www.davy.ie Bloomberg: DAVY
November 4, 2011
Rating: OUTPERFORM Issued 04/11/11 Equity Report: Company update
Previous: UNDER REVIEW Issued 04/01/11
Bank of Ireland Emer Lang [email protected] / +353 1 6148925 Price: 9c
Share Price Performance 300 200 Making steady progress 180
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100 80 100 60 Recapitalised to withstand the anticipated challenges 40 20 • The Irish PCAR/PLAR process has credibly recapitalised Irish 0 0 Oct 08 May 09 Oct 09 Apr 10 Oct 10 Apr 11 Oct 11
BKIR price (c) Rel to FTSE E300 banks index (rhs) banks to deal with anticipated losses from impairments and Key financials (€m) deleveraging. The Irish economy remains largely on track, Year end Dec11E Dec12F Dec13F Net Interest Income 1580.0 1530.0 1740.0 although risks remain; our GDP estimates are broadly in line Other Income 550.0 660.0 730.0 with base PCAR. Total Income 2130.0 2190.0 2470.0 Total Costs 1640.0 1600.0 1560.0 • Unemployment, a key driver of mortgage arrears, is running Bad Debts 1723.0 1200.0 900.0 Associates 35.0 45.0 45.0 1% higher (14.4% versus 13.4%) but looks to have stabilised. Exceptionals 1867.0 -500.0 0.0 FRS3 PBT 669.0 -1065.0 55.0 • Our central case puts Bank of Ireland (BKIR) non-NAMA EPS Basic 4.0 -3.5 -0.5 impairments at €6.7bn. Our PLAR estimate is €1.7bn, EPS Diluted (Adj) -8.6 -2.2 -0.5 Total Assets 150627 136001 129681 including €1.2bn for disposals of €10bn (€5bn has already Ord. Share. Funds 7832 7058 7150 been sold at an average 9.5% discount). Each €1bn hit is Valuation P/E N/A N/A N/A equivalent to 2.7c in the context of our revised end-2013 Dividend Yield (%) N/A N/A N/A TNAV of 22.6c (previously 24c). Price / Book 0.4 0.4 0.4
Company data Funding headwinds remain Reuters/Bloomberg/Xetra BKIR.I/BKIR ID/BIR Sector European banks index • The cost of customer deposits remains elevated; reducing the Shares (m) 30132.5 premium rates paid is a prerequisite for margin rebuild. A Daily No. Shares Traded (m) 90.181 52 Week High/Low 49.61255/6.8 flatter interest rate trajectory makes this task all the more Free Float (%) 57.9 challenging; hence we have trimmed our margin estimates. Mkt. Weight (%) 4.2 Mkt. Cap (€m) 2802.3 • A managed exit from the government funding guarantee (ELG) is key to restoring pre-provision operating profits. Our Summary of nearest peer-group valuations P/E PEG Div Yield Price/Book analysis demonstrates that provided deleveraging is kept on Banco Popular Espanol R et ail track, BKIR can be selective in terming out its funding. b a n ks in 8.8 N/A 5.7 0.5 d ex Barclays Play on Irish economic recovery R et ail b a n ks in 5.2 0.4 4.4 0.4 d ex Danske Bank • BKIR is geared to an Irish recovery and, all going well, our R et ail b a n ks in 6.3 0.2 5.2 0.5 d ex end-2013 TNAV of 22.6c, which hinges on successfully KBC R et ail b a n ks negotiating a number of hurdles (both macro and bank- in 2.7 N/A 5.9 0.4 d ex RBoS R et specific), implies attractive upside from here. ail b a n ks in 6.8 N/A N/A 0.4 d ex
• In the context of a sector plagued by uncertainty, BKIR is Recent research and research resources progressing its recovery plan; we rate the shares 'outperform'. Recent research and financial data on Bank of Ireland Sector research and data on European banks index
Please refer to important disclosures at the end of this report. J&E Davy, trading as Davy is regulated by the Central Bank of Ireland. Davy is a member of the Irish Stock Exchange, the London Stock Exchange and Euronext. For branches in the UK, Davy is authorised by the Central Bank of Ireland and subject to limited regulation by the Financial Services Authority. Details about the extent of our regulation by the Financial Services Authority are available from us on request. All prices are as of close of business November 2nd unless otherwise indicated. All authors are Research Analysts unless otherwise stated. For the attention of US clients of Davy Securities, this third-party research report has been produced by our affiliate, J&E Davy. Equity Report: Bank of Ireland November 4, 2011
A play on Irish recovery
One of Ireland's two 'Pillar' banks BKIR has emerged from an Bank of Ireland (BKIR) has emerged from an extensive sector extensive sector restructuring and recapitalisation as one of Ireland's restructuring and recapitalisation as one of Ireland's two designated two designated 'Pillar' banks and 'Pillar' banks and the only Irish bank to have avoided almost complete the only Irish bank to have avoided nationalisation. The €1.1bn investment by a private investor group in almost complete nationalisation the bank's recent fundraising diluted the government's stake from 36% previously down to 15.1%, leaving 84.9% in private hands. The bank raised €3.8bn (net of costs) of its directed equity raise of €4.2bn and has until the end of 2011 to raise the residual €0.4bn. It is anticipated that this will come from liability management. The latest European Banking Authority (EBA) capital test, which marked to market banks' end-June sovereign bond exposures to September values, concluded that Irish banks need no further capital to meet a target Core Tier 1 ratio of 9% by mid-2012.
BKIR's €3.8bn included a €1.9bn rights issue at 10c per share. Excluding the state's 6.9bn entitlement, private shareholders subscribed for 36.8% of their rights, leaving a rump of 7.7bn shares. A total of 1.43bn of these were placed with investors at 10.1c per share, with the remaining 6.3bn shares taken up by the state which subsequently sold 10.5bn shares to the new investor group. The broad mix of investors after the rights issue/conversion of bondholder allotment instruments (on August 12th) is summarised in Table 1.
Table 1: BKIR shareholders
Government 15.10% New investor group 34.90% Previous/new shareholders 31.00% Bond holders 19.00% 100.00% Source: BKIR; Davy estimates
Market-leading position in right-sized banking system The recapitalised bank's fate is The recapitalised bank's fate is inextricably linked to the medium- to inextricably linked to the medium- long-term fortunes of the Irish economy (we assume that the ECB will to long-term fortunes of the Irish facilitate an orderly weaning off its funding support). It will enjoy a economy market-leading position in a recapitalised, consolidated and right-sized banking system. The Irish economy is stabilising and is expected to deliver attractive growth in the medium to long term. However, the pace of what is anticipated to be an export-led recovery will depend on a number of macro factors – not least global economic fortunes. Anticipated weaker demand for Irish exports is a key factor behind our recent downgrade to our 2012 GDP forecasts (please see our report, "Reducing GDP forecasts; downside risks from the global slowdown," issued September 19th 2011, for more detail).
Domestic demand, more relevant to the bank's performance, remains weak. An economic recovery is key to the rehabilitation of the sovereign, which will remain reliant on IMF/ECB support until 2013, with the prospect of the EFSF thereafter. Eurozone crisis developments have been keeping markets on tenterhooks; they initially reacted favourably to
2 Davy Research Equity Report: Bank of Ireland November 4, 2011
Ireland's determination to European leaders' October 26th announcement of the broad outline of a implement the required austerity recovery plan for the crisis but reacted negatively to the subsequent measures is being acknowledged; announcement on November 1st that Greece would hold a referendum Irish 10-year bond yields have on its euro membership/bailout package (subsequently abandoned). For fallen to around 8% from their now, Ireland's determination to implement the required austerity summer peak of over 14% measures is being acknowledged; Irish 10-year bond yields have fallen to around 8.2% from their summer peak of over 14%.
Focus on deleveraging; impairment management Arising from the Central Bank's Prudential Capital and Liquidity Assessment Reviews (PCAR and PLAR), a recapitalised BKIR is now A recapitalised BKIR is now focusing on deleveraging to transform its funding profile and on focusing on deleveraging to transform its funding profile and minimising impairment losses. The bank is targeting the required loan- on minimising impairment losses to-deposit (LTD) ratio of below 122.5% by the end of 2013 while extricating itself from the government's eligible liabilities guarantee (ELG) (ELG fees will cost an estimated €480m this year). The bank estimates that incremental 2011-2013 impairment losses can come in at circa €2.5bn compared with the PCAR base case estimate of €3.9bn (we are forecasting €3.2bn).
Rebuilding operating profits combined with a reversion to ‘normalised’ Rebuilding operating profits combined with a reversion to impairment losses can deliver attractive medium-term returns. Assuming ‘normalised’ impairment losses can the cost of both PCAR/PLAR can be contained below official base case deliver attractive medium-term estimates, we see group tangible net assets of circa €6.8bn at the end of returns 2013 compared with the pro-forma €8.4bn reported at the end of June 2011. The current market cap of €2.8bn stands at a substantial discount to this. The restoration of Ireland's fortunes, coupled with delivery of the bank's medium-term objectives, can narrow this current deep discount to TNAV.
Outperformance hinges on transforming funding; containing impairments The bank's success will be measured by its progress in tackling two key issues, namely funding and impairment.
The funding challenge encompasses: reducing the over-reliance on wholesale funding, principally through deleveraging; rebuilding the net interest margin; extricating the bank from the government guarantee.
The first half of 2011 saw some The first half of 2011 saw some progress in deleveraging through book progress in deleveraging through run-off, helped by currency moves, but margins continued to contract as book run-off, helped by currency funding headwinds weighed. Recent confirmation of loan divestments of moves, but margins continued to €5bn, the €4.54bn proceeds of which will be used to repay down contract as funding headwinds weighed monetary authority reliance, is encouraging (discount of 9.5% is better than expected).
A return to more 'normal' impairment losses looks some way away, but containing losses close to the bank's own estimates (€6bn), which are within base case PCAR (€7.4bn), would be a very positive outcome.
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BKIR's key financial targets
2014 targeted for a return to more 'normal' profits BKIR set out its medium-term financial targets in June and reiterated these at the interim results stage (August). In particular, the bank BKIR reiterated that it was reiterated that it was targeting a net interest margin of over 2% in 2014, targeting a net interest margin of over 2% in 2014, a 50% increase on a 50% increase on the first half 2011 level. Reducing the unsustainable the first half 2011 level prices being paid for customer deposits can be a key driver as can higher loan pricing. We look at the prospect for margin enhancement through both these sources in more detail later, but the fact that the prospect of rate rises (both euro and sterling rates) has diminished is a mixed blessing. On the one hand, clawing back deposit subsidies will be much more difficult in a flat rate environment, although it may make re- pricing loans a bit easier (and also has positive implications for asset quality). On balance, we see flatter rates as a negative for margins and are trimming our estimates accordingly.
Targeting pre-provision operating profit (PPP) rebuild The bank's targets are broadly consistent with pre-provision operating The bank's targets are broadly profits of circa €1.5-1.6bn. BKIR is targeting 55-65bps of average loans consistent with pre-provision operating profits of circa €1.5-1.6bn as a more 'normal' impairment charge in 2014. Ultimately, accounting rules (currently under review) will have a say in how much banks can put aside, but assuming the mid-point of the bank's target would leave PBT in a €900m-€1bn range in 2014.
Table 2: Progress towards key financial targets in H1
Measure Dec 2010 June 2011 Dec 2014 target Customer loans (net) €114bn €107bn €90bn Loan/deposit ratio 175% 164% <120% Government guarantee ELG scheme in place ELG scheme in place Disengaged for new issuance/rollovers Net interest margin % 1.46% 1.33% >2% Cost/income ratio 63% 83% <50% Impairment charge €1.8bn (FY) €842m (H1) 55-65bps Core Tier 1 capital 9.7%/15.4% pro-forma 9.5%/15.4% pro-forma Margin maintained over regulatory minimum Source: BKIR
Low rates make margin trajectory more challenging We are taking a more cautious view on the margin potential for now, given the prospect of rate rises has receded (the ECB cut rates from 1.5% to 1.25% on November 3rd), and we are forecasting 1.68% in 2014 (1.8% previously). In Table 3 we show how pre-provision operating profits might be rebuilt over the next few years assuming a margin of 2% (BKIR target) or 1.68% (Davy forecast).
Extrication from ELG is a game-changer Reducing ELG fees to a residual €70m (the latter may still be too high if the bank can extricate itself as planned as it currently only has one guaranteed bond that will remain in issue; €2.5bn with a maturity of 2015) would make a big difference. The other key component of the pre-provision profit recovery comes from the net interest margin.
