Uncertainty over Brexit could make it more difficult for the Government to sell down the remaining shares it holds in domestic banks, the European Stability Mechanism has warned.

In its latest annual report, the organisation has said Irish banks have increased profits partly because of low interest rates and lower charges for bad loans.

However, it says that bank profitability could be affected by the remaining bad loans – some of which may be intractable – and also from the Brexit “hit” the economy might sustain.

It also flags the possibility of changes in international tax policy having a bearing on the Irish economy, which is heavily reliant on foreign direct investment.

“Looking ahead, external uncertainty remains considerable, particularly around Brexit and international tax policies. In a still-low interest rate environment, Irish banks, with significant UK exposures, will continue to face a challenging outlook,” it states.

“Brexit uncertainties may weigh on limited [bank] profitability going forward, and also on the Government’s intention to place its banking assets in the private sector.”

‘Growth champions’

Overall the ESM gives a positive assessment of the Irish economy, saying that it has been one of the “growth champions” in the euro zone along with other former bailout countries Spain, Portugal and Cyprus. It says Ireland has been the fastest-growing economy in the euro zone.

The State recently sold over 28 per cent of AIB and a longer-term goal is to sell down the rest in the years ahead. It also holds a small stake in Bank of Ireland and 75 per cent of Permanent TSB.

The report says the banks have been building up their capital but that the results for AIB and Bank of Ireland in last year’s EBA (European Banking Authority) stress tests were “below expectations”.

The ESM was established in 2012 to protect the euro zone and acts as a lender of last resort to economies which have found themselves in difficulty.

In a somewhat neutral commentary on house prices, it says the growth of 6.4 per cent last year would continue in the near term.

“The anticipated modest expansion in supply will be insufficient to meet growing demand. Existing macro-prudential rules regarding loan-to-income and loan-to-value ratios, however, may somewhat mitigate the upward pressure on house prices,” it has stated.

Financial ‘buffer’

The Luxembourg-based institution welcomed the plan announced by then minister for finance Michael Noonan in last October’s