ECONOMICS:The retail margins of Irish-owned banks are a long way below pre-crisis levels, writes PAT McARDLE

RECENT INCREASES in mortgage lending rates generated quite a furore but these are merely a harbinger of what might happen if Ireland’s standing in international financial markets does not improve.

The reaction to the increases varied over time. First, there was surprise, even shock, that institutions recently rescued by the State should increase rates at all.

Then, for a good while, there was a tendency to generalise. Movements in the standard variable rates (SVRs) were portrayed as if they applied to all mortgages.

Finally, there was an irresistible temptation to base calculations on a “standard” €300,000, 30-year mortgage ignoring the fact that SVRs, the principal form of variable-rate mortgage affected, were older, with much smaller amounts outstanding.

A small survey I did indicates that just over one-third of borrowers were affected but they accounted for only a fifth of total mortgages outstanding by value.

These interest-rate moves can be seen as the correction of an error that occurred in late 2008-early 2009. This was a chaotic period, which included the introduction of the guarantee on bank liabilities and big cuts in official ECB interest rates. Banks came under pressure to lower lending rates even if this was not fully matched by falls in the cost of deposits, causing margins to narrow.

Irish banks covered by the guarantee (about 70 per cent of the market) responded differently to their competitors. Their average SVR fell to 2.7 per cent. The foreign-owned banks held their SVRs at 3.4 per cent, almost three-quarters of a percentage point higher.

There are two schools of thought as to why this happened. The first is that the Irish banks felt unable to go against the tide of falling ECB rates. The second is that pressure was applied by Merrion Street and the “newly-guaranteed” banks did not have the stomach to resist. I favour the latter explanation but either way it was a mistake, which has now been painfully corrected and the differential eliminated.

The rush to lower mortgage rates was also reflected in a widening gap between Ireland and the euro zone average. ECB data show that, while Irish and euro rates (the average rate on all mortgage loans, not just SVRs) were virtually identical before the crisis, a gap of up to 1.25 percentage points subsequently emerged (see chart, below left).

By June 2010, that gap had still not been fully closed although recent announcements will likely rectify this.

To sum up, recent mortgage rate increases have been confined largely to the Irish-owned banks, with four of the five foreign retailers leaving their rates unchanged. Furthermore, the proportion of mortgages affected was only about 20 per cent – the remainder are either trackers (60 per cent) or fixed-rate mortgages (another 20 per cent), which remain unchanged.

The big issue for the banks and ultimately for all Irish citizens is the high proportion of mortgage loans that are fixed and whose rates cannot be changed.

This brings us to the average size of mortgage, the area of greatest misrepresentation. Trackers were introduced by Bank of Scotland Ireland and constituted the vast bulk of mortgages drawn down in recent years. It follows that the variable-rate mortgages affected were predominantly of the older SVR type plus a smaller number of LTV (loan to value) mortgages that were introduced after the crisis.

The €300,000 “standard” mortgage came into vogue a few years ago when the average house price peaked at just over €300,000 according to the ESRI/ Permanent TSB index. However, the PwC/Irish Bankers’ Federation data show that the average first-time buyer loan peaked at €250,000 so the €300,000 figure was never representative.

More pertinently, the amount outstanding on the older SVR loans is much lower still. While some individual banks quoted figures in the €60,000 range, my survey puts the average for all lenders closer to €100,000.

On average, Irish banks raised rates from 2.7 per cent to 3.7 per cent over the past year. A one percentage-point increase on a 15-year €100,000 mortgage adds just under €50 to the monthly bill whereas the figures quoted were frequently multiples of this.

The increases are modest enough and leave banks’ retail margins a long way below pre-crisis levels (see chart, below right). The fundamental cause of the decline in margins is the much greater fall in lending rates (mortgage, consumer and business credit combined). Margins were in the 3 per cent to 3.5 per cent range from 2005 until the crisis broke but are now 1.75 per cent, despite a modest recovery, as deposit rates ease back while lending rates track sideways.

However, even this does not capture the full picture, as banks also depend on wholesale funding. The cost of such funding, which can account for up to a third of total bank resources, is prohibitive.

It does not seem to be generally realised that banks have to pay a credit spread that reflects the Government’s standing when they raise funding. A paper delivered at the Kenmare economics conference last October showed that the cost of five-year bank debt, about 4.5 per cent, can be broken down into a three-month interbank rate of less than 1 per cent, a bank guarantee fee of another 1 per cent and a credit spread on Irish Government guaranteed risk of 2.5 per cent.

Combined with the high cost of deposits, this makes it uneconomic for Irish banks to lend at less than 4 per cent. Following recent moves, SVRs are around 3.7 per cent, still below the threshold, while trackers yield just 1.75 per cent. It makes little sense to recapitalise the banks and then allow that capital to be frittered away in further losses.

Getting the spread over German government debt down to more reasonable levels is critical for the viability of banks and Government alike.

Here I see three possibilities. We can wait and see what happens. We could try to give greater certainty regarding the Anglo bailout cost, possibly by postponing all other transfers to Nama until Anglo is taken care of. Or we can take out some insurance by increasing this year’s budget package to €4 billion, as suggested recently by John FitzGerald of the ESRI.

This week’s surprise downgrade by Standard Poors is just the latest reminder that we need to do something.