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Cost progress needs to be maintained We are forecasting a further net Costs have been reducing as the bank has completed the reduction of €100m in costs between 2011 and 2014 restructuring/transitioning of its major infrastructural contracts. Staff- related costs are falling, reflecting lower numbers employed by the group and the steps taken in 2010 to deal with the structural deficit in our pension funds. We are forecasting a further net reduction of €100m in costs between 2011 and 2014.
Table 3: Rebuilding pre-provision operating profits
Assume: Margin of 2% (BKIR target) Margin of 1.68% (Davy forecast) Trough PPP 2011 (Davy 490 490 forecast) ELG fee reduction 410 410 NIM uplift, inc IFRS adjustments 510 110 Other income 50 50 Costs 100 100 PPP 2014 1560 1160 Source: Davy
Sensitivity analysis
Reconciling our forecasts to adverse PCAR/PLAR The Central Bank's Financial Measures Programme Report on March 31st 2011 included forecasts of each bank's evolution of available capital under the severe macroeconomic conditions and 'conservative forecasting assumptions of the stress scenario'. It suggested that BKIR's capital, pre the incremental capital raise, would be depleted (albeit it was the only bank to maintain a positive balance) over the 2011-2013 period (Table 4). These calculations and the associated available capital resources determined the bank's capital requirement of €5.2bn (equity €4.2bn; CoCo €1bn). Adding the residual €2.5bn equity capital raise and deducting remaining government preference shares of €1.8bn implies end-2013 equity of €2.02bn.
Table 4: Stress case pre-injection available capital
2011 2012 2013 Core Tier 1 (inc €1.7bn from Nov 2010 target) 4,241 2,640 1,320 New equity capital 2,500 2,500 2,500 Adjusted Core Tier 1 6,741 5,140 3,820 Deduct government prefs -1,800 Adjusted core equity 2,020 Source: Central Bank; Davy estimates
We reconcile our forecast tangible net assets of €6.8bn at the end of 2013 to this adverse scenario level in Table 5; the key adjustments not Our forecast end-2013 group net surprisingly relating to PCAR impairment losses and PLAR deleveraging tangible assets of €6.8bn is losses, where we are assuming a more optimistic outcome. Following the significantly above the adverse recent €5bn disposals at a discount of 9.5% and recognising that the stress scenario level; in per share disposal market is getting more crowded, our revised forecasts assume terms, our TNAV is 22.6c compared with the adverse scenario outcome that disposals of €10bn can be achieved at an average 12% discount (up of 6.7c from 10% previously). Our forecast end-2013 group net tangible assets of €6.8bn is significantly above the adverse stress scenario level; in per share terms, our TNAV is 22.6c compared with the adverse scenario
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outcome of 6.7c. Should our assumptions prove optimistic, our NAV sensitivity to an incremental €1bn pre-tax hit is 2.7c per share.
Table 5: Reconciliation of net assets
2013F Shares (bn) Per share (c) Core equity - post recap adverse scenario per CB 2,020 30.1 6.7 Add: after-tax adjustments: Impairment provisions: Davy pre-tax €6.7bn vs. PCAR €10.1bn 2,750 PLAR provisions: Davy pre-tax €1.7bn vs. PLAR €3bn (estimate) 1,193 Other adjustments (operating profits, reserves etc) 864 Davy forecast net tangible assets 6,827 30.1 22.6 Sensitivity to higher charges: either PCAR or PLAR Assume an extra €1bn 6,017 30.1 19.9 Source: Central Bank; Davy forecasts
Focus on margin; impairment Looking at it a different way, in Table 6 we stress our forecasts for three key assumptions: a flat net interest margin trajectory, adverse scenario impairments and adverse PLAR. We assume the margin in 2012 and 2013 is in line with the 2011 figure of 1.35% and that the bank incurs the PCAR adverse scenario impairment losses of €10.1bn and adverse PLAR losses of an estimated €3bn. The result is a TNAV of 9.2c at the end of the period compared with the 6.7c in Table 5.
Table 6: Davy sensitivity analysis
2011F 2012F 2013F Existing pre-provision profit 490 590 910 Existing margin assumption 1.35% 1.40% 1.54% Assume no margin rebuild 1.35% 1.35% 1.35% 'Stress' pre-provision profit 490 524 673 NAMA 1 and 2 423 200 0 Existing non-NAMA impairments 1300 1000 900 Other 35 45 45 Existing LBT (pre-exceptional) -1198 -565 55 Adverse PCAR impairments 2680 2065 1855 Adverse PLAR hit 1000 300 9 'Stress' LBT -3578 -1995 -1138 Incremental LBT -2380 -1430 -1193 After-tax -1928 -1158 -966 Existing TNAV per share (c) 24.8 22.3 22.6 'Stress' TNAV per share (c) 18.4 12.0 9.2 Source: Davy
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Valuation Valuation and performance metrics are summarised in Table 7. The shares have underperformed a weak E300 bank sector ytd, leaving them trading at 0.4x our end-2012/2013 TNAV forecasts, a sector relative of 0.8x. Banks have been one of the worst-performing sectors in the E300 Index ytd (30th of 33) or over the past 12 months (33rd), although their ranking has improved a bit (27th) over the past month as markets began to take the view that the eurozone crisis will be resolved by hook or by crook. Initial reaction to European leaders' October 26th announcement of a road-map to crisis resolution was favourable but proved short-lived as Greek Prime Minister George Papandreou's announcement that Greece will hold a referendum on its bailout package, prompting speculation that this could lead to a disorderly default rather than the planned orderly default, took its toll.
BKIR shares have outperformed E300 banks (by 12.8%) in the past three months, effectively since the July recap, which also satisfied the European Banking Authority's (EBA) July stress test. The plan announced on October 26th includes a proposal for European banks to raise another €106bn capital to create a temporary buffer (Core Tier 1 hurdle has been set at 9% by mid 2012) to allow for a marking to market of their sovereign exposures. BKIR does not require incremental capital to meet this latest test.
Since its end of July recapitalisation, BKIR has: demonstrated that it can access wholesale markets through the issuance of secured unguaranteed debt (€4bn to date); benefited from first mover advantage to sell €5bn of loans, half its end 2013 disposal target of €10bn, at a lower-than-expected discount (of 9.5%).
With its recovery plan well on track, we rate the shares 'outperform' in the context of a sector that continues to face capital and funding challenges.
Table 7: Valuation
2011 2012 2013 2011 rel 2012 rel 2013 rel P/E n/a n/a n/a n/a n/a n/a Mkt cap/operating profits 5.72 4.75 3.08 n/a n/a n/a Price/book 0.36 0.40 0.39 0.7 0.8 0.8 Price performance 1 wk 1 mth 3 mths 6 mths Ytd 1 yr Absolute -7.0 20.8 -7.9 -66.5 -75.0 -81.3 Rel to ISEQ -5.0 15.8 -4.4 -61.5 -72.4 -80.7 Rel to E300 -5.8 14.8 -0.6 -60.1 -71.2 -78.9 Rel to E300 Banks -5.4 19.3 12.8 -50.1 -63.9 -71.5 Price and P/E history High Low Yr end High Low Avge 2011 40 7 2010 120 25 37 6.3 n/a 2.0 2009 216 8 84 11.3 n/a 4.1 2008 661 43 53 7.3 0.5 4.2 2007 1176 561 643 15.9 6.2 11.2 2006 1104 826 1104 15.3 11.2 13.4 Source: Davy
7 Davy Research Equity Report: Bank of Ireland November 4, 2011
Figure 1: BKIR rel E300 Banks Index
0.55 0.55
0.50 0.50
0.45 0.45
0.40 Greek 0.40 referendum announcement 0.35 0.35 PCAR/PLAR 0.30 0.30
0.25 S&P 0.25 downgrades 0.20 Ireland Ireland's €85bn Significant private EBA sov stress 0.20 bailout investment test 0.15 Interims 0.15
0.10 0.10 Cap raise 0.05 0.05 Oct 10 Nov 10 Dec 10 Jan 11 Feb 11 Mar 11 Apr 11 May 11 Jun 11 Jul 11 Aug 11 Sep 11 Oct 11 Nov 11
Bank of Ireland Eurobanks (Rebased) Source: Factset
Figure 2: BKIR rel Irish 10-year bond
1.00 1.00
0.90 10 yr yields 0.90 peak at 14% 0.80 0.80
0.70 0.70
0.60 0.60
0.50 0.50
0.40 0.40 Yields dip below 8% as 0.30 investors acknowledge 0.30 Ireland's austerity 0.20 progress 0.20
0.10 0.10
0.00 0.00 Oct 10 Nov 10 Dec 10 Jan 11 Feb 11 Mar 11 Apr 11 May 11 Jun 11 Jul 11 Aug 11 Sep 11 Oct 11 Nov 11 Bank of Ireland 10-year Government Bond
Source: Factset
8 Davy Research Equity Report: Bank of Ireland November 4, 2011
Funding remains the key challenge
Unsecured issuance is at a decade low
The funding environment for The funding environment for Europe's banks in general remains fraught Europe's banks in general remains as sovereign debt concerns have persisted. According to data provider fraught as sovereign debt concerns Dealogic, the amount of senior unsecured debt issued by the continent's have persisted financial institutions in the quarter ended September 2011 was the smallest of any quarter in more than a decade. Most issuance was in bite- size deals of less than $500m apiece. Traditionally, issuing such debt has been among the most popular ways for banks to finance themselves over the long term.
It is estimated that the banks face a debt mountain of nearly €800bn that will be due in 2012. Much of it will need to be replaced with new debt or banks will be faced with the prospect of shrinking their balance sheets. Europe’s banks are seeking increasingly creative ways to finance themselves as they attempt to make up for a dearth of traditional debt funding amid market turmoil. Reports suggest a renewed focus on covered bonds, 'quasi' covered bonds, collateral swaps and longer-term repos.
EBA advocates guarantees As part of the broad plan to resolve the crisis, the EBA advocated "public guarantee schemes" to support banks’ access to term funding on reasonable conditions. What exactly it envisages is unclear, but it suggests that guarantees would help banks to continue their lending activities in 2012 and "avoid a spiral of forced deleveraging and the ensuing credit crunches", which would affect the real economy.
BKIR's priority is to deleverage, predominantly foreign assets
The key focus for BKIR has been Against this backdrop, the key focus for BKIR has been reducing its reducing its reliance on wholesale reliance on wholesale funding, including monetary authority support, by funding, including monetary deleveraging. Under the Central Bank's PLAR, the bank envisages authority support, by deleveraging reducing its loan book from €114bn (net of provisions) at the end of 2010 to €90bn by the end of 2014. The €114bn included a net €3bn (€4.5bn gross) of smaller (<€20m) land and development loans remaining with the bank.
The net reduction of €24bn reflects a gross €30bn, less anticipated new core lending of €6bn over the period. It includes planned disposals of c.€10bn, €5bn of which have been completed, with the balance expected in late 2011/early 2012. The other circa €20bn gross is expected to come from book run-off/redemptions. There were no disposals in the first half, but run-off/redemptions reduced the book from €114bn to €107bn (albeit helped by currency) – leaving the bank well on track. There was a corresponding €9bn reduction in the level of wholesale funding from €70bn at the turn to the year to €61bn at the mid-year stage.
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Table 8: BKIR – key funding metrics (€bn)
Dec 2010 % June 2011 % Customer loans (net) 114 107 Customer deposits 65 65 Loan to deposit (LTD) ratio % 175% 165% Wholesale funding profile Senior bonds, bank deposits and CP/CD 20 29 12 20 Securitisations 5 7 5 8 Covered bonds 7 10 7 11 Market bilateral repos 7 10 7 11 Central Bank of Ireland 8 10 7 11 Other monetary authority reliance 23 34 23 38 Total wholesale funding 70 100 61 100 Of which < 1 year 48 68 42 69 Of which > 1 year 22 32 19 31 Source: BKIR
Deleveraging progress is critical Our simple cash flow analysis in Table 9 demonstrates that cash generated from net deleveraging/disposals together with other sources can meet maturing liabilities as they fall due and pay down monetary authority reliance. Other sources of cash include the €4bn proceeds of secured market issuance in June/July/October, the €1.9bn cash element of the capital raise (the rest was generated from LME), the €1bn government CoCo, some other modest inflows (AFS maturities, NAMA bonds etc) and deposit growth (from 2012 onwards).
Our model is purely illustrative; for instance, it assumes that the bank will not raise any further new term funding over the period, which is clearly overly simplistic as the bank will want to term out its funding further. However, it demonstrates that the bank has some breathing space and is not under any immediate pressure to raise wholesale funding at any cost.
