Credit availability - capital scarcity is not the whole story

There appear to be two fundamental - if loosely defined - beliefs regarding credit availability:
that the banks require additional capital and that when in place, credit availability will
resume. NAMA (National Treasury Management Agency) is intended to address the issue of
bank capitalisation and implicit in its implementation is the expectation that credit will flow
again. All else being equal, removing up to !90 billion of assets in exchange for Government
bonds would release capital to support an equal amount of new lending.

To meaningfully determine how much capital the banks require, however, it is first necessary
to determine the actual credit needs of the Irish economy - only then can one assess if the
amount of capital to-hand is adequate or otherwise. The conclusion here, albeit from a broad-
brush and top-down perspective, is that the amount of core capital required to at least meet the
short-term credit needs of the economy is not significant overall. The corollary of this is that
increasing capital via the removal of non-performing loans will not necessarily solve the
immediate short-term credit crunch issue.

Central Bank statistics tell the credit tightening story – total loans owed by Irish borrowers at
end-April fell by almost !8 billion from their peak in November 2008 (to !428 billion from
!436 billion) compared with a !17 billion increase in the same period last year. While new
gross mortgage advances in Q1 were almost !9 billion, mortgage loans outstanding increased
by just !428 million indicating that the main lending activity is re-mortgaging and probably
renegotiation of existing loans. Loans outstanding to corporations fell !3.5 billion in Q1 to
!166 billion compared with a !6 billion increase last year. Credit growth was 1.8% year-on-
year in April - this time last year it was 16.4%.

In recent results presentations, the two major banks have indicted that control of balance sheet
growth is a key element of their strategies. AIB’s 2008 results presentation indicates a fall in
forecast risk weighted assets – a proxy for loans - through 2009 and 2010 (!143 billion: 2009;
!141 billion: 2010); Bank of Ireland has explicitly stated that ‘building capital resources is a
key priority….achieved through a range of options…including controlling risk weighted asset
growth’. Its risk weighted assets have already fallen from !117 billion at March 2008 to !105
billion at March 2009. Also, not surprisingly, Anglo Irish Bank’s loan book reduced to !72
billion at March 2009 from !73 billion last September.

The logic behind this deleveraging is clear – as quoted banks, a key priority is to re-establish
their appeal to private investors, which is also NAMA’s objective. In this respect, the focus
will be on strengthening balance sheets and resuming dividend payouts. This means achieving
a 6% or better Tier I ratio (50% higher than the international minimum), reducing dependence
on wholesale funding and improving the risk profile of the balance sheet. The banks are also
highly incentivised to replace the Government’s preference shares as soon as possible with
alternative sources of capital, requiring a viable solvency proposition to appeal to replacement
investors. It is also no surprise in a downturn that the banks have tightened credit criteria and
reduced their appetite for credit risk – in addition, they point to ‘weak demand by borrowers’
as partly responsible for the minimal growth in credit.

For those unfamiliar with the capital structure of banks, the fact that a relatively small loss –
say 6% of total loans – can eliminate equity capital has probably come as a surprise. This
reflects the highly leveraged nature of banking but which factor also works in the other
direction – a relatively small amount of core capital can sustain a large increase in lending.
Capital required to back specific loan categories also varies – broadly speaking mortgage
loans require half the capital backing of a commercial or unsecured personal loan.

Private Sector Credit (PSC) - 1999-2008

1
 ! billions PSC % yoy Net Lending Cap. Req'd
Mortgages Other (min.)
Dec-99 94 n/a n/a n/a n/a
Dec-00 114 18% 6 14 0.7
Dec-01 134 15% 6 14 0.7
Dec-02 146 9% 9 4 0.3
Dec-03 165 11% 12 7 0.5
Dec-04 204 19% 18 21 1.2
Dec-05 264 23% 22 38 1.9
Dec-06 330 20% 24 43 2.2
Dec-07 394 16% 17 47 2.2
Dec-08 429 8% 8 27 1.3

The table shows loans outstanding each year since 1999 – increasing from !94 billion to !429
billion by December, 2008. ‘Net Lending’ shows the net increase in loans outstanding each
year, also determining the minimum amount of additional core bank capital required to
support it, shown under ‘Capital Req’d’. Thus in 2006, private sector borrowers took on an
additional !24 billion in mortgages and !43 billion in other loans, the highest of the years
shown, requiring minimum additional core capital of !2.2 billion – over the nine years, the
average amount of capital required to support new lending each year was !1.2 billion.

The objective here is to show that meeting the likely reduced credit needs of the economy
over the next two years – being the expected duration of the downturn - does not require a
large amount of capital relative to the existing bank sector capital base, and existing and
proposed State capital injections. For example, supporting 5% credit growth over both
2009/10 - around !22 billion on average each year - would require minimum additional core
capital each year of around !750 million, if a third, say, is allocated to mortgages, and around
!875 million if it is all commercial and personal lending. Allocated across the whole domestic
sector, this would not be a substantial burden for any one institution.

Having the capacity to lend does not, however, mean that one should then expand credit to the
level possible if it risks creating the basis for another future abnormal bad debt cycle. This is,
of course, the nub of the problem – following the devastation of their balance sheets the banks
are now applying stricter credit underwriting criteria in assessing loan applications.

The sectors most dependent on the domestic banks are small-to-medium sized businesses and
personal borrowers - large corporates can access international markets. There is an onus on
businesses to present viable loan propositions to the banks while bank loan officers must, in
turn, be sufficiently skilled to ensure that viable businesses are identified and supported. On
the mortgage side, the risk of further substantial asset devaluation has certainly decreased
while affordability has improved – however certainty of future income is the key criteria
applied and rising unemployment continues to add risk.

Building up the bank sector’s capital base will eventually lead to increased credit availability
– this capital needs to earn an adequate return. In the short-term however, bank credit
committees are likely to be risk-averse following the massive bad debt write-offs incurred.
Quickly restarting an adequate flow of credit may take something else in addition to the,
albeit, highly challenging and complex NAMA process currently underway.

Oliver O’Shea is currently leading a new social banking venture in France (Voxpay365). He
was previously CFO of the UK’s Abbey National and Senior Banking Analyst with Goodbody
Stockbrokers. He also worked with international management consultants Accenture and
BearingPoint.