How much is the bank making on your mortgage?

It’s difficult to avoid mortgages these days. Pick up a paper or turn on the radio and it seems it won’t be long before mortgages make an appearance; no, not people taking them out, but the shocking disparity – of about 2 percentage points – between what Irish property owners are paying on variable interest rates compared to their peers across Europe.

"Mortgage rates are too high, they're not just a little bit higher in Ireland, they're way higher than across the euro zone," says Brendan Burgess of the Fair Mortgage Rates Campaign and founder of consumer forum askaboutmoney.com.

Now the issue is on the legislative agenda. Earlier this month Fianna Fáil tabled a Bill proposing to give the Central Bank extra powers to allow it to have greater control over the course of mortgage interest rates. If it is to be passed into law it could have a significant impact on the Irish mortgage market.

But why does such an anomaly still exist and how profitable is Irish mortgage lending?

European context

If Irish banks are charging over the odds on mortgages, then it stands to reason that they’re earning considerably higher margins – or the differential between what they pay out on deposit accounts and earn on loan products – for their efforts than their European counterparts.

Indeed figures from the European Central Bank (see table) indicate that out of the 27 European Union countries, banks in Ireland earned the seventh highest margins on bank lending in March 2016, and the second highest in the euro zone, second only to Latvia (2.9 per cent). With average margins of 2.8 per cent on mortgage lending, Irish banks are earning considerably more than their counterparts in the UK (1.95 per cent); France (1.8 per cent) and Germany (1.6 per cent). This puts them closer to higher risk eastern European economies that have only recently acceded to the European Union, such as Poland (3 per cent) then the more traditional European economies of Portugal (1.7 per cent) and Spain (1.7 per cent).

This makes Irish bank lending look more profitable than euro zone norms. Indeed the two big Irish banks generate about 200 basis points – or 2 percentage points of net interest margin, according to Fitch’s calculations, for their entire business – not just mortgage lending – and this compares well in a European context.

"It's a pretty good ratio compared to European peers," says Marc Ellsmore, banks analyst at Fitch Ratings.

And it's still improving. In its recent trading update in May, AIB reported a widening of its net interest margin, up from 1.97 per cent for 2015 to 2.09 per cent in the first quarter.

But it’s worth noting that Irish margins haven’t always been so high. Indeed back in 2007 for example, at the peak of profitability – and the peak of competition perhaps too – margins on mortgage lending in Ireland were as low as 1.3 per cent, down from almost 4 per cent back in about 1997. This put it on a par with Germany (1.3 per cent) and Spain (1.3 per cent), although a booming property market in the UK drove margins down as low as 0.3 per cent, or 0.6 per cent in France.

One can infer a number of things from these figures; 1) tracker mortgages may not have been even that profitable for banks at the time; 2) a greater volume of business may drive margins lower; and 3) strong competition may also drive margins lower.

As a report from the Central Bank from 2013 says: “Increased competition in the Irish retail banking industry was a major driver of falling net interest margins prior to the financial market crisis.”

Lower rates, lower profits

However, in the absence of this competition and with a big historic book of tracker mortgages, Irish banks are clinging tightly to higher rates. And any attempts to cut them, will hit their profits.

John Cronin, head of financials research at Investec, estimated that the costs of the latest 0.25 pecentage points rate cut to AIB was of the order of about €30 million, and would have been about €45 million if the cut had also been applied to both EBS and Haven.

If, as expected, AIB goes ahead and cuts rates by a further 50 basis points, this cost will rise.

While bank profitability may typically not be a concern for consumers, in the case of State-owned AIB, diminished profitability may impact on the chances of its much-touted return to private investment.

As Davy Stockbrokers recently warned, if the new mortgage Bill were to force mortgage rates down, it could “be destructive of value in the State’s investments and further impact investor sentiment toward the banking sector”.

Tracker problem

Of course it’s not the Irish banks’ entire mortgage books that are proving to be so profitable. Their significant holdings of tracker mortgages (still about 50 per cent of the entire mortgage book, and as high as 64 per cent at PTSB) limit their ability to increase interest income on their outstanding loan stock or “back book”.

