Address to Joint Oireachtas Committee on Finance and the Public Service

Dan O’Connor – Executive Chairman, AIB Group

Eugene Sheehy – CEO AIB Group

Robbie Henneberry – MD, AIB Bank RoI Division

25th November 2009

Address to Joint Oireachtas Committee on Finance and the Public Service by AIB Group plc

Chairman,

Thank you for providing us with this opportunity to update your committee on matters that have impacted on the costs involved in the provision of loans to our customers.

At the outset I would like to make the following observations;

  • Lending Costs for Commercial customers have increased over the course of 2009 for new borrowings and also where there is re-negotiation of existing facilities.
  • The drivers for the increase relate directly to the increased costs to AIB in funding its loan book both from Wholesale Money Markets and our customer Deposit book.
  • Our pricing guidelines could lead to a customer being charged 4% to 5% over Euribor. It is important to note that Euribor no longer represents the cost of funds.
  • The implementation of NAMA is expected to have a positive effect on the cost of funding to AIB over time. Already there is evidence that International providers of Funds to Ireland have taken a positive view of the NAMA proposal.
  • AIB is very conscious of the needs of Businesses in Ireland and in particular SME’s. In this regard significant effort has gone into ensuring that the cost increases and their justification are properly explained to customers.

Drivers for increased costs

AIB funds its balance sheet including its commercial loan book through a combination of customer account balances (approx 50%) and wholesale market funding (approx 50%). The impact of recent dislocation of the Wholesale Money Market has had a significant impact on the costs to AIB of funding its loan book.

When AIB accesses funding in the wholesale money markets, the cost of raising these funds, particularly through the issuance of bonds, has risen significantly. The graph in Appendix 1 illustrates the scale of this cost increase for AIB ‘5 year’ bond issuances. As can be seen from the table below the Irish Government is also experiencing increased costs when raising sovereign debt through the bond issuance programme by the National Treasury Management Agency. As AIB is now rated by International Credit Rating Agencies as A minus, the price for borrowing by AIB is determined by the market in that context.

Over the last year, uneconomic pricing levels have evolved in the Deposit market in Ireland as banks have attempted to grow customer account balances in order to reduce their wholesale Funding. In order to attract and maintain customer deposits, banks are offering customer’s interest rates well above market rates. The tables below illustrate this by comparing typical AIB Deposit interest rates in 2007 versus 2009.

AIB Deposit Margins
End of June 2007 / End of June 2009
6 Month Euribor / 4.375% / 1.331%
Typical Rate for €100k Deposit / 4.070% / 2.350%
Margin / 0.310% / -1.020%

Addressing these changes

The result of the above is that for AIB, the cost of our ‘raw material’ i.e. the funds sourced to provide loans to our business customers has increased significantly. Like any business AIB needs to make commercial decisions to maintain its long term financial strength. Some of these additional costs have been absorbed by the bank and the balance has been passed onto the customer in the form of higher interest rates.

In February 2009 it was decided to recover some of this cost through the introduction of a new but separately identifiable element of the lending interest rate called a Funding Premium. This variable informs customers and staff of the level of Funding Costs attributable to a lending facility. This new variable is reviewed quarterly with the intention that if market conditions improve and Funding Costs reduce then this can be passed onto customers at the earliest opportunity.

In a time of historically low market interest rates in Europe (ECB at 1%) and given that this is a significant increase in cost to customers, AIB has placed a priority on ensuring that in all customer interactions the background and nature of this cost can be explained. In order to achieve this, AIB has conducted a significant training exercise with our staff across the country. As the Funding charge increases with longer terms (e.g. 1yr vs 5yr), customers are tending toward an annual pricing review and are charged the lower one year Funding Premium in an attempt to minimise the level of cost.

AIB provides a standardised approach to pricing across the network where lenders in all branches are fully informed on the pricing to be applied to all individually negotiated facilities. The pricing process involves, in all cases, a meeting between the customer and the local Relationship Manager to discuss the requirements of the customer and to advise the pricing that the facility will attract. Once terms have been set, the customer receives a written contract which includes details of all elements of the pricing including the Funding Premium.

In overall terms for AIB, the Pricing of the Deposit book tends to be short term in nature where customers’ accounts are repriced on a regular basis. However pricing of the loan book is of a contractual nature and repricing occurs over a much longer period. In this situation AIB carries the price differential particularly where there is extreme market movement in a short time as has occurred over the last year. Year to date in 2009 AIB’s retail and commercial business in the Republic of Ireland has seen its overall loan margin increase by 7% but its deposit margin has fallen by 70% in the same period. The graph below illustrates the recent decline in deposit margins in Ireland.

