The litany of uncertainties hanging over the big two in Irish banking has reversed a rally that ran counter to fundamentals, writes JOHN McMANUS

IRISH BANK shares have comes back down to earth with a bump. This week saw the most precipitous declines, with AIB and Bank of Ireland down 26 per cent and 35 per cent respectively before yesterday. The trend, though, has been evident for several weeks, with both banks down almost 50 per cent from their recent highs.

No one reason explains the reversal but there is a consensus that banks shares are now back at a level more properly reflective of their difficulties and those of the wider economy.

The run-up in Irish bank shares post the announcement last March of the creation of the National Asset Management Agency (Nama) was at odds with the fundamental uncertainties over how Nama would work in practice and when operations would get under way.

The wavering attitude of the Government when it comes to attacking the hole in the exchequer finances also seemed to be ignored by investors.

The rally also had a self-fulfilling aspect. The higher bank shares rose, the less potentially diluting would be the impact of the recapitalisations associated with Nama on the existing shareholders.

Both banks will require fresh capital in order to absorb the losses on the loans being sold to Nama, but their buoyant share prices held out the prospect that the money might come from sources other than the Government.

Something similar is now working in reverse. The more the banks shares fall, the more likely it looks that they will have to call on the Government for more capital.

Not only will this see shareholders greatly diluted, based on today’s prices it could result in the Government having majority control in both banks.

The proximate cause of the sell-off in Irish banks this week is seen as the fairly stringent conditions attached by the European Commission to the rescue of the Dutch financial services group ING. The commission has insisted that the group is broken up into its insurance and banking arms and that it also raise funds through a rights issue.

Eamonn Hughes – an analysts at AIB’s stockbroking subsidiary Goodbody – is of the view that investors had, to a certain extent, been kidding themselves about the extent to which the EU would demand reforms in return for bailouts.

“The ING break-up and rights issue on Monday finally led investors to reappraise the risk profile for banks,” he says, arguing that it is a potential “game changer”.

Given the extent of the bailout being extended to AIB and Bank of Ireland by the Government (the purchase of €77 billion in bad loans at above market prices), investors are right to be wary (albeit belatedly) of what might be demanded in return.

That said – and as Hughes also points out – the Government has worked hand in glove with the European Commission and the European Central Bank (ECB) in putting Nama together. It seems unlikely that the commission would upset the applecart at this stage.

Hughes’s opposite number at Davy Stockbrokers, Emer Lang, is similarly sanguine, pointing out that “the European Commission has already indicated its broad approval of the Nama process, though it has cautioned against overpaying for loans”.

Lang also relies on the fact that 5 per cent of the €54 billion that will be paid to the banks in return for their loans is in the form of subordinated debt, payment of which ultimately hinges on the performance of Nama.

She believes that this, combined with the Government’s commitment to legislate for a separate levy to deal with any possible residual loss at Nama, “would appear to us to tick the necessary boxes in the commission guidelines for state aid”.

She even goes as far as to postulate that a commission-driven break-up of the Irish banks might not be a bad thing.

Dan O’Connor, the chairman of AIB, did not appear to be quite so confident when questioned yesterday at the Irish Bankers’ Federation conference. He warned that the bank could face “serious consequences” as a result of accepting State support.

“We have seen what’s happened this week in terms of ING . . . Draconian measures have been taken.”

He said AIB expects three to six months of active negotiations with EU authorities once it submits its restructuring plan. “We don’t know what’s going to happen to our organisation but certainly it’s going to have serious consequences,” he said.

Bank of Ireland filed its restructuring plan with the European Commission in September, and AIB may submit its plan next month. Also contributing to the banks’ woes this week were comments by the Minister for Finance Brian Lenihan to the effect that Nama may be delayed. The agency’s business plan, published earlier this month, envisaged that the 10 largest exposures, accounting for €16 billion of the total loans of €77billion, would by transferred by the end of the year.

Lenihan’s comments are interpreted as meaning that this may slip into January. What is not clear is the extent to which his comments reflected impatience with his parliamentary colleagues who are currently debating the Nama legislation in committee or a growing realisation that valuing and shifting the loans will be more difficult than originally thought.

The net result of this week’s events is that shares in the two main Irish banks have given up the bulk of their gains of the past six months. The question is where do they go from here? While it is theoretically possible to make an investment case for the banks, in practice it’s extremely difficult.

Once the banks have transferred their property and development loans to Nama, they will be left with their strong and profitable Irish and international businesses. They will have predictable profits – albeit dependent for the most part on the stuttering Irish economy – and a peer group against which they can be measured. All of this makes possible a judgment as to whether they offer good value or not at current prices.

But the litany of uncertainties associated with Nama – including what conditions if any will be attached to the rescue by the commission – means that, for the time being, such judgments cannot yet be made with any sort of accuracy.

The clouds, however, should start to clear in the coming months with the establishment of Nama. “It’s back to one step at a time,” according to Hughes.