Our summary in Table 10 shows how cash generation of €45bn over the Our assumed €10bn deposit inflows period would leave the bank's wholesale funding requirement at €25bn, (BKIR is targeting €10-15bn) would well below the €70bn total coming into 2011. Our assumed €10bn leave the key LTD ratio at 120%, meeting the target of <122.5% deposit inflows (BKIR is targeting €10-15bn) would leave the key LTD ratio at 120%, meeting the target of <122.5%.
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Table 9: BKIR funding trajectory (assuming no further term issuance)
Cash generation In 2011 In 2012 In 2013 In 2014 Net deleveraging of €24bn less disposals - €14bn 5.0 5.0 4.0 0.0 Disposals of €10bn (assume avg 12% discount) 6.0 2.8 0.0 0.0 Cash element of equity capital raise 1.9 0.0 0.0 0.0 Government CoCo 1.0 0.0 0.0 0.0 Deposits 0.0 2.5 3.5 4.0 AFS maturities 1.0 1.0 1.0 1.0 NAMA bonds (€bn) 0.1 0.1 0.3 0.6 Secured funding 4.0 0.0 0.0 0.0 19.0 11.4 8.8 5.6 Dec Repay At Dec Repay At Dec Repay At Dec Repay At Dec Liabilities 2010 in 2011 2011 in 2012 2012 in 2013 2013 in 2014 2014 Monetary authority reliance 34.0 16.2 17.8 6.7 11.1 2.7 8.5 2.2 6.3 Government guaranteed term debt 5.9 0.1 5.8 1.5 4.4 1.5 2.9 0.0 2.8 Other wholesale 30.1 2.8 27.3 3.3 24.0 4.6 19.4 3.3 16.1 Total wholesale funding 70.0 19.0 51.0 11.4 39.5 8.8 30.7 5.6 25.2 Customer deposits 65.0 0.0 65.0 2.5 67.5 3.5 71.0 4.0 75.0 Total funding base/net repayment 135.0 19.0 116.0 8.9 107.0 5.3 101.7 1.6 100.2 Source: Davy estimates
Table 10: Funding summary
Wholesale funding 1.1.11 70 Inflows 2011-2014 Deposit inflows 10 AFS maturities 4.0 NAMA bonds 1.1 Unsecured funding 4.0 Asset disposals 8.8 Net run off 14 Capital raise 1.9 Coco 1.0 Total cash generation 44.8 Wholesale funding 31.12.14 25.2 Source: Davy estimates
Banking on lower PLAR cost Our model assumes that disposals Our model assumes that disposals of €10bn of loans can generate of €10bn of loans can generate proceeds of circa €8.8bn proceeds of circa €8.8bn. This implied 12% discount is well below the average level envisaged by the Central Bank; the €24bn capital the sector was directed to raise included €13.2bn for deleveraging, but asset sales to date suggest this may prove high. Our calculations suggest that it incorporates a provision of €9.5bn for disposals of €35bn, an average discount of 27% which we continue to believe looks on the high side notwithstanding a more crowded market, as a number of European banks now see asset sales as an attractive alternative to capital raises. In its latest Global Debt Sales report, KPMG notes that since the end of 2010, activity has started to gather pace in the European debt sale market with an increasing number of banks sounding out market interest for their portfolios.
11 Davy Research Equity Report: Bank of Ireland November 4, 2011
€5bn sales at 9.5% discount leaves BKIR halfway towards target To date the bank has announced divestments of circa €5bn of its non- core loan portfolios at an average discount of 9.5%. The €5bn comprises five separate components including US Commercial Real Estate (CRE), UK CRE, UK mortgages, project finance and UK corporate loans. The portfolio prices range from par for its US$1.13bn CRE book (sold to Wells Fargo) to a discount of 19.5% for its £1.33bn UK CRE book (sold to investor Kennedy Wilson and institutional partners). UK mortgages of £1.23bn were sold to a subsidiary of Nationwide Building Society, The Mortgage Works, at an 8% discount, while a pool of project loans (drawn balances €0.57bn) were sold to GE Energy Financial Services at an 11% discount. BKIR notes that the capital impact (neutral as the discount is offset by the RWA reduction) is lower than the assumptions used in its own financial targets.
We are assuming an average of 15% on the residual €5bn. The The announced disposals leave the announced disposals leave the bank halfway towards its target of €10bn bank halfway towards its target of by end-2013. Our model assumes a €1.2bn hit on the overall €10bn €10bn by end-2013 (revised from €1bn previously in light of the higher loan volumes coming onto the market); hence it implies a residual €740m (almost 15%) on the remaining €5bn.
Table 11: Bank of Ireland: deleveraging progress
Businesses Assets 1. Sold Foreign Currency Exchange for $42m 1. Sold US commercial property portfolio 2. Sold 50% stake in Paul Capital for $13m 2. Sold UK commercial & residential property portfolios 3. Announced disposal of Bank of Ireland Security 3. Sold project finance loans Services 4. Sold BIAM for €57m 4. Managed down UK corporate loan book Source: BKIR
Table 12: Details of loan sales
Disposals Loans local Loans Price Discount % Buyer currency €m €m US commercial real $1.13bn 0.82 0.82 0.0% Wells Fargo estate UK commercial real £1.33bn 1.52 1.22 -19.5% Kennedy Wilson & Ptnrs estate UK mortgages £1.23bn 1.41 1.29 -8.1% The Mortgage Works Project finance €0.57bn 0.57 0.51 -11.0% GE Energy Fin'l Services UK corporate banking €0.7bn 0.70 0.70 0.0% Pro-active management Aggregate 5.01 4.54 -9.5% Source: BKIR
The group notes that it continues to make good progress in relation to The group notes that it continues the sale processes in respect of other non-core loan portfolios, including to make good progress in relation being in advanced discussions with potential purchasers in relation to its to the sale processes in respect of Burdale assets and other loan assets within its project finance loan other non-core loan portfolios portfolio.
12 Davy Research Equity Report: Bank of Ireland November 4, 2011
Funding costs weigh heavily on the margin
The group's net interest margin fell The group's net interest margin fell to 133bps in the first half of 2011 as to 133bps in the first half of 2011 elevated deposit and wholesale funding costs continued to take their toll. as elevated deposit and wholesale This figure is before the cost of the government guarantee (ELG); funding costs continued to take including it and IFRS adjustments, the margin was 1.09%. their toll Figure 3: Net interest margin
1.8%
1.7%
1.6%
1.5%
1.4%
1.3%
1.2% 2006 2007 2008 2009 2010 2011 2012 2013 2014
Source: BKIR
No let-up in deposit competition as banks guard against outflows The battle for domestic deposits The battle for domestic deposits continues to be intense, with no sign of continues to be intense, with no sign of any easing in the any easing in the unsustainable rates being paid, notwithstanding more unsustainable rates being paid stability in banks' retail deposits bases in recent months, the recapitalisation of the sector and the effective removal of three competitors (PTSB acquired the deposits of INBS and Northern Rock, while ALBK took over the Anglo deposit book). The Irish covered deposit-taking banks (BKIR, ALBK/EBS and PTSB) continue to populate the best buy tables alongside KBC Bank and Nationwide UK. Although it offers lower rates, Rabobank's AAA credit rating continues to attract deposits. However, its base is small in the context of Irish private sector deposits of €144.5bn at the end of August; the Irish subsidiary's annual report shows it had customer deposits of €3.7bn at the end of 2010, the bulk (€3.5bn) of which was for a term of three months or less.
Table 13 shows trends in deposits for the Irish domestic banking system (incorporating 20 banks including Danske, KBC and Rabobank) since the beginning of 2010, split between resident and non-resident deposits. There were substantial outflows in 2010, particularly of ratings-sensitive corporate deposits (mainly non-resident RoW deposits) as the sovereign debt crisis unfolded. There has been further outflows in 2011, albeit deposits have been more stable since the July sector recapitalisation.
13 Davy Research Equity Report: Bank of Ireland November 4, 2011
Table 13: Irish 'domestic' banks deposit trends
€bn Private sector MFIs Government Non-res Euro Non-res RoW Total December 2009 176.2 131.1 3.3 26.4 202.2 539.2 January 2010 175.2 133.9 3.1 29.4 202.4 544.0 February 2010 176.9 127.3 2.8 27.9 198.4 533.3 March 2010 175.0 130.3 3.0 25.1 194.3 527.8 April 2010 175.4 130.2 3.2 24.6 186.3 519.7 May 2010 173.8 132.8 3.4 25.0 193.9 529.0 June 2010 170.9 132.7 3.0 24.2 192.8 523.6 July 2010 170.0 131.4 3.1 29.8 194.3 528.5 August 2010 169.3 129.3 3.1 29.6 193.1 524.4 September 2010 166.1 134.7 3.1 24.4 178.5 506.8 October 2010 166.7 133.5 3.2 22.4 170.6 496.4 November 2010 160.4 133.3 3.3 17.6 155.0 469.7 December 2010 157.1 131.5 3.4 16.2 121.1 429.3 Change in 2010 -19.1 0.4 0.1 -10.2 -81.1 -109.9 January 2011 155.6 124.7 2.9 17.1 109.0 409.4 February 2011 153.6 132.8 3.1 17.1 99.1 405.8 March 2011 151.6 122.0 8.9 16.4 93.8 392.7 April 2011 153.6 117.7 21.7 15.1 92.0 400.0 May 2011 152.8 94.4 21.6 14.2 91.1 374.0 June 2011 147.2 99.8 21.5 13.6 85.1 367.3 July 2011 146.1 100.1 2.3 13.3 86.8 348.7 August 2011 144.5 101.8 2.4 13.2 87.4 349.3 September 2011 142.8 103.3 2.7 13.2 90.2 352.2 Year to date -14.3 -28.2 -0.7 -3.0 -30.9 -77.1 Source: Central Bank
Deposit flows are a key gauge of confidence Trends in private sector deposits are crucial as they represent deposits from domestic individuals and businesses and as such are an important gauge of the health of this domestic cohort and also their confidence in 'domestic' banks. The banks experienced outflows of resident private sector deposits during 2010, albeit on a somewhat smaller scale, helped by the attractive rates on offer and the backing of the ELG for deposits above the insured threshold of €100,000.
'Covered' banks' deposits are broadly stable since July Within the 'domestic' banks figure, 'covered' banks' private sector deposits stood at €113.7bn at the end of 2010. They have proved more resilient in the past few months, albeit they are down by €11.6bn (10%) to €102.1bn ytd. Since the Irish bank recapitalisation in July, deposits have been broadly stable, but rates are likely to remain high for the foreseeable future as banks are determined to guard against any resumption of outflows.
14 Davy Research Equity Report: Bank of Ireland November 4, 2011
Table 14: Irish 'covered' banks' deposit trends
€bn Private sector MFIs Government Non-res Euro Non-res RoW Total December 2010 113.7 117.5 3.1 5.4 98.2 337.9 March 2011 106.3 109.3 8.6 4.3 73.5 302.0 June 2011 103.5 85.4 21.1 2.8 67.0 279.8 July 2011 102.6 86.0 1.9 2.9 68.0 261.4 August 2011 102.2 88.2 2.0 2.6 68.0 263.0 September 2011 102.1 89.5 2.4 2.6 68.4 265.0 Year to date -11.6 -28.0 -0.7 -2.8 -29.8 -72.9 Source: Central Bank
BKIR's Irish retail deposits have proved stable
An analysis of BKIR's deposit trends An analysis of BKIR's deposit trends since December 2009 (Table 15) since December 2009 shows that shows that the bank's Irish retail deposit base was remarkably stable over the bank's Irish retail deposit base the 18-month period. Elsewhere, growth in UK Post Office deposits was remarkably stable over the 18- offset outflows from UK business banking, with the net loss of €20bn month period over the period almost entirely due to outflows from capital markets.
Table 15: BKIR deposit profile
December 2009 June 2010 December 2010 June 2011 Capital Markets 29.0 26.0 9.0 10.0 UKFS - Business 10.0 9.0 7.0 6.0 UKFS - POFS 9.0 10.0 11.0 13.0 Retail Ireland - current 11.0 11.0 11.0 10.0 accounts Retail Ireland - deposit 24.0 24.0 24.0 24.0 accounts Total deposits 85.0 84.0 65.0 65.0 Source: BKIR
Covered banks offer best rates At the time of writing, comparison website Bonkers.ie suggests that banks are offering up to 4.1% for one-year deposits, with the four covered Irish deposit takers offering the highest rates (Table 16) in the market followed by Nationwide UK (Ireland) and KBC.
