The risky business of banking in Northern Ireland
BANKING is a complex balancing act of risk and reward. Banks risk the mismatch in funding long term loans with short term deposits for the reward of profitable interest rate differences.
In Northern Ireland, where the banking industry mirrors the rest of the UK in its concentrated nature, political instability has injected further complexities in this balancing act.
An EU exit and the collapse of Stormont places real pressures on business lending. Specifically, the RHI scandal and Brexit put pressure on small to medium enterprise (SME) lending by adding further financial woes to the agricultural sector.
One way to quantify these risks would be to take an aggregate look at the ratio of borrowings to deposits for some risky SME business categories. Using British Banking Association data this can be measured on a quarterly basis over 2013/2016. This ratio approximates a bank's liquidity position and epitomises the balancing act.
Too high a value suggests that a bank will not have enough funds available to absorb unforeseen funding shocks, while too low a value suggests profit inefficiencies due to a bank not earning as much as it could from its liquid assets.
The SME sector has seen a reduction in the average liquidity ratio, from 138 per cent in 2013 Q3 to 82 per cent in 2016 Q3, which is largely due to a reduction in lending. This depletion was driven by a deleveraging process in the real estate and construction industries, due to large non-performing loan write offs and the sale of debt portfolios to investment companies. In 2016 Q3, liquidity risk in construction was below 100 per cent while the real estate business remains well above the sector average at 181 per cent.
In contrast the agricultural sub-sector, while capturing a smaller portion of the SME lending stock (eight per cent on average for the same period), has remained a high liquidity risk averaging 288 per cent for the same period. This high risk position can be in part explained by the heavily subsidised nature of the industry (and is commensurate to the rest of the UK, which has a 324 per cent average for the same period); EU and government backed income is purported to account for some 87 per cent of farming income in Northern Ireland.
Clearly this guaranteed income stream is now at risk both from budget cuts and Brexit concerns. A further concern is the ‘cash for ash' scheme which was likely used as lending collateral. Income from this scheme was made certain, regardless of future reviews, following assurances by the finance department to the banks that the 12 per cent rates of return would be ‘grandfathered'.
With these guarantees now likely to be under review in a newly formed Assembly the high ratio may signal increased default risk if promised guarantees are now in doubt.
In summary, political uncertainty has some clear risk challenges for banks in Northern Ireland. While a large deleveraging process in construction and real estate has significantly lowered liquidity risk in SME lending this is likely to squeeze profitability in these areas. More importantly, the lending to the agricultural sub-sector will require careful risk recalibration as guaranteed income may prove illusory.
:: Dr Barry Quinn is a lecturer in finance from the Management School at Queen's University Belfast, specialising in banking, financial cooperatives, regulation, and financial data analytics.