To take a broader perspective Appendix 2 shows how Irish interest margins and fee income rank as some of the lowest in Europe according to both the ECB and the IMF.

Credit Risk and Bank Margin

Another key component of our margin relates to the banks view of the level of risk of default that the customer presents to the bank. The bank’s margin will increase in line with the level of customer risk. In recent times, AIB has seen the level of risk associated with many of its commercial customers increase as their businesses are impacted by the downturn in the Irish economy. As a result some customers who seek new loans or whose existing facilities are out of contract and are being re-negotiated will observe an increase in the bank’s margin which relates directly to the increased level of risk relevant to that customer.

AIB like all banks is required under international regulatory Capital Requirements (Basle) to have extensive risk rating systems to support the calculation of risk into customer margins.

The impact of NAMA

Given the current economic outlook and as long as AIB’s Credit Rating remains at A minus, liquidity costs are likely to remain a factor in the pricing of loans for the foreseeable future. However a successful implementation of NAMA is expected to have a positive impact on liquidity costs over time.

AIB’s ongoing commitment to SME’s in Ireland

Our key focus is on supporting our 170,000 SME Customers through the current economic and trading cycle, seeking to meet their individual financial needs and helping them to overcome their key business challenges.

We are doing this in a number of ways:

- We are providing over €15bn in working capital and investment loan facilities

- Between January and October this year, we have approved over 42,000 facilities for business customer totalling €1.85bn

- We have launched a number of new credit initiatives this year such as our EIB Loan Fund and our revamped Invoice Discounting Offer. In addition, we will shortly announce details of a new €23m Seed Capital Fund with Enterprise Ireland

- We have realigned our business model to support the changing needs of our customers, which included the launch of 15 new Business Centres nationwide

- We are communicating our commitment to the SME market via an extensive communication campaign targeted at SME owners / managers, Industry Groups, State Agencies and key media influencers

We are determined to play a leading role in supporting and enabling the SME agenda. The SME market is key to the recovery of our national economy and we recognise our role in helping to achieve this. Our commitment to business customers including SME’s remains strong. Where we write lending business, the interest rates we charge will continue to reflect the costs we encounter.

Appendix 1

Appendix 2

Source: European Central Bank Report- EU Banking Sector Stability, August 2009

Country / Net Interest Income / Net fee and commission Income / Total Operating Expenses
Romania / 4.04% / Romania / 1.76% / Romania / -3.34%
Bulgaria / 4.01% / Poland / 1.21% / Bulgaria / -2.69%
Hungary / 3.00% / Bulgaria / 1.12% / Poland / -2.67%
Latvia / 2.79% / Czech Republic / 0.93% / Hungary / -2.56%
Poland / 2.75% / Italy / 0.89% / Latvia / -2.23%
Greece / 2.60% / Latvia / 0.84% / Austria / -2.19%
Czech Republic / 2.59% / Lithuania / 0.81% / Slovakia / -1.96%
Estonia / 2.54% / Hungary / 0.80% / Italy / -1.92%
Slovakia / 2.46% / Slovenia / 0.76% / Greece / -1.88%
Lithuania / 2.30% / Estonia / 0.76% / Czech Republic / -1.88%
Slovenia / 2.19% / Slovakia / 0.73% / Slovenia / -1.84%
Italy / 1.88% / Austria / 0.72% / Portugal / -1.62%
Portugal / 1.88% / Portugal / 0.69% / Lithuania / -1.51%
Cyprus / 1.73% / Luxembourg / 0.64% / Estonia / -1.48%
Austria / 1.64% / Spain / 0.63% / Spain / -1.25%
Spain / 1.64% / France / 0.62% / France / -1.25%
Finland / 1.19% / Greece / 0.61% / Cyprus / -1.21%
Malta / 1.18% / United Kingdom / 0.59% / Belgium / -1.13%
United Kingdom / 1.13% / Cyprus / 0.50% / United Kingdom / -1.12%
Denmark / 1.10% / Belgium / 0.44% / Netherlands / -1.12%
Belgium / 1.02% / Sweden / 0.40% / Denmark / -0.96%
Netherlands / 1.01% / Germany / 0.38% / Germany / -0.93%
Sweden / 0.93% / Netherlands / 0.36% / Sweden / -0.85%
Ireland / 0.90% / Finland / 0.32% / Finland / -0.80%
Germany / 0.85% / Denmark / 0.29% / Luxembourg / -0.73%
Luxembourg / 0.74% / Ireland / 0.14% / Malta / -0.56%
France / 0.71% / Malta / -0.03% / Ireland / -0.50%

Appendix 2

According to the IMF 'Average Interest margins have been low in Ireland……..

…Irish margins have fallen further recently'

Sources: Haver Analytics; and IMF staff estimates