Table 16: Deposit best buys
Bank Type of account Rate Details Amount ALBK I-year Fixed Term Reward Account 4.1% AER Restricted access €1 -1m KBC I-year Fixed Term Account 4.1% AER Restricted access €3k - €1.5m PTSB 1-year Interest First Savings Account 4.1% AER Restricted access €10k + BKIR I-year Intro Fixed Term Reward Acc 3.95% AER 30 days notice €10-500k EBS (ALBK) 12-month Fixed Term Savings Acc 3.95% AER Restricted access €3k + Nationwide UK 12-month Fixed Rate Savings 3.9% AER Restricted access €3k - €2m Account Source: Bonkers.ie
Prior to this week's rate cut, one-year fixed rates were up to 2.6% above the ECB base rate of 1.5%. However, Central Bank data show that the average cost of domestic household deposits has been broadly stable for the past 12 months, notwithstanding the two quarter point rate rises in 2011, implying the spread was even wider for a while. The challenge is to reduce rates when official rates are reduced (ideally by more than the official rate decrease).
15 Davy Research Equity Report: Bank of Ireland November 4, 2011
Figure 4: Deposit versus market rates
5
4.5
4
3.5
3
2.5
2
1.5
1
0.5
0 Aug 10 Sep 10 Oct 10 Nov 10 Dec 10 Jan 11 Feb 11 Mar 11 Apr 11 May 11 Jun 11 Jul 11 Household average rate ECB
Source: Central Bank
Historically, banks enjoyed positive deposit margins Our analysis suggests that paying such high rates for deposits relative to official rates is a relatively recent phenomenon. Using BKIR's average balance sheets as a guide implies that historically it enjoyed positive spreads on its customer deposits (Table 17). It is no surprise that 2010 stands out as banks fought to retain domestic retail customer deposits in the wake of substantial outflows of ratings-sensitive corporate deposits. Although the bank does not split domestic and foreign deposits in 2010, it paid an average rate of 1.9% on average customer deposits of €68bn compared with ECB/Bank of England rates of 1%/0.5%.
Our estimates suggest that on Our estimates suggest that on average it probably paid domestic average it probably paid domestic customers a subsidy of 120bps above the ECB rate. Restoring deposit customers a subsidy of 120bps above the ECB rate pricing to more rational levels is a key element of the bank's margin rebuilding strategy. We estimate that clawing back even half the subsidy could add circa 24bps to the margin by 2014. A rising interest rate environment would help as not passing on rate increases is more palatable than reducing rates paid. Hence diminishing rate rise prospects may postpone the margin improvement.
Table 17: BKIR – average deposit spreads
Y/E Mar/Dec Average rate Average ECB Spread vs average paid rate ECB 2004 1.76% 2.30% -0.54% 2005 1.44% 2.00% -0.56% 2006 1.75% 2.30% -0.50% 2007 2.70% 3.10% -0.43% 2008 3.70% 3.90% -0.18% 2009 2.90% 2.80% 0.15% 2009 (9 months to Dec) 1.20% 1.20% 0.05% 2010 2.20% 1.00% 1.20% Source: BKIR; Davy
16 Davy Research Equity Report: Bank of Ireland November 4, 2011
Own use bonds have provided a useful backstop Wholesale funding costs are a blend of elevated term funding costs and ECB drawdowns at market rates. At the end of June, the bank had €61bn of wholesale funding, including €30bn of monetary authority reliance (Irish Central Bank €7bn, ECB €23bn). The ECB figure included 'own use' bonds of circa €8bn. BKIR created these instruments when in January 2011 the ECB eligibility criteria for sterling denominated collateral changed. As previously eligible collateral with a liquidity value of €8bn was no longer eligible for ECB operations, it replenished its available collateral by the issue of government guaranteed, own-use bonds that it retained but that are eligible for ECB monetary policy operations. These bonds have a liquidity value of €8bn and roll- over on a three-monthly basis. At the interim stage they were due to expire in October 2011. Excluding monetary authority reliance, the €31bn balance included €19bn long-term (>1 yr) and €12bn short-term debt.
Table 18: Wholesale funding profile (€bn)
Dec 2010 % June 2011 % Senior bonds, bank deposits and CP/CD 20 29% 12 20% Securitisations 5 7% 5 8% Covered bonds 7 10% 7 11% Market bilateral repos 7 10% 7 11% Central Bank of Ireland 8 10% 7 11% Monetary authorities 23 36% 23 38% Total 70 100% 61 100% Source: BKIR
BKIR has €5.9bn of ELG bonds outstanding The ELG is currently in place until Term debt includes a number of the bank's ELG securities (the main the end of 2011 but with heightened funding market ones are detailed in Table 19). The coupon on the euro issues ranges dislocation in Europe generally and from 4% for the five-year bond issued in January 2010 to 6.75% for the still fragile confidence domestically, two-year bond issued at the end of 2010, a weighted average of 6.5%. we think it will inevitably be The ELG is currently in place until the end of 2011 but with heightened extended for a further six-month funding market dislocation in Europe generally and still fragile period confidence domestically, we think it will inevitably be extended for a further six-month period.
Table 19: Overview of main ELG bank securities
Security ISIN Issue date Maturity date Outstanding Coupon Currency Mid-price (m) BKIR 6 3/4 01/30/12 EI5188749 Corp 30/12/2010 01/30/12 532 6.75 EUR 99.51 BKIR 2 3/4 03/02/12 EI158392 Corp 02/03/2010 03/02/2012 1,000 2.75 USD 97.35 BKIR 3 02/18/13 011559816 Corp 18/08/2010 02/18/13 425 3 CHF 89.375 BKIR 5 7/8 05/03/13 EI451465 Corp 03/11/2010 05/03/2013 750 5.875 EUR 91.56 BKIR 5 3/4 10/22/13 EI439441 Corp 22/10/2010 10/22/13 300 5.75 GBP 98.1 BKIR 4 01/28/15 EI121778 Corp 28/01/2010 01/28/15 2,500 4 EUR 78.71 Source: Bloomberg; Davy
Recent secured unguaranteed issuance shows BKIR has market access In June and July 2011, the group accessed term funding of €2.9bn with an average maturity of 2.2 years through bilateral secured repo transactions utilising securities backed by its UK mortgage portfolios.
17 Davy Research Equity Report: Bank of Ireland November 4, 2011
Although the pricing reflected a market premium (on average, it paid 265bps above three-month EURIBOR), the transactions represented an important step on the path to funding normalisation, demonstrating the ability of the group to access term wholesale funding. A further issuance of €1.1bn was announced on October 11th, taking the total to €4bn, with an average maturity of 2.4 years at an average rate of 250bps above three-month EURIBOR.
ELA drawings likely to be repaid first As the wholesale funding base reduces through deleveraging, we would The average cost of remaining expect ELA drawings to be the first to go followed by 'own-use' bonds. wholesale funds will inevitably rise Hence the average cost of remaining wholesale funds will inevitably rise and the challenge will be to and the challenge will be to compensate for this through further loan re- compensate for this through pricing and reducing existing generous deposit subsidies to avoid further further loan re-pricing and reducing margin erosion. Reports suggest that BKIR is changing the way it prices existing generous deposit subsidies to avoid further margin erosion business loans to reflect a margin over its own blended cost of funds as opposed to inter-bank rates. The proposed change, which is expected to come into effect from November 16th on loans above €300,000, would be positive for margins. Higher asset pricing added 22bps to the margin in 2010, partly offsetting erosion of 40bps largely from funding pressures. However, in H1 re-pricing added a more modest 3bps.
BKIR has further scope to re-price Potential sources of loan re-pricing and other margin enhancement include: Irish SME loans of circa €10bn - assuming half is yet to re-price by say 2% – this could add €100m or 8 basis points. UK SME loans: assuming a €6bn book and that half has yet to re-price by say 2% – this could add €60m or 5bps. UK mortgages: BKIR aims to maximise margins during run-off; assuming half the book has yet to move off introductory rates and re- prices by 75-100bps could add €120-160m or 9-12bps. Corporate loans have largely re-priced. We understand there is some CRE loan re-pricing potential; at worst, any new lending (albeit scarce for now) will be at higher rates. In some CRE loan cases, customers who borrowed at variable rates and switched to fixed may still see a lower all-in cost even if the bank re- prices the loan at renewal given where rates are currently. 2011 LME saves c.€200m per annum, equivalent to 16bps or €100m (8bps) net of the initial CoCo coupon. Media reports suggest that Irish banks used their CoCo proceeds to buy high yielding Irish sovereign bonds in July, providing a useful yield pick-up.
Asset quality
Elevated loan losses likely to persist BKIR has been recapitalised in anticipation of continuing elevated impairment losses in 2011-2013. The Central Bank's PCAR analysis produced base case losses of €7.4bn and adverse scenario losses of €10.1bn (above the bank's own estimates of €6bn and €7.9bn
18 Davy Research Equity Report: Bank of Ireland November 4, 2011
respectively). These estimates all exclude NAMA, which was largely accounted for in 2010 and also exclude further anticipated losses on the smaller L&D portfolio retained by the bank (loans below €20m). The cost of topping provisions on the latter up to 60% is incorporated in the deleveraging component of the Central Bank's capital calculations.
Key variance lies in CRE
The magnitude of the impairment The magnitude of the impairment losses that eventually emerge is clearly losses that eventually emerge is a key factor in determining the net worth of the bank. In Table 22, we clearly a key factor in determining detail the bank's base case loan loss estimates by loan book segment the net worth of the bank alongside the Central Bank's estimates, as calculated by external consultants Blackrock Solutions (BS). The key difference (€1.4bn) between the two arises in the investment property book where the bank noted the Blackrock methodology applies, in its view, a 'repossess and sale' approach with conservative commercial property values as the primary driver of loan losses in the investment property portfolios and places less emphasis on customers’ repayment capacity including contracted income streams. According to BKIR, 'this approach is materially different to the methodology used in previous reviews of potential future loan losses by Bank of Ireland and other leading international risk consultants including Oliver Wyman'. Predicting losses without access to the book's characteristics is difficult, but we are Our €6.7bn impairment estimate inclined to give the bank some benefit of the doubt and we are averaging lies between the bank's €6bn and the two; hence our €6.7bn impairment estimate lies between the bank's the €7.4bn provided by BS €6bn and the €7.4bn provided by BS.
BKIR believes non-NAMA impairments peaked in 2009 The bank has consistently reiterated that non-NAMA impairments peaked in 2009, declining in 2010 with further reductions anticipated in 2011/2012. However, in the wake of PCAR, the Central Bank reviewed how existing accounting standards 'could be applied in a more conservative and prudent manner'. In particular, it noted that there was significant variation in how judgement was applied by institutions, producing wide variations in provision outcomes for similar portfolios, collateral values, emergence periods, forbearance and restructured loans. This, it said, suggested that certain banks were more conservative than others, even within the confines of existing accounting rules (deliberations on a replacement for IAS30s 'incurred loss' methodology are continuing and may at this stage slip into 2012). Hence the fact that the Central Bank is keen that banks increase their provisions towards the projected PCAR levels as far as possible could impact the timing of recognition of losses.
Much of the recent market focus has been on potential mortgage losses, while pending legislation which proposes giving tenants greater flexibility to negotiate their rents may have implications for banks' commercial property investment loan losses. The latter comes against the background of a wide gap between banks' own CRE loss estimates and those compiled by BS in the PCAR process.
In relation to mortgages, although BKIR and BS may have adopted a different approach, they produced broadly similar estimates under the base case, although the BS adverse loss estimate of €2.4bn exceeds BKIR's €2bn figure. The key assumptions underpinning BKIR's mortgage loss estimates are unemployment (key driver of arrears) and
19 Davy Research Equity Report: Bank of Ireland November 4, 2011
house prices (drives losses). The PCAR base case assumed unemployment would peak at circa 13.5% and that house prices would fall 55% from peak. The adverse scenario saw unemployment spiking to 15.8% in 2012 and house prices falling 58.5% from peak. At the time of writing, unemployment stands at 14.4% (above the base case assumption, although it appears to be broadly stable).
