White knights or loan book cannibals – what will happen at Ulster Bank?

Niamh Brennan, the University College Dublin management professor, was preparing to sit through an induction session for new Ulster Bank board members on September 11th, 2001 when news of the terrorist attacks in the US came through.

It ended up being interrupted as the world absorbed the "seismic nature of those events", she would tell the Oireachtas banking crisis inquiry five years ago.

Brennan wasn't to know it at the time, but a legacy of the attacks was the global credit bubble that followed as central banks – led by the US Federal Reserve – accelerated interest rate cuts to save the economy. The Fed's main rate slumped from 6 per cent at the onset of the 2000 dotcom crash to 1 per cent in 2003, as the geopolitical fallout from 9/11 led to the Iraq War.

Ulster Bank, bought by Royal Bank of Scotland (RBS) in 2000, saw its loan book swell 265 per cent to €46.7 billion in the four years to 2008 in the Republic as banks globally gorged on cheap funding to grow.

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The big issue for NatWest is the €3.95 billion of trapped capital in a division that is delivering little or no return

Ulster Bank only accounted for 3 per cent of RBS’s assets when the crash came. Still, it would absorb the equivalent of a third of the group’s £45 billion (€50.5 billion) UK taxpayer bailout as bad loans soared.

More than a decade later, Ulster Bank is nowhere closer to making enough money to cover its funding costs – let alone deliver an acceptable return on the capital its parent has tied up in the operation.

Alison Rose, the UK group's chief executive of one year, has already ditched the RBS name after almost 300 years to rebrand the group as NatWest, and moved to shrink its problematic investment banking unit. She is now focused on Ulster Bank, whose problems have been compounded by Covid-19.

The Irish Times revealed in September that Rose is actively considering winding down Ulster Bank in the Republic (Ulster Bank in Northern Ireland is a separate operation), and reported this week that Goldman Sachs is advising on the strategic review that is also looking into the less likely options, such as merging the unit with another Irish bank. A final decision is expected within months.

“The writing has been on the wall for some time that Ulster Bank was not a natural fit at RBS,” said a former Ulster Bank executive, who declined to be identified. “You’ve had strategic review after strategic review of Ulster since 2008. But as RBS, or NatWest, has become smaller and smaller, remaining problems in the group have become much more noticeable.”

An exit would follow a string of overseas lenders, including Bank of Scotland, Danske Bank and Rabobank, that retreated from the Republic following the 2008 crash. It would increase the dominance of Bank of Ireland and AIB in a market where local lenders Anglo Irish Bank and Irish Nationwide Building Society also imploded.

Ulster Bank has about a 15 per cent share of the mortgage market, 20 per cent of small business (SME) lending and a strong corporate banking business – making its potential exit much more significant than any of the other overseas banks.

Trapped capital

The big issue for NatWest is the €3.95 billion of trapped capital in a division that is delivering little or no return, according to Bank of America Merrill Lynch analyst Alastair Ryan. Half of this is in excess of normal regulatory requirements, further suppressing returns on equity.

“Unless the owner is allowed to extract a significant amount of capital, then shareholders of the owner will expect it to find another way of extracting that capital,” said Ryan.

In the home of Europe's biggest banking crash, Irish lenders must hold "substantially more" expensive capital in reserve against their mortgage books than elsewhere in Europe as a result of the greater perceived riskiness of their loans, Deutsche Bank analysts said in a recent report. This has knock-on effects for loan rates – among the highest in Europe – and profit returns in an otherwise historically low global interest rate environment.

The total assets of Irish banks is about 11 times their equity reserves, compared to 22 for the UK, Deutsche noted. That means Irish banks are holding twice the level of capital as their nearest competitors.

Even after convincing the Central Bank of Ireland to allow Ulster Bank to return €3.5 billion of surplus capital to NatWest in recent years, it is still being made retain one of the highest capital bases in Europe. Its equity capital ratio stands at about 28 per cent of risk-weighted assets, double what most banks, including the NatWest, are targeting over the long term.

Ross McEwan, RBS chief between 2013 and 2019, repeatedly expressed a frustration on trips to Dublin during his tenure about a lack of engagement by the Central Bank on the capital issue, according to sources.

The current review “reflects the very high cost of doing business in Ireland and the extremely high capital requirements Irish banks face relative to their risk and their ability to charge, too”, said Ryan.

Efforts to rebuild the loan book, following years of sales of toxic commercial property loans and non-performing mortgages, have also been hampered by muted credit demand amid Brexit uncertainty, a dysfunctional housing market and, Covid-19.

Cutbacks

Ulster Bank has eliminated more than 1,000 roles since 2008 and is currently in the middle of another cost-cutting drive under Jane Howard, its fourth Irish chief executive during the period, to axe 266 of its remaining 2,800 positions. But running expenses have remained stubbornly high, ranging between 95 and 111 per cent of income in the past three years, compared with the typical 50 per cent target set by banks.

Established in 1836 as a conservative lender by a group of Belfast merchants, Ulster Bank's linen trade customers continued to thrive even as the island was ravaged by the Famine a decade later. It went on to set up a Dublin office in 1862, before merging in 1917 with London County and Westminster Bank, a precursor to NatWest.

RBS, then under chief executive Fred Goodwin, inherited an exposure to the Celtic Tiger economy in 2000 as part of its takeover of NatWest, before doubling down three years later in Ireland through the purchase here of First Active. With caution thrown to the wind, the bank would bankroll some of the country's largest developers, including Sean Dunne, and launch the State's first 100 per cent mortgages.

"I think they forgot were they came from. They just completely lost the run of themselves," said David Went, Ulster Bank's chief executive from 1988 to 1994, who would follow the bank's lead into 100 per cent mortgages when he was in charge of Permanent TSB before the crash.

