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Irish banks shrug off EBA stress test projections as outlook brightens

Confidence in the Irish banking sector is building among investors, despite the recent European Banking Authority's recent stress test suggesting it would be one of the weakest performers in the European Economic Area through 2023, according to analysts.

An improving domestic economic outlook, strengthening capital positions and the potential for mergers and acquisitions are all feeding into mounting belief in the banks, they said. The positive flow of news and data in recent months has allowed analysts to distance their forecasts from the EBA's latest projections, which used 2020-end data as their starting point, they said.

Bank of Ireland Group PLC, the country's largest lender by total assets, saw its share price rise by 14.50% from July 30, the day on which the EBA's stress test was published, through Aug. 20. The share price of AIB, Ireland's largest bank by market capitalization and second-largest by assets, rose by 17.67% during the same period.

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"Investors are more focused on the improved momentum from the economy reopening [following the lifting of COVID-19 restrictions]," Eamonn Hughes, senior banking analyst at Dublin-based financial services firm Goodbody, said in an interview.

Capital depletion in adverse scenario

The EBA stress test, which examined 50 banks from EU and EEA countries, found that Ireland's two largest lenders were among the worst impacted by capital depletion in a simulated adverse scenario. Bank of Ireland would have the joint-seventh-lowest fully loaded common equity Tier 1 capital ratio by 2023 at 8.1% in the event of the adverse scenario, losing 532 basis points from December 2020. AIB would rank 37th, with a ratio of 8.8%, losing 677 bps during the period.

In the stress test's baseline scenario, Bank of Ireland would rank 41st out of 50 with a fully loaded CET1 ratio of 13.9% by 2023, an increase of 50 bps from December 2020. AIB would rank 40th.

Click here for S&P Capital IQ Pro's EBA Stress Test 2021 Results template.

Since the stress test's end-of-2020 starting point, several economists have revised growth projections for the Irish economy upward as it reopens and rebounds from the COVID-19 pandemic. Irish financial services group Davy more than doubled its GDP growth forecast for the country Aug. 9 to 10% from 4.8%.

"The stress test's underlying base economic forecast for Ireland, and hence the profitability for the banks, was significantly weaker than we're forecasting," said Hughes.

The improving economic picture helped bolster capital at Ireland's two largest banks in the second quarter. Bank of Ireland saw its fully loaded CET1 capital ratio increase by 70 bps to 14.1% from 13.4% at the end of 2020. AIB's ratio increased by 80 bps to 16.4% from 15.6%.

The banks' total capital ratios have risen steadily since the global financial crisis of 2008-2009.

Both banks have got "very high capital ratios," well in excess of the ratios that they are required to hold, Diarmaid Sheridan, banking analyst at Davy, told S&P Global Market Intelligence.

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Opportunities for strong growth in the Irish market through M&A are also boosting prospects for the banks. NatWest Group PLC, which has 15% of the Irish mortgage market and 20% of its small and medium-enterprise lending market, announced in February that it was exiting the Republic of Ireland but would retain its business in Northern Ireland, which is part of the U.K. NatWest's move was followed soon after by Belgian lender KBC Group NV, which announced in April that it was in talks with Bank of Ireland to sell the bulk of its units assets in Ireland, where it has a 12.6% share of the mortgage market.

"[These exits] will mean that some of the nonbanks or new challengers can scale up quicker," said Hughes. "But, net-net, anybody who's left can do a little bit better."

Conservative stress test

Part of the disparity between the EBA's recent projections for Ireland's two largest banks and current forecasts is due to the conservatism of some of the stress test's inputs, the analysts said. The use of historical data as a basis for assumptions on future GDP and house price growth was particularly influential given the severity of the impact of the 2008 global financial crisis on the Irish economy and its banking sector, said Sheridan.

Other features of the stress test, such as the assumption that banks would have to pay interest to current accounts one which would "never bear out in reality" as current accounts at Irish banks have "never, ever been paid interest," said Sheridan also constrained the projected performance of the Irish banks.

"[The stress test] has some inherent things built into it which maybe overly penalize the Irish banks versus others because of the structure of the banking system here," Sheridan said.

The results of the stress test are expected to have no bearing on the Irish government's plans or ability to continue selling off its stakes in the three Irish banks it bailed out during the 2008 global financial crisis. The government announced in June a "phased exit" of its stake in Bank of Ireland, of which it owns almost 13%, according to a regulatory filing. It also owns more than 70% of AIB and Permanent TSB, S&P Global Market Intelligence data shows.

House price growth, mortgage lending revenues, SME lending activity and the potential for impairment write-backs as the threat of the COVID-19 pandemic eases will all be watched closely in the coming months for signs of further improvement at Ireland's banks, the analysts said.

"That's what investors are focused on," said Hughes. "Less on the stress test."