Table 20: Central Bank PCAR/PLAR assumptions
Base 2012 Adverse 2012 Current position/ Comments 2011 2011 GDP 0.9% 1.9% -1.6% 0.3% Our forecasts are 1.1%/1.7% GNP -1.5% 0.8% -2.6% -0.2% Our forecasts are 0.2%/1% Unemployment % 13.4% 12.7% 14.9% 15.8% Currently broadly stable at 14.4% Peak to trough declines House prices -55% -58.5% CSO index suggests PTT of 44% at end September Commercial RE values -61% -69% Indices suggest off 64/65% at end Sept 2011 Source: Central Bank
House price decline within base PCAR but further to fall The CSO House Price Index implied a national decline of 44% from peak at the end of September (Dublin -52%). The most recent Daft.ie report puts the average asking price at the end of September at just under €195,000 compared to €366,000 at the 2007 peak, a decline of 47%. Asking prices in Dublin fell by an average of 4.5% over the past three months, with prices now 55% below the peak in some parts of the city. Daft describes the outlook for house prices as 'tough' for the rest of the year; prices are expected to continue to fall into 2012.
Arrears running at 7.2%; ‘troubled’ mortgages at 12.2% Irish mortgage arrears have been steadily rising. Central Bank statistics showed that 55,763 owner-occupier mortgages (7.2% of the 777,321 total) were more than 90 days in arrears at the end of June, up from 49,609 (6.3%) at the end of March and 36,438 (4.6%) at the mid-year stage in 2010. The number of restructured mortgages rose to 69,837 (9%) from 62,936 (8%) in the quarter. Stripping out restructured mortgages in arrears (30,442) to avoid double-counting, the aggregate of mortgages in arrears and restructured stood at 95,158, or 12.2% of the total, up from 11% at the end of March.
BKIR's book looks better than average Owner-occupier mortgage books at However, owner-occupier mortgage books at both 'Pillar' banks looked both 'Pillar' banks looked to be in to be in somewhat better shape than the overall market at the half-year somewhat better shape than the stage. Their reported arrears levels at the end of June were below the overall market at the half-year market average (ALBK 4% and BKIR 4.55% versus the market average stage of 7.2%), while the numbers presented for modified mortgages (ALBK has also modified more than 5,000 mortgages, mostly involving customers moving to paying interest only on their mortgages while BKIR has modified 3,900 mortgages, with 95% of these customers meeting at least the interest due on their loans) also look low relative to the overall Central Bank figures. In aggregate, they have modified over 8,900 mortgages, a fraction of the Central Bank's total of 69,837. Ulster
20 Davy Research Equity Report: Bank of Ireland November 4, 2011
Bank recently revealed that it has modified 12,000 mortgages but this includes Northern Ireland and buy to let (BTL).
Arrears are set to rise further; containing losses to PCAR level is key With mortgage arrears expected to continue to rise into 2012, the key issue is whether ultimately losses can be contained at the base case level envisaged at the time of the PCAR analysis or whether losses will be higher. Losses will hinge on how many mortgages default and how much the bank loses on defaulted mortgages. We show a grid of possibilities in Table 21; for instance, if 10% of mortgages defaulted and the bank lost an average of 50%, the bank's losses would be 5%.
Table 21: Mortgage losses
Losses Default rate 5% 6% 7% 8% 9% 10% 11% 12% LGD 10% 0.5% 0.6% 0.7% 0.8% 0.9% 1.0% 1.1% 1.2% 20% 1.0% 1.2% 1.4% 1.6% 1.8% 2.0% 2.2% 2.4% 30% 1.5% 1.8% 2.1% 2.4% 2.7% 3.0% 3.3% 3.6% 40% 2.0% 2.4% 2.8% 3.2% 3.6% 4.0% 4.4% 4.8% 50% 2.5% 3.0% 3.5% 4.0% 4.5% 5.0% 5.5% 6.0% 60% 3.0% 3.6% 4.2% 4.8% 5.4% 6.0% 6.6% 7.2% 70% 3.5% 4.2% 4.9% 5.6% 6.3% 7.0% 7.7% 8.4% Source: Davy
At this juncture, the house price decline (44% from peak) remains within the base case assumption (of 55%); unemployment is higher (14.4% versus 13.5%); but the interest rate trajectory looks somewhat more favourable for borrowers, particularly those with tracker mortgages. Reports that the Regulator is urging banks not to increase SVR rates further would ease pressure on this segment, which has borne the brunt of any mortgage re-pricing to date.
Table 22: BKIR loan book and impairment provisions
At end June 2011 Cumulative 3-year Net of charge provisions Loan portfolio Gross loans H1'11A 2011F 2012F 2013F BOI BS Davy F % of loans At end 2010 Irish owner-occupied mortgages 20914 70 110 85 76 667 656 662 3.2% 380 Irish BTL mortgages 7000 70 110 85 76 613 600 607 8.7% 388 Irish mortgages 27914 140 220 169 153 1280 1256 1268 4.5% 767 UK mortgages 29958 19 44 34 30 111 105 108 0.4% -116 Residential mortgages 57872 159 264 203 183 1391 1361 1376 2.4% 651 Non property SME & corporate 28038 251 314 241 217 2253 2244 2249 8.0% 774 Investment property 18642 386 590 454 409 1670 3148 2409 12.9% 1455 Personal loans 3288 46 132 101 91 665 627 646 19.6% 325 Total excluding L&D 107840 842 1300 1000 900 5979 7380 6680 6.2% 3205 Land & Development (< €20m) 4062 300 200 0 Total inc L&D 111902 1600 1200 900 Held for NAMA 800 112702 Source: Davy
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Table 23: Impaired loans
Loan portfolio at end-June 2011 Gross loans Provisions % Impaired % Irish owner-occupied mortgages 20914 467 2.2% 669 3.2% Irish BTL mortgages 7000 251 3.6% 385 5.5% Irish mortgages 27914 718 2.6% 1054 3.8% UK mortgages 29958 139 0.5% 138 0.5% Residential mortgages 57872 857 1.5% 1192 2.1% Non property SME & corporate 28038 1594 5.7% 3769 13.4% Investment property 18642 1155 6.2% 3972 21.3% Personal loans 3288 297 9.0% 355 10.8% Total excluding L&D 107840 3903 3.6% 9288 8.6% Land & Development (< €20m) 4062 1524 37.5% 3023 74.4% Total including L&D 111902 5427 4.8% 12311 11.0% Held for NAMA 800 200 25.0% 112702 Source: BKIR
CRE losses are the source of higher PCAR estimates BKIR's commercial investment property loan book was the sole source of the gap between its own estimate of group TTC losses of €6bn and the Central Bank's €7.4bn, as calculated by BS.
The BS approach to CRE for the Irish sector was to 'reunderwrite' 75% by value of loans over €50m. An additional 200 individual CRE loans were reviewed. For the rest of the portfolio, BS used property level debt service coverage ratios and LTVs to project defaults and subsequent losses. Default triggers were more conservative than banks would typically apply; for instance, at maturity – regardless of debt service coverage – if the LTV was >120%, the loan was considered in default.
BKIR has highlighted that BS applies a 'repossess and sale' approach, under stress scenarios, with stressed residential and commercial property values as the primary driver of loan losses in investment property portfolios. Hence it places less emphasis on customers’ repayment capacity, including contracted income streams, than BKIR does. Table 24 summarises the base/adverse case loss estimates of each. The gap between the two is €1.4bn (7.2% of the CRE book) under the base case and widens to €1.57bn (7.7%) under the adverse scenario.
Table 24: CRE loss estimates
BKIR PCAR - BS Gap Base case €bn 1670 3148 1400 % 8.2% 15.4% 7.2% Adverse case €bn 2275 3847 1572 % 11.1% 18.8% 7.7% Increment €bn 605 699 94 % 2.9% 3.4% 0.5% Source: Central Bank
BKIR's commercial property loan book stood at €18.6bn at the mid- year stage. Geographically, over half the book (57%) relates to the UK (57%), with Ireland at 38% and the remaining 5% in the US/Europe.
22 Davy Research Equity Report: Bank of Ireland November 4, 2011
The bank held provisions of €1.2bn (6.5%) against its €18.6bn book at the mid-year stage. Impaired loans were €4bn or 22% of the book; the bank attributed the increase in the six months to the continued impact of the weak economic environment together with an increase in past 90 days due loans, where the facilities were being renegotiated but where a loss was not anticipated.
Table 25 compares the profile of BKIR's CRE book at the mid-year stage with that of ALBK. Both banks reported a similar level of impaired loans at 22% of their books. Base case PCAR envisaged CRE losses of 16.9% and 22.5% for BKIR and ALBK respectively, while the banks themselves put losses at 55%/54% of this level. In BKIR's case, specific provisions at the interim stage covered over 70% of its own base case loss estimates (ALBK: 65%), although this falls to 38% of the PCAR base case estimate (ALBK: 34%) and 31% (ALBK: 28%) of the PCAR adverse case estimate.
Table 25: How the 'Pillar' banks compare
CRE book BOI % AIB % Commercial investment 15.8 85% 12.9 80% Residential investment 2.8 15% 3.3 20% Total loans 18.6 100% 16.2 100% Geographic profile ROI 7.1 38% 8.0 49% UK 10.6 57% 6.7 41% US/RoW 0.9 5% 1.5 9% Total 18.6 16.2 Challenged/Criticised loans n/a 7.0 Of which impaired 4.0 22% 3.5 22% Specific provisions 1.2 1.3 Provisions as % loans 6.5% 7.8% Provisions as % impaired 30% 36% Loss estimates Banks' own forecasts - base case 1.7 9.0% 2.0 12.1% PCAR base case 3.1 16.9% 3.7 22.5% Banks' forecasts as % PCAR 55% 54% Banks' own forecasts - adverse case 2.3 12.2% 2.9 18.0% PCAR adverse case 3.8 20.7% 4.5 27.7% Banks' forecasts as % PCAR 61% 64% Provisions as % banks' own base loss estimates 71% 65% Provisions as % PCAR base 38.1% 34.4% Provisions as % PCAR adverse 31.2% 28.0% Source: BKIR; ALBK; Central Bank
Irish commercial property values had fallen by 64.2-64.9% at the end of September, according to the Jones Lang LaSalle or IPD Indices. In a recent speech, NAMA CEO Brendan McDonagh noted that the agency was seeing 'strong indicative interest from investors, mainly foreign, in purchasing Irish commercial property'. Apart from a minority of potential investors who are interested only in picking up loans or property at rock-bottom, fire-sale prices, NAMA has seen 'a lot of interest from professional investors who have a more long-term horizon in mind'.
NAMA says the key constraint is finance, while uncertainty about possible changes to existing lease contracts with respect to rent reviews in
23 Davy Research Equity Report: Bank of Ireland November 4, 2011
Ireland is also a significant issue holding back potential investors. NAMA is hopeful that this will be clarified soon so 'the market can digest it and move on'. In this respect, the draft Landlord and Tenant (Business Leases Review) Bill is anticipated in the next month or two.
The PCAR process assumed values would fall by 61% from peak in the base case or by 69% in the adverse scenario. Estimates suggest that the proposed legislation – which would give commercial tenants greater scope to renegotiate their rents if they can prove that their rent is in excess of market rates, that the Irish company is vulnerable and that a lower rent would enhance the chances of the business continuing to trade – may knock a further 20% off property values. From the end- September level, this would imply a peak to trough decline of 71%, although Q2/Q3s declines may already have at least partly discounted the proposed legislation given that it has been mooted for some time at this stage.
The CRE book is where the greatest uncertainty over possible losses lies Hence the CRE book is where the greatest uncertainty over possible losses lies. Our forecasts for BKIR assume that provisions will ultimately fall halfway between the bank's own estimate of €1.67bn and base case Our forecasts for BKIR assume that PCAR (€3.1bn), i.e. €2.4bn. The pending legislation could ultimately provisions will ultimately fall drive losses higher. In this respect, the sensitivity of our estimates can be halfway between the bank's own best gleaned by quantifying the impact of moving to the base case PCAR estimate of €1.67bn and base case level; this would knock 1.9c off our end-2013 TNAV of 22.6c. PCAR (€3.1bn), i.e. €2.4bn
AFS book held €3.2bn Irish sovereign debt at end- June BKIR held Irish sovereign debt at a fair value of €3.2bn in its AFS book at the end of June. The mark to market (MTM) reserve, which amounted to €0.6bn at that date, is held within reserves. Separately, Bank of Ireland Life held €441m (fair value), which gave rise to a €50m valuation hit through the profit and loss account in the first half. Apart from a modest €29m in Italian bonds, the group had no other peripheral sovereign debt exposure; remaining sovereign debt of €2.7bn at the end of June was predominantly UK, with a minor exposure to France (€21m). Based on media reports suggesting that banks used their CoCo proceeds to purchase Irish sovereign bonds, the exposure is likely to be closer to €4bn at this juncture.