While the tracker burden has diminished over time, it is still a significant drain on a bank. “It continues to act as a drag on profitability,” says Ellsmore.

This means banks are still looking to compensate their loss-making trackers with profitable new lending rates. Prior to 2009, for example, research from the Central Bank shows there was no substantial difference between tracker rates and standard variable mortgage rates. Now however, an SVR on a rate of 3.4 per cent is some 2.4 percentage points above a tracker rate of 1 per cent (ECB plus 1 per cent).

Risky market

For Cronin, part of the reason for the higher rates is to compensate banks operating in the market for the higher risk they are taking on due to difficult repossession rules.

“Enforcing security in the Irish market is very challenging,” says Cronin, adding: “That is not the case in other European markets.”

Indeed Cronin suggest that, historically, Irish mortgage margins were too low.

“The margins weren’t high enough then,” he says. “They should have been higher, given the relative risks banks were running in lending to various customers and in the context of added constraints around enforcing security.”

It’s not just mortgages Irish-based banks are not just looking to mortgages to boost profits: Irish banks are availing of lower funding costs to boost profitability.

“What has helped Irish banks quite a lot has been the fall in funding costs recently,” notes Ellsmore.

And some have also considerably boosted their non-interest income in recent years by increasing fees for banking services.

While AIB has actually seen a big decline in fees earned from retail banking customers, down from €846 million in 2007 to €381 million last year, Bank of Ireland is taking a different approach. Thanks to the disappearance of free banking BOI has managed to grow this income base quite significantly. Indeed it has managed to increase these fees by a considerable 26 per cent, or €100 million more, from 2007, with fees of almost half a billion in 2015 alone.

And banks can also boost their income in another way; by offering less of a return on deposits. After all, the lower the level of interest that is paid out, and the higher the rate of interest that is earned, the larger a bank’s margin will be.

ECB figures also show that Irish banks are offering some of the lowest deposit rates across Europe, and indeed it's now impossible to get a return of 1 per cent in an instant access demand account in Ireland, following cuts by two of the market leaders, Rabobank and KBC Bank. And rate cuts won't stop there.

If, as is expected, AIB goes ahead with a further cut to its variable rate, then it may seek to make up some of the difference by cutting deposit rates; while it may not make up for all it has lost, it will go some of the way.

Embrace switching

So what can be done to drive down rates? Allowing banks to repossess more easily may be one route, but this is likely to be politically unpalatable. Competition, say opponents of the mortgage Bill, is the best way to get rates more in line with European norms. And the Bill works against this.

Indeed Davy Stockbrokers has argued that the Bill will “eliminate the prospect of new market entrants, stymie competition and ill-serve consumers over the longer term”.

"Competitive dynamics will result in the continued decline in mortgage rates," analysts Diarmaid Sheridan and Conall Mac Coille argue.

Burgess is not convinced however, arguing that the competition argument is “absolute nonsense”.

“I agree with the ideological position that we would be better off not having control of mortgage rates,” he says, but adds that experience to date has shown that mortgage rates have to be controlled – “there is no alternative”.

Indeed he notes that the mooted legislation has not been in place for the last few years – and yet no mainstream lender has come in. While Frank Mortgages has oft been touted as a potential new player, offering expected rates of as little as 2.8 per cent, its licence has yet to be approved by the Central Bank.

“The problem in attracting a mainstream lender rather than a niche lender is the size of the market,” he says, noting that the number of eligible switchers is quite small, given the high proportion loathe to give up their trackers, or others who are still in negative equity. And new lending is constrained as a result of the Central Bank’s lending rules.

But there is one area where Irish consumers can drive competition – in the switching market – small as the number of eligible switchers may be. And Government could play its part in facilitating this by making the process easier.

“It’s the appropriate policy response,” says Cronin. “They should make it easier to switch, it does make sense and it would stimulate competition in time.”