“It’s one of the big regrets of my career that we followed that product. But it was extraordinarily attractive for borrowers at the time and if you did not follow it, or indeed the tracker mortgage product that Bank of Scotland brought into the market [in 2001], you would have seen your business cannibalised.”

Ulster Bank in the Republic set aside €16.3 billion of bad loan provisions between 2008 and 2013, the equivalent of about a third of its peak loan book. It was far from alone. The top 11 boom-time lenders in Ireland reported almost €134 billion of net loan losses within a decade of the crash, according to Irish Times calculations.

UK government-controlled RBS had a serious look at Ulster Bank a number of times between 2009 and 2014, concluding each time to stick to the status quo.

A review in 2013, under the auspices of the UK Treasury, which looked at options including swapping a chunk of the bank with the Irish State for Nama assets in Britain. It ended up with decision to move soured Ulster Bank commercial property loans into an internal bad bank and sell them on.

In 2014, RBS sought out investors to buy a stake in Ulster Bank – or a merger with another lender. It led to talks with private equity firms such as Warburg Pincus, CVC and KKR as well as another bank with scale and profitability issues: Permanent TSB. They came to nothing.

The review at the time struck industry observers as odd. It would have meant RBS handing the upside over to others as the Irish economy was rebounding and Ulster Bank and rivals were beginning to release some of the money previously set aside for bad loans.

Besides, RBS was trying at the time to spin off its Williams & Glyn unit. The execution risks attached to that transaction alone were massive.

In addition, the business in the Republic was intertwined in 2014 with Ulster Bank Northern Ireland, making a carve-out even more difficult when the UK taxpayer-owned group would have been under political pressure to remain a force in the North.

Since then, however, the provision write-backs story have played out, RBS has abandoned a sale of Williams & Glyn and closed its branches, and Ulster Bank Group has been split into two distinct business in the North and Republic. Ulster Bank Northern Ireland is not part of the current review.

Gerry Mallon, who took over as the bank's chief executive in June 2016 as UK voters decided to quit the EU, would tell staff in the subsequent months that Ulster Bank had become more strategically important to RBS as a subsidiary in the single market. By the time he quit in early 2018, however, the group's Dutch unit had been picked as its EU hub.

Meanwhile, diplomatic sensitivities bubbling in the background as the UK group pondered Ulster Bank over the years are less a concern now – as Brexit has changed the dynamic between the governments in Dublin and London.

NatWest’s response to questions on the current review has been that Ulster Bank’s current strategy is to grow the business “organically and safely” and that any changes “would be undertaken with full consideration of any impact on customers, colleagues and shareholders”.

Ulster Bank must continue with business-as-usual until a board decision determines otherwise. Earlier this week, it announced a serious of price cuts to its fixed-rate mortgages.

"There will be some that read into the move as an assertion that UB is actually here to stay, so is protecting its turf, but with a massively overly capitalised balance sheet it probably has the luxury to still slug it out while NatWest management ponders its future," said Goodbody Stockbrokers analyst Eamonn Hughes.

Ulster Bank has had its fair sure of skirmishes since the financial crisis. An IT systems failure in 2012 that left up to 600,000 customers deprived of basic banking services over a 28-day period resulted in an almost €60 million compensation bill – and a €3.5 million Central Bank fine.

Of 2,000 Irish SMEs pushed into a controversial global restructuring group (GRG) unit RBS set up after the crash, about 100 went out of business and 1,800 saw their loans sold to investment groups. Businessman Bill Cullen, a high-profile borrower, launched a law suit in 2018 against Ulster Bank and the receivers of his former Glencullen car dealership empire, alleging the bank and its GRG unit targeted his business. The case remains live.

The bank set aside about €300 million in recent years to cover its role in the State’s tracker-mortgage crisis, including money to cover refunds and compensation – and a likely fine.

A tie-up with another bank hasn’t been ruled out. Deutsche Bank analysts estimate a merger with Permanent TSB could result in a 60 per cent profit jump in a combined entity if overall costs were cut by 10 per cent. However, the high capital banks must hold means the return on equity would be only 3 per cent – a third of what investors would expect.

In the past month, Permanent TSB chief executive Eamonn Crowley and KBC Bank Ireland boss Peter Roebben have each played down speculation that they might emerge as white knights. Still, a decision to wind-down will see most rivals vie to buy portions of its loans book. Debt investment funds that have snapped up tens of billions of euro or Irish loans in the wake of the financial crash are also said to be keeping a watching brief.

Sources have said US firm Cerberus has its sights on the entire book with a view of selling on performing loans to other banks while keeping problem debt for itself. This could accelerate a wind-down and settlement of deposits – and allow NatWest to get hold of the trapped Ulster Bank capital sooner. NatWest has said it is not in talks with Cerberus.

Staff

For employees, the lingering uncertainty is unsettling, not helped by the recent surprise departure of chairman Ruairí O’Flynn after only two months in the role, even if he let it be known it had nothing to do with the review. Ulster Bank has 88 remaining branches.

“We’re being bombarded by emails all the time from on high about the group wanting to be a purpose-led bank and the importance of things like sustainability, climate change and wellbeing and mental health of staff,” said one, who asked not to be identified. “You’re just left wondering if you are living in a parallel universe.”

Others, it must be said, have welcomed how Howard has not gone to ground during the review and has kept up regular communications with staff.

But as Brennan, a non-executive director between 2001 and 2009, told the Oireachtas inquiry how Ulster Bank’s board had no say when directed by RBS to buy former building society First Active in 2003, a decision on the bank’s future will come from the UK as a fait accompli.

“I always said that the best job I ever had was running Ulster Bank. It was such a great place with great people,” says Went. “I think it’s a tragedy to see where things are now.”