This excludes €4.9bn of NAMA senior bonds secured on NAMA assets, which are accounted for as ‘loans and receivables’ rather than as ‘available for sale financial assets'. Repayments reduced these from €5.1bn at the end of 2010. The bonds are due to mature in March 2012, when they are likely to be replaced by comparable one-year bonds. To date, NAMA has repaid close to €1.6bn of debt and expects to make 'another substantial repayment before the end of 2011 given our healthy cash balances'.
24 Davy Research Equity Report: Bank of Ireland November 4, 2011
Table 26: AFS portfolio
December 2010 Mark-to- June 2011 Mark-to- fair value market fair value market Irish government bonds 3.2 -0.3 3.2 -0.6 Other government bonds 0.5 0 2.7 0 Total government securities 3.7 -0.3 5.9 -0.6 Bank debt and covered bonds 10.7 -0.3 7.3 -0.2 Liquid asset portfolio 14.4 -0.6 13.2 -0.8 Asset-backed securities 1.2 -0.2 1.0 -0.2 Total AFS assets 15.6 -0.8 14.2 -1.0 Source: BKIR
The bank's Irish sovereign debt maturity profile at end-June is shown in Table 27. The bulk of the debt (78%) has a term of up to five years. The rally in Irish bonds since mid-July has substantially reduced the mark-to- market reserve.
Table 27: Maturity profile of Irish sovereign debt At June 30th 0-6 mths 6-12 mths 1-2 yrs 2-5 yrs 5-10 yrs Total Nominal value 301 678 717 1375 849 3921 Fair value 300 664 630 1051 563 3208 Charge to AFS reserve (before deferred tax) -3 -15 -73 -289 -284 -664 Source: BKIR
Senior bank debt and covered bonds are geographically well spread (Table 28) and have an average credit rating of 'A'. The Spanish exposure of €1.3bn relates to bank covered bonds.
Table 28: Senior bank debt and covered bonds (net of impairment) €m
Australia 154 Austria 74 Belgium 156 Canada 283 Denmark 214 Finland 81 France 1,007 Germany 195 Ireland 308 Italy 540 Luxembourg 10 Netherlands 550 Norway 168 Portugal 146 Spain 1,301 Sweden 265 UK 1,318 US 555 7,325 Source: BKIR
25 Davy Research Equity Report: Bank of Ireland November 4, 2011
Capital adequacy At June 30th, BKIR's Core Tier 1 and total capital ratios were 9.5% and 11.0% respectively, broadly in line with the end-2010 levels. On a pro-forma basis, assuming the €4.2bn (net) equity capital requirement had been completed at June 30th, the group’s Core Tier 1 ratio would have been 15.4 %.
The PCAR/PLAR exercise directed BKIR to raise €4.2bn equity capital in order to remain above a minimum capital target of 10.5% Core Tier 1 in the base scenario and 6% Core Tier 1 in the stress scenario plus an additional protective buffer (of €500m).
Taking our forecast end-2013 RWAs of €58.6bn as a base, the difference of 4.5% is equivalent to €2.6bn, which can be largely explained by the gap between the base (€7.4bn) and adverse scenario (€10.1bn) impairment losses (€3.4bn pre-tax).
Bank of Ireland passed the July EBA stress test as under the adverse stress scenario the group’s Core Tier 1 ratio would be 7.1% at December 31st 2012, which is 2.1% or €1.3bn in excess of the 5% Core Tier 1 capital requirement in the adverse stress scenario.
The Central Bank summarised the key differences between the two sets of stress tests (Table 29). Please see our report, "Irish Banks: PCAR ensures Irish banks pass EBA stress test with capital ratio of 9.8%", for more detail.
Table 29: Comparison of PCAR and EBA tests
2011 PCAR 2011 EU-wide Time horizon 3 years (to Dec 2013). 2 years (to Dec 2012). Recapitalisation threshold Contraction in line with Contraction in line with deleveraging plans. deleveraging plans; this was an exemption from the “zero balance sheet growth” rule applied to other participating banks. Funding mix Required to achieve a 122.5% No changes allowed from Dec loan to deposit ratio in Dec 2013 2010 funding mix of deposits, by reducing reliance on external unsecured, collateralised, term sources of funding (ECB, debt, etc. unsecured money market, etc.). Cost of funding ECB base rate increase of 1% by ECB base rate increase of 0.75% end 2013.Standard funding costs by end 2012. Funding costs applied to all banks. varied according to prescribed bank credit spreads. Impact of deleveraging Losses due to asset disposals up to Losses due to asset disposals up Dec 2013 included. to Dec 2012 included. Conservatism buffer Additional recapitalisation buffer No buffer applied. of circa 20% applied to overall capital shortfall identified. Credit losses attributable to Losses independently forecast by Losses independently forecast by retail & commercial exposures BlackRock Solutions. BlackRock Solutions; a deviation from the methodology applied to other participating banks. Credit losses attributable to Haircuts applied to exposures in Haircuts applied to exposures in sovereign & bank exposures the trading book. No credit the trading book and credit default losses applied to default losses applied to exposures in the banking book. exposures in the banking book. Source: Central Bank
26 Davy Research Equity Report: Bank of Ireland November 4, 2011
On October 26th, as part of the road-map to resolve the eurozone crisis, On October 26th, as part of the road-map to resolve the eurozone the EBA confirmed that Europe's banks must build up additional capital crisis, the EBA confirmed that buffers to reach a core Tier 1 ratio of 9% by the end of June 2012. Its Europe's banks must build up €106bn estimate is described as 'preliminary and indicative' as it is based additional capital buffers to reach a on banks' end-June capital positions and sovereign debt holdings, which core Tier 1 ratio of 9% by the end have been marked to market at September 2011 prices. of June 2012
The EBA confirmed that it has not conducted a new round of stress tests — i.e. no adverse macroeconomic scenarios were applied to the figures provided by the banks, which would presumably have produced a higher number — but has merely reviewed banks' actual capital positions and sovereign exposures and requested them to set aside additional buffers where appropriate. Greek (€30bn) and Spanish (€26bn) banks have the largest requirement, followed by Italian (€14.8bn), French (€8.8bn) and Portuguese (€7.8bn) banks. Irish and UK banks have no incremental requirement.
Table 30: Breakdown by country of estimated capital target buffers
Country Estimated target capital buffer (€m) Sovereign capital buffer (€m) Austria 2,938 224 Belgium 4,143 5634 Cyprus 3,587 3085 Germany 5,184 7687 Denmark 47 35 Spain 26,161 6290 Finland 0 3 France 8,844 3550 Great Britain 0 0 Greece 30,000 / Hungary 0 43 Ireland 0 25 Italy 14,771 9,491 Luxembourg 0 0 Malta 0 0 Netherlands 0 99 Norway 1,312 0 Portugal 7,804 4,432 Sweden 1,359 4 Slovenia 297 20 Total 106,447 * The sovereign capital buffer is indicative and can already be covered by existing CT1 capital if the CT1 ratio exceeds 9%. Source: EBA
Basel 111 Basel 111 proposes setting the hurdle rate for banks' core equity and Tier 1 ratios at 4.5% and 6% respectively (after applying capital deductions). It introduces a 2.5% buffer on top of this, taking core equity and Tier 1 ratios to 7% and 8.5% respectively. It also proposes an extra 'countercyclical buffer' within a range of 0-2.5% of common equity or other fully loss absorbing capital, according to national circumstances, implying a total potential Tier 1 ratio of 11%.
27 Davy Research Equity Report: Bank of Ireland November 4, 2011
The €106bn capital raise directed by the EBA is described as a 'temporary capital buffer' against sovereign debt exposures and, as such, Those banks that must raise capital is not expected to change the Basel 111 requirements. However, those have effectively been put on a fast- banks that must raise capital have effectively been put on a fast-track track towards Basel 111 towards Basel 111.
The Basel 111 hurdle is based on a narrower definition of capital; for example, negative AFS reserves and pension deficits will no longer be added back for regulatory capital purposes and certain deferred tax assets and minority investments in qualifying financial institutions will be recognised as Tier 1 capital only up to an aggregate 15% of equity. A lengthy phase-in period ensures full implementation is postponed until January 1st 2019.
From BKIR's perspective, steps have already been taken to reduce the From BKIR's perspective, steps have already been taken to reduce the pension deficit. The AFS reserve (€987m at end-June) should have pension deficit reduced significantly by 2014 (30% of the bank's AFS book matured in less than a year and 80% in less than five years at end-2010), and the bank is expected to have sold New Ireland by then. Hence the deferred tax asset (€1.2bn at end-June, including €963m available to relieve future profits from tax) is likely to be the biggest issue. Our forecast end- 2014 equity Tier 1 ratio on a B2 basis is 13.6%; this may fall to around 13% on a B3 transitional basis (only 20% of deductions excluded in 2014, rising by 20% per annum through to 2019) – still comfortably above the regulatory minimum.
28 Davy Research Equity Report: Bank of Ireland November 4, 2011
Key 2011 events timeline March 2011 – The Irish Central Bank published the results of its Prudential Capital Assessment Review (PCAR) and Prudential Liquidity Assessment Review (PLAR) and directed BKIR to raise €5.2bn of incremental capital, including €4.2bn equity (please see our report, "Irish bank stress tests: significant development in sorting out Irish banks and funding environment for Irish sovereign").
July 2011 – The bank passed the EBA stress test, where under the adverse stress scenario, its Core Tier 1 ratio would be 7.1% at December 31st 2012, 2.1% or €1.3bn in excess of the 5% Core Tier 1 capital requirement in the adverse stress scenario. The result confirmed the adequacy of its capital-raising proposals and its ability to remain above the required minimum capital ratio under the EBA severe adverse stress scenario. The €1bn of contingent capital would, if required, add a further 1.6% to the group’s Core Tier 1 ratio, bringing it up to 8.7% under the EBA adverse stress scenario at December 31st 2012 (please see our report, "Irish Banks: PCAR ensures Irish banks pass EBA stress test with capital ratio of 9.8%").
July 2011 – BKIR's 2011 recapitalisation was largely completed. The bank raised a net €3.79bn of equity capital, including LME of €2.03bn and a rights issue of €1.91bn, net of €150m costs. The latter included a €1.1bn investment by a group of private investors, diluting the Irish government stake to 15.1%. The bank has until the end of 2011 to raise the residual €0.41bn requirement. August 2011 – Interim results reflected the predicted, largely funding- related, revenue headwinds. These include deposit competition and elevated deposit pricing; higher wholesale funding costs; and higher systemic guarantee fees. Pre-provision profits were significantly lower (-66%) as a result, but impairment trends were broadly on track.
August 2011 – The bank announced that it had raised €2.9bn of unguaranteed funding secured on UK assets, paying an average of 265bps over three-month EURIBOR for an average term of 2.2 years.
October 2011 – The bank announced a further €1.1bn unguaranteed funding secured on UK assets. The aggregate of €4bn has a 2.4 year term and costs 250bps over three-month EURIBOR.
October 2011 – BKIR announced €5bn divestments, taking it halfway to its €10bn target. The average 9.5% discount is lower than the bank's own assumptions, within the base case PCAR discounts and 'well within' the adverse stress scenario discounts.
October 2011 – The Central Bank confirms that Irish banks involved in the 2011 EU-wide stress test have been included in the latest capital exercise. The results published by the EBA show that the Irish banks do not require any additional capital.
29 Davy Research Equity Report: Bank of Ireland November 4, 2011
Rating: OUTPERFORM Issued 04/11/11
Investment thesis
Emer Lang [email protected] / +353 1 6148925
Company profile Bank of Ireland has emerged from an extensive sector restructuring and Bank of Ireland provides a broad range of retail and recapitalisation as one of Ireland's two designated Pillar banks and the only corporate financial services in Ireland through an extensive Irish bank to have avoided almost complete nationalisation. The bank raised nationwide distribution network including 251 full-time branches and approximately 1,300 ATMs. Its UK Financial €3.8bn (net of costs) of its directed equity raise of €4.2bn and has until the Services (UKFS) division incorporates Business Banking in end of 2011 to raise the residual €0.4bn, which it anticipates will come from Great Britain and Northern Ireland, its branch network in liability management. Northern Ireland, the discontinued intermediary-sourced mortgage business and joint ventures with the UK Post Office. Global Markets delivers a comprehensive range of risk management products to the group's customer base. Market leader in an extensively restructured market
• The bank's fate is inextricably linked to the medium to long term fortunes of the Irish economy. It will enjoy a market-leading position in a recapitalised, consolidated and right-sized banking system. • The Irish economy is stabilising and is expected to deliver attractive growth in the medium to long term. However, the pace of what is anticipated to be an export-led recovery will depend on a number of macro factors, not least global economic fortunes. • An economic recovery is ultimately key to the rehabilitation of the sovereign, which will remain reliant on IMF/ECB support for the forseeable future. • Eurozone crisis developments have driven extreme market volatility, but for now Ireland's determination to implement the required austerity measures is being acknowledged; Irish 10-year bond yields have fallen below 8% from their summer peak of over 14%.
