself on a job well done.

Instead, it may figure that the near-collapse of two, or perhaps even more, Irish institutions should act as a catalyst for a wave of mergers and takeovers not seen in Ireland since the 1960s.

Then three regional banks merged to create AIB and Bank of Ireland moved to snap up two smaller entities. Comments made by Lenihan last week, that the Irish banks were friendless outside the country, suggest that any lingering hopes that foreign institutions would take advantage of depressed share prices to acquire an Irish bank are misplaced.

Similarly, Irish Nationwide’s inability to find a buyer, despite having been on the block for over two years, should be taken as a signal that it has no future as part of an international institution.

In this context, any solutions to the Irish banking sector’s problems that can be provided by consolidation are more likely to come from deals forged among local institutions alone.

But who will pair up with whom? Much has been read into the fact that AIB chief executive Eugene Sheehy and Brian Goggin, his Bank of Ireland equivalent, were in the room last Monday night when the new guarantee scheme was drawn up.

While the chief executives of the other institutions were kept in the loop through phone briefings, Sheehy and Goggin have unrivalled insights into the government’s thinking behind the new legislation. It is also likely that they were given the opportunity to express a wish list of things the government needed to do if it wanted their banks to acquiesce in tidying up the industry through a series of mergers.

Just as the British government looked to Lloyds TSB to help engineer a deal that had attractions for itself, the government and HBOS, the Irish government was undoubtedly aware that its list of potential deal-doers is a short one.

Of the two banks, AIB appears to be the more likely driver of the consolidation bus. Sheehy recently surprised the markets by continuing to increase his shareholder dividend payouts. He also took great care to highlight his view that the bank had no issues on the capital or funding fronts.

‘‘We’re not in any way concerned about funding or capital,” he said at the time. ‘‘But lots of banks are in that position.”

Within weeks of Sheehy’s move, the pressures on other banks’ capital became clear. Goggin dramatically slashed the Bank of Ireland dividend by 50 per cent to help shore up the bank’s balance sheet, while Irish Life & Permanent froze its dividend with the similar aim of adding to its capital base.

Uniquely among banks, AIB has signalled in recent months that it remains in the market for acquisitions, in the right circumstances.

Last year, Sheehy wrote to the board of EBS expressing his interest in the building society should it decide to demutualise in the future. Although EBS threw out the approach at the time, the sea change in the markets that triggered last week’s emergency intervention by the government could make the AIB proposal a lot more attractive.

But other institutions could be even closer to the end of the road as a standalone entity.

While AIB had never been considered a likely acquirer of Irish Life & Permanent - on the grounds that such a deal would never make it past the Competition Authority - last week’s developments have offered the country’s biggest bank an unprecedented opportunity to gobble up market share in its home market through sizeable acquisitions.

If Britain can allow Lloyds TSB to acquire HBOS, AIB is now in the unexpected position of effectively having its pick of the institutions around it.

It is also worth noting that the changed legislative environment means that restrictions that would have stood in the way of a once-unthinkable merger between AIB and Bank of Ireland are no longer in place. While former Bank of Ireland chief executive Mike Soden was once ridiculed for floating the idea, the prospect no longer belongs in the farfetched category.

Both banks will be aware that it will soon be much easier to fund major deals that would otherwise be impossible in the current funding freeze. Lenihan could use his new powers to offer loans, perhaps using the Central Bank, if the circumstances were right.

Of the remaining two institutions, meanwhile, much has changed in the two weeks since Anglo Irish Bank and Irish Nationwide were being touted - outlandishly, it now seems - as potential bedfellows.

Both institutions will be relieved at the lifeline thrown to the sector by the government’s intervention, but both will be conscious that their heavy exposure to commercial property developers makes them unattractive targets as the deep malaise afflicting some of their clients becomes increasingly clear.

The Irish banking sector fell out of favour largely because international investors and funding counterparties remain convinced that too many bad loans will not be paid back.

As the unsentimental logic of the markets dictates that this pain will have to be felt somewhere, any potential acquirer of a commercial property book will need hefty incentives to agree a deal.

But buyers would also need a mechanism to ensure that they could justify any deal with a property-heavy lender to their own shareholders and that they would not be taking on pain unnecessarily.

Just as the British government did not find a bank to take on the role performed by Lloyds TSB in the rescue of HBOS when it came to salvaging Bradford & Bingley, Lenihan may end up using his new powers to carve out attractive elements from unattractive targets and taking the pain on what’s left.

Last week may have provided the Irish banking industry with a big bang. We will soon find out if intelligent design also played a part.

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