OREANDA-NEWS. The rating outlook for Bank of Ireland (BOI) and Allied Irish Banks (AIB) is positive, but the banks' weak asset quality is a hurdle in the path to upgrades, says Fitch Ratings. The volatility of the country's economic cycles and high private sector indebtedness are likely to constrain their ultimate rating levels. But the positive outlook reflects our expectations that the ratings may be upgraded over the next 12-24 months if improvements in asset quality and capitalisation continue to feed through to the banks' credit profiles.

Weak asset quality is the key vulnerability for Irish banks, in our view, and this constrains their fundamental credit worthiness. However, BOI and AIB have made good progress in reducing problem assets. Data released by the European Banking Authority in November 2015 showed that Irish banks have been among the EU's most active in reducing stocks of non-performing loans. Nearly EUR6bn of bad loans were cut back in 1H15, equivalent to 15% of total bad loans at that date. Progress has been made through rehabilitation, loan curing and non-recourse sales of problem assets.

However, asset quality is still fragile and working through the EUR30bn backlog of impaired loans at BOI and AIB will take time. We estimate that net impaired loans as a percentage of Fitch core capital has fallen to just below 100% for BOI for the first time in seven years. For AIB, this ratio was significantly above 100% but once end-2015 figures are published, there will be an improvement because the bank will have converted some of its government-held preference shares into common equity. At their worst, the banks' net impaired loans represented 555% (BOI) and 400% (AIB) of Fitch core capital.

Our assessment of asset weaknesses includes a high proportion of forborne loans in the system, very low yielding loans, defaulted but not impaired loans, and restructured loans, all of which add up to a high proportion of the banks' balance sheets. It will take many years to work through all these problems, especially because many of them date back a long time. For example, the stock of Irish residential mortgage loans, both owner-occupied and buy-to-let, in arrears for over 720 days is high at EUR15.1bn, equivalent to 12% of outstanding mortgages.

While capital ratios at BOI and AIB strengthened significantly over the past six months, we believe the banks could still be vulnerable to severe shocks. In particular, we are monitoring developments in Ireland's commercial real estate market (CRE). Irish banks are not expanding aggressively into this type of financing but the market is particularly cyclical and investment levels currently exceed pre-crisis levels. International and domestic investors are driving this expansion but the CRE sector could be vulnerable to changes in investor sentiment and significant expansion in CRE financing at BOI and AIB would therefore increase risks.

Economic growth in Ireland was strong in 2015, with year-to-date growth rates at 3Q15 reaching 7%, well above the average reported by other eurozone countries. Fitch forecasts GDP growth of 2.4% in 2016 and this provides a supportive operating environment for the banks. Private sector indebtedness at 150% of GDP is similar to the UK (154%), but the Irish central bank highlighted in its 2Q15 quarterly bulletin that debt overhang is still a problem for many households in Ireland, with mortgage indebtedness particularly heavy for 18-44 year olds.