Bank has set out key financial targets • The group stresses that margin recovery from current depressed levels is a key priority and is seeking a margin of over 200bps in 2014. Other key targets include a cost/income ratio below 50% and a normalised impairment charge of 55-65bps, both in 2014. • Our estimates see the group TNAV at €6.8bn at the end of 2013. Key assumptions include impairment provisions of €6.7bn in 2011- 2013 (BKIR estimates €6bn; Central Bank estimates €7.4bn) and a PLAR deleveraging cost of €1.7bn over the period. • The shares are an attractive play on the Irish economic recovery; they trade at a significant discount to our forecast of 22.6c.
30 Davy Research Equity Report: Bank of Ireland November 4, 2011
Trading summary Mar07 Mar08 Mar09 Dec09 Dec10 Dec11E Dec12F Dec13F Income Statement (€m) Net Interest Income 2757 3263 3670 2121 2236 1580 1530 1740 Other Income 1112 857 239 316 566 550 660 730 Total Income 3869 4120 3909 2437 2802 2130 2190 2470 Total Costs 2110 2140 2022 1381 1785 1640 1600 1560 Op. Profit before Prov's 1759 1980 1887 1056 1017 490 590 910 Bad Debts 103 232 1513 4063 4357 1723 1200 900 Other Items 0000-1680 00 Associates 44 46 -42 35 49 35 45 45 Profit on Ord. Activities before Ex. 1700 1794 332 -2972 -3459 -1198 -565 55 Exceptionals 258 139 -339 1159 2509 1867 -500 0 Equity component of exceptional 0 0 0 -214 0 0 00 FRS3 PBT 1958 1933 -7 -1813 -950 669 -1065 55 Tax -306 -229 41 344 341 153 202 -10 Discontinued operations 000000 00 Minorities -1 -5 35 9 -5 -5 -5 -5 Preference Dividends -15 -14 0 0 -207 -199 -199 -199 Attributable Profit (Basic) 1636 1685 69 -1460 -821 618 -1067 -159 Per share data (c) EPS Basic 108.6 110.1 4.4 -105.5 -21.5 4.0 -3.5 -0.5 EPS Diluted (Adj) 90.5 94.4 19.1 -167.6 -83.0 -8.6 -2.2 -0.5 Dividend 38.1 40.1 0.0 0.0 0.0 0.0 0.0 0.0 NBV 432.8 417.3 209.2 272.0 101.4 26.0 23.4 23.8 NBV (incl. Goodwill) 466.0 450.6 241.6 323.0 111.0 27.7 25.2 25.5 Memo Items Average No. of Shares (m) 1506.1 1529.8 1567.9 1587.3 3810.5 15632.0 30100.0 30100.0 Number of Shares - Diluted (m) 1558.4 1575.8 1590.1 1587.3 3810.5 15632.0 30100.0 30100.0 Tax Rate (%) 15.6 11.8 N/A N/A N/A N/A N/A 18.2 Adj. Tax Rate (%) 18.0 12.8 N/A 11.6 9.9 12.8 35.8 18.2 Number of shares reflects Bank of Ireland's capital raising update issued on July 8th
31 Davy Research Equity Report: Bank of Ireland November 4, 2011
Financial summary Mar07 Mar08 Mar09 Dec09 Dec10 Dec11E Dec12F Dec13F Balance Sheet (€m) Cash & Liquid Assets 57919 55488 54609 46518 39810 35800 32694 31694 Customer Loans 125048 135738 133740 129020 115261 103500 93500 89700 Securitised Assets - on BS 000000 00 Earning Assets 182967 191226 188349 175538 155071 139300 126194 121394 Other Assets 5846 6207 5767 5568 12402 11327 9807 8287 Total Assets 188813 197433 194116 181106 167473 150627 136001 129681 Securitised Assets - off B/S 000000 00 Total Assets under Management 188813 197433 194116 181106 167473 150627 136001 129681 Customer Deposits 72277 86234 83119 84812 65443 67443 69443 72443 Bank Deposits 20405 14130 28814 17903 41075 26651 15795 12195 Debt Securities 59523 60842 45133 43144 28693 26000 22000 18000 Subordinated Liabilities 7808 7808 7942 6053 2775 0 00 Other Liabilities 22285 21897 22256 22757 22080 19707 18711 18837 Ordinary Shareholders Funds 6724 6484 3329 2752 5413 7832 7058 7150 Minority Interests 34 38 61 50 56 56 56 56 Preference Shares 0 0 3462 3635 1938 2938 2938 1000 Total Liabilities 189056 197433 194116 181106 167473 150627 136001 129681 Share Data (€m) Year End No. Shares (m) 1554 1554 1592 1012 5340 30100 30100 30100 Year End Price 1019 594 33 84 37 9 99 Capital Structure (€m) Ord. Share. Funds 6724 6484 3329 2752 5413 7832 7058 7150 Tier 1 Capital 9308 9424 12649 9651 7676 10400 9717 9629 Total Capital Ratio 13327 13031 15971 12990 8723 10401 9559 10456 Weighted Risk Assets 112940 116961 105377 98153 79045 69119 65100 58600
32 Davy Research Equity Report: Bank of Ireland November 4, 2011
Financial analysis Mar07 Mar08 Mar09 Dec09 Dec10 Dec11E Dec12F Dec13F Growth EPS Diluted (Adj) (%) 22.1 4.3 -79.8 N/A N/A N/A N/A N/A Dividend (%) 15.0 5.3 N/A N/A N/A N/A N/A N/A Total Income (%) 12.5 6.5 -5.1 N/A 15.0 -24.0 2.8 12.8 Op. Profit before Prov's (%) 21.1 12.6 -4.7 N/A -3.7 -51.8 20.4 54.2 Customer Loans (%) 23.5 8.5 -1.5 N/A -10.7 -10.2 -9.7 -4.1 Total Assets (%) 16.4 4.6 -1.7 N/A -7.5 -10.1 -9.7 -4.6 Profitability / Activity Net Interest Margin (%) 1.8 1.9 2.1 1.2 1.4 1.1 1.2 1.4 Cost / Income Ratio (%) 54.5 51.9 51.7 56.7 63.7 77.0 73.1 63.2 Income - Cost 6.3 5.1 0.4 -6.0 -14.3 -15.9 5.3 15.3 Loans / Tier 1 Capital (x) 13.4 14.4 10.6 13.4 15.0 10.0 9.6 9.3 Loans / Deposits (x) 1.7 1.6 1.6 1.5 1.8 1.5 1.3 1.2 Return ROE (%) 23.7 22.5 6.2 N/A N/A N/A N/A N/A ROA (%) 0.8 0.8 0.2 N/A N/A N/A N/A N/A RORWA (%) 1.2 1.3 0.3 -2.7 -4.0 -1.9 -1.0 -0.3 Cost of Equity (%) 8.3 8.2 9.5 8.8 7.9 6.8 6.8 6.8 Cost of Sub. Debt (before tax) (%) 4.0 4.5 4.6 N/A N/A N/A N/A N/A WACC (%) 7.5 7.8 8.0 3.6 3.7 3.8 4.3 4.8 Financial / General Prefs / Tier 1 (%) 37.8 31.8 52.1 54.1 23.0 18.6 20.5 20.0 Tier 1 Capital (%) 8.2 8.1 12.0 9.8 9.7 15.0 14.9 16.4 Total Capital Ratio (%) 11.8 11.1 15.2 13.2 11.0 15.0 14.7 17.8 Dividend Cover (x) 2.4 2.4 N/A N/A N/A N/A N/A N/A Mkt Cap / Op Profits 1.6 1.4 1.5 2.7 2.8 5.7 4.7 3.1 Asset Quality Bad Debts / Loans (%) 0.1 0.2 1.1 3.1 3.6 1.6 1.2 1.0 Provisions / Loans (%) 0.3 0.4 1.3 4.5 4.4 5.6 6.4 6.9 NPLs / Loans (%) 0.8 0.8 4.0 10.3 9.9 12.9 12.8 10.0 Provisions / NPLs (%) 44.2 56.6 33.5 43.3 44.4 43.2 50.0 68.9
Valuation Price Mkt. Cap % Change Company (c) (€m) Wk 1 Mth YTD Ireland Allied Irish Banks (ALBK ID) 10 48736 33.8 137.5 -68.3 Bank of Ireland (BKIR ID) 9 2802 -7.0 20.8 -75.0 Banks 59 51538 -5.4 24.2 -72.4 UK Banks Barclays (BARC LN) 181 25619 2.4 11.9 -31.1 Lloyds Banking Group (LLOY LN) 29 23314 -13.9 -16.5 -55.8 RBoS (RBS LN) 23 29567 -5.8 -1.8 -41.1 UK banks index 73 78552 -5.9 -3.0 -43.9 Austrian Banks Erste Bank (EBS AV) 1466 5546 -10.9 -24.3 -58.3 Raiffeisen Bank (RBI AV) 1926 3747 -11.2 -13.1 -53.0 Austrian banks index 1028 9293 -11.0 -20.1 -56.3 Benelux Banks KBC (KBC BB) 1429 5115 -5.0 -18.3 -44.0 Dexia (DEXB BB) 50 965 -16.1 -65.8 -81.0 Benelux banks index 272 6080 -6.9 -33.1 -57.1 French Banks Credit Agricole (ACA FP) 498 12450 2.3 -4.7 -47.6 BNP Paribas (BNP FP) 2969 35852 -1.2 -1.2 -37.7
33 Davy Research Equity Report: Bank of Ireland November 4, 2011
Societe Generale (GLE FP) 1760 13659 -6.2 -12.0 -56.2 Natixis (KN FP) 211 6507 -8.0 -11.4 -39.7 French banks index 432 68468 -2.3 -5.2 -44.4 Greek Banks Alpha Bank (ALPHA GA) 93 496 -10.7 -30.2 -75.6 EFG Eurobank (EUROB GA) 63 349 -11.1 -32.2 -83.2 Natl. Bank of Greece (ETE GA) 162 1549 -10.0 -41.1 -73.2 Greek banks index 65 2394 -5.6 -29.1 -68.6 German Banks Commerzbank (CBK GY) 166 8499 -5.7 -12.5 -62.7 Deutsche Bank (DBK GY) 2866 26639 0.8 8.9 -26.7 Deutsche Postbank (DPB GY) 2106 4608 3.1 2.2 1.3 German banks index 306 39746 -0.2 2.8 -32.9 Italian Banks Intesa Sanpaolo Spa (ISP IM) 114 18767 -10.6 -4.0 -40.0 Unicredit SpA (UCG IM) 80 15362 -8.9 -0.7 -48.5 Banca Monte Dei P. (BMPS IM) 31 3605 -13.3 -25.5 -56.6 UBI Banca (UBI IM) 258 2327 -7.9 -7.9 -57.9 Mediobanca (MB IM) 556 4784 -6.2 -6.1 -16.6 Italian banks index 1308 44844 -9.7 -5.6 -43.9 Nordic Banks Danske Bank (DANSKE DC) 6850 8583 -8.4 -12.5 -51.9 Nordea (NDA SS) 5655 25218 -3.5 2.2 -23.5 SE Banken (SEBA SS) 3968 9593 -4.3 7.8 -30.0 DNB NOR ASA (DNBNOR NO) 6375 13340 -3.0 8.2 -22.0 Svenska Handelsbanken (SHBA SS) 17980 12363 -5.0 3.7 -17.2 Swedbank (SWEDA SS) 8985 9555 -4.1 19.1 -5.3 Nordic banks index 876 78883 -3.9 3.9 -25.7 Portuguese Banks Banco Comercial P. (BCP PL) 13 944 -16.6 -32.8 -77.5 Banco Espirito Santo (BES PL) 139 1622 -4.1 -30.5 -51.7 Banco BPI (BPIN PL) 46 453 -13.8 -32.8 -66.9 Portuguese banks index 76 3019 -9.8 -31.6 -65.5 Spanish Banks Banco Popular Espanol (POP SM) 312 4366 -5.5 -10.4 -18.8 BBVA (BBVA SM) 617 30276 -1.0 -0.2 -18.5 Banco Sabadell (SAB SM) 250 3474 -4.3 -6.9 -15.3 Banco Espanol Credito (BTO SM) 400 2750 -7.5 -11.1 -35.5 Banco Santander (SAN SM) 580 49994 -3.0 -6.8 -26.8 Spanish banks index 504 90859 -2.7 -5.0 -23.8 Swiss Banks Credit Suisse (CSGN VX) 2339 23160 -3.3 -2.2 -36.0 UBS AG (UBSN VX) 1081 34119 -1.4 3.0 -27.4 EFG International (EFGN SW) 684 826 -8.0 1.7 -44.9 Julius Baer Group (BAER VX) 3320 5650 -3.1 8.6 -21.9 Swiss banks index 384 63941 -1.9 1.5 -30.5 European banks index 271 488882 -4.1 -3.2 -38.7
P/E Ratios PEG Div Yield Price/
Company 2011 2012 2013 Ratio 2011 2012 Book
Ireland
Allied Irish Banks (ALBK ID) N/A N/A N/A N/A N/A N/A 4.3
Bank of Ireland (BKIR ID) N/A N/A N/A N/A N/A N/A 0.4
Banks N/A N/A N/A 0.0 0.0 2.6
UK Banks
Barclays (BARC LN) 6.7 5.2 4.3 0.5 3.3 4.4 0.4
Lloyds Banking Group (LLOY LN) 29.2 6.9 4.5 N/A N/A 1.7 0.4
RBoS (RBS LN) 22.9 6.8 5.3 N/A N/A N/A 0.4
UK banks index 13.2 6.2 4.7 3.3 3.1 0.4
Austrian Banks
34 Davy Research Equity Report: Bank of Ireland November 4, 2011
Erste Bank (EBS AV) 6.3 4.6 3.5 0.4 4.8 4.8 0.4
Raiffeisen Bank (RBI AV) 4.3 3.9 3.0 0.1 5.5 5.8 0.5
Austrian banks index 5.3 4.3 3.3 5.0 5.2 0.5
Benelux Banks
KBC (KBC BB) 3.2 2.7 2.7 N/A 5.4 5.9 0.4
Dexia (DEXB BB) N/A 1.2 1.0 N/A N/A 10.1 0.1
Benelux banks index 3.2 2.3 2.1 5.4 6.5 0.3
French Banks
Credit Agricole (ACA FP) 4.0 3.1 2.8 0.1 9.0 10.6 0.3
BNP Paribas (BNP FP) 4.4 4.3 4.2 0.6 7.4 7.8 0.5
Societe Generale (GLE FP) 3.8 3.2 3.0 0.0 8.9 9.9 0.3
Natixis (KN FP) 4.8 4.4 4.3 N/A 10.7 10.9 0.4
French banks index 4.2 3.8 3.6 8.3 9.0 0.4
Greek Banks
Alpha Bank (ALPHA GA) N/A 46.5 3.0 N/A N/A N/A 0.1
EFG Eurobank (EUROB GA) N/A 63.1 2.9 N/A N/A N/A 0.1
Natl. Bank of Greece (ETE GA) 54.0 3.4 2.9 N/A N/A N/A 0.2
Greek banks index 54.0 5.1 2.9 N/A N/A 0.2
German Banks
Commerzbank (CBK GY) 5.0 3.9 3.4 N/A N/A 3.0 0.4
Deutsche Bank (DBK GY) 5.8 5.4 5.1 N/A 2.6 3.1 0.5
Deutsche Postbank (DPB GY) 18.1 8.0 7.4 0.3 N/A N/A 0.8
German banks index 6.1 5.2 4.8 2.6 3.1 0.5
Italian Banks
Intesa Sanpaolo Spa (ISP IM) 7.6 6.3 5.6 3.5 7.0 7.0 0.3
Unicredit SpA (UCG IM) 6.6 5.0 4.0 0.4 4.5 5.2 0.2
Banca Monte Dei P. (BMPS IM) 7.9 6.2 4.5 0.3 5.9 6.4 0.2
UBI Banca (UBI IM) 10.9 7.6 6.3 10.4 5.8 5.8 0.2
Mediobanca (MB IM) 12.1 9.5 7.1 0.0 3.1 4.0 0.7
Italian banks index 7.6 6.0 4.9 5.6 6.0 0.3
Nordic Banks
Danske Bank (DANSKE DC) 12.5 6.3 4.8 0.4 2.3 5.2 0.5
Nordea (NDA SS) 9.4 8.0 7.3 1.6 4.8 5.5 1.0
SE Banken (SEBA SS) 7.5 8.4 7.9 0.2 5.0 5.4 0.8
DNB NOR ASA (DNBNOR NO) 8.3 7.6 7.0 0.9 6.3 6.7 0.9
Svenska Handelsbanken (SHBA SS) 9.5 9.5 8.9 1.8 5.5 5.7 1.2
Swedbank (SWEDA SS) 7.7 8.7 8.4 N/A 6.7 5.8 1.0
Nordic banks index 8.9 8.0 7.2 5.2 5.7 0.9
Portuguese Banks
Banco Comercial P. (BCP PL) 6.6 6.7 3.3 3.4 N/A N/A 0.1
Banco Espirito Santo (BES PL) 5.3 5.0 4.6 N/A 7.1 0.7 0.3
Banco BPI (BPIN PL) 3.5 3.4 3.1 N/A N/A 4.8 0.3
Portuguese banks index 5.2 5.0 3.8 7.1 1.6 0.2
Spanish Banks
Banco Popular Espanol (POP SM) 9.6 8.7 7.8 N/A 5.8 5.7 0.5
BBVA (BBVA SM) 6.8 5.9 5.7 N/A 6.7 6.8 0.8
Banco Sabadell (SAB SM) 13.2 10.9 8.7 N/A 3.6 4.0 0.6
Banco Espanol Credito (BTO SM) 7.0 6.7 5.6 N/A 7.0 7.0 0.5
Banco Santander (SAN SM) 6.6 6.2 5.7 N/A 10.1 10.1 0.7
Spanish banks index 6.9 6.3 5.9 8.4 8.5 0.7
Swiss Banks
Credit Suisse (CSGN VX) 8.4 6.4 5.9 N/A 4.3 4.7 0.9
UBS AG (UBSN VX) 10.3 7.5 6.2 N/A N/A N/A 0.8
EFG International (EFGN SW) 9.8 7.8 6.0 3.2 1.5 2.2 1.0
Julius Baer Group (BAER VX) 15.1 12.6 11.2 2.3 1.9 2.0 1.5
Swiss banks index 9.8 7.3 6.4 3.7 4.1 0.9
European banks index 7.6 5.8 5.1 6.1 6.2 0.5
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Important disclosures
Analyst certification I, Emer Lang hereby certify that: (1) the views expressed in this research report accurately reflect my personal views about any or all of the subject securities or issuers referred to in this report and (2) no part of my compensation was, is or will be, directly or indirectly, related to the specific recommendation or views expressed in this report.
Investment ratings definitions Davy ratings are indicators of the expected performance of the stock relative to its sector index (FTSE E300) over the next 12 months. At times, the performance might fall outside the general ranges stated below due to near-term events, market conditions, stock volatility or – in some cases – company-specific issues. Research reports and ratings should not be relied upon as individual investment advice. As always, an investor's decision to buy or sell a security must depend on individual circumstances, including existing holdings, time horizons and risk tolerance. Our ratings are based on the following parameters: Outperform: Outperforms the relevant E300 sector by 10% or more over the next 12 months. Neutral: Performs in-line with the relevant E300 sector (+/-10%) over the next 12 months. Underperform: Underperforms the relevant E300 sector by 10% or more over the next 12 months. Under Review: Rating is actively under review. Suspended: Rating is suspended until further notice. Restricted: The rating has been removed in accordance with Davy policy and/or applicable law and regulations where Davy is engaged in an investment banking transaction and in certain other circumstances.
Distribution of ratings/investment banking relationships Investment banking services/Past 12 months Rating Count Percent Count Percent Outperform 51 57 29 80 Neutral 26 295 13 Underperform 7700 Under Review 4425 Suspended 0000 Restricted 0000
This is a summary of Davy ratings for all companies under research coverage, including those companies under coverage to which Davy has provided material investment banking services in the previous 12 months. This summary is updated on a quarterly basis. The term 'material investment banking services' includes Davy acting as broker as well as the provision of corporate finance services, such as underwriting and managing or advising on a public offer.
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Share ownership policy Davy allows analysts to own shares in companies they issue recommendations on, subject to strict compliance with our internal rules governing own-account trading by staff members. We would like to advise you that: Emer Lang holds shares in Bank of Ireland. We are satisfied that our internal policy on share ownership does not compromise the objectivity of analysts in issuing recommendations.
Conflicts of interest Our conflicts of interest management policy is available at www.davy.ie/ConflictsOfInterest. Davy acts as stockbroker to Bank of Ireland. Investors should be aware that this research has been disclosed to the issuer(s) in advance of publication in order to correct factual inaccuracies. We are satisfied that this has not compromised the report's objectivity. The remuneration of the analyst(s) who prepared this report is based on various factors including company profitability, which may be affected to some extent by revenues derived from investment banking. Davy is a registered market-maker in the securities of Bank of Ireland on the Irish Stock Exchange. Davy is a registered market-maker in the securities of Bank of Ireland on the London Stock Exchange. Davy may have acted, in the past 12 months, as lead manager/co-lead manager of a publicly disclosed offer of the securities in Bank of Ireland. Investors should be aware that Davy may have provided investment banking services to, and received compensation from, Bank of Ireland in the past 12 months or may provide such services in the future. The term investment banking services includes acting as broker as well as the provision of corporate finance services, such as underwriting and managing or advising on a public offer. From time to time, Davy may hold a position or deal in the securities referred to in this report. Should an instance arise where Davy has a holding that exceeds 5% of the issued share capital of a company, this will be disclosed in this report.
Other important disclosures A description of this company is available at www.davy.ie/RegulatoryDisclosures. A summary of our standard valuation methods is available at www.davy.ie/ValuationMethodologies. All prices used in this report are as of close of business November 2nd unless otherwise indicated. A summary of existing and previous ratings for each company under coverage, together with an indication of which of these companies Davy has provided investment banking services to, is available at www.davy.ie/ratings. The data contained in this research note have been compiled by our independent analysts, based on a combination of publicly-available information and the analysts assumptions and modelling. Further information is available upon request. This document does not constitute or form part of any offer, solicitation or invitation to subscribe or purchase any securities, nor shall it or any part of it form the basis of, or be relied upon in connection with, any contract or commitment whatsoever. Any decision to purchase or subscribe for securities in any offering must be made solely on the basis of the information contained in the prospectus or other offering circular issued by the company concerned in connection with such an offering. This document has been prepared by its authors independently of the company or companies covered. Davy has no authority whatsoever to give any information, or make any representation or warranty on behalf of the company or companies. In particular, the opinions, estimates and projections expressed in it are entirely those of the analysts and are not given as an agent or financial adviser of the company or companies. In the UK this document is restricted to (i) persons who have professional experience in matters relating to investments falling within Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (the "Order") or (ii) high net worth entities falling within Article 49(2)(a) to (d) of the Order. Please note that in accordance with the Central Bank of Ireland's Market Abuse Rules, no person, other than a market-maker, may enter into any transaction or arrangement which would have the effect of generating a net economic benefit arising from a fall in the price of the following shares: the Governor and Company of Bank of Ireland, Allied Irish Banks plc, Irish Life & Permanent plc and Anglo Irish Bank Corporation plc. Please refer to the Market Abuse Rules for full details.
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Distribution of research to clients of Davy Securities in the US Davy Securities distributes third-party research produced by its affiliate, J & E Davy. Davy Securities is a member of FINRA and SIPC and is regulated by the Central Bank of Ireland. Davy Securities does not act as a market-maker. Davy Securities or an affiliate holds a proprietary position and/or controls on a discretionary basis more than 1% of the total issued share capital of Bank of Ireland. This information was current as of the last business day of the month preceding the date of the report. An affiliate of Davy Securities may have acted, in the past 12 months, as lead manager/co-lead manager of a publicly disclosed offer of the securities in Bank of Ireland. Investors should be aware that an affiliate of Davy Securities may have provided investment banking or non-investment-banking services to, and received compensation from, Bank of Ireland in the past 12 months or may provide such services in the next three months. The term investment banking services includes acting as broker as well as the provision of corporate finance services, such as underwriting and managing or advising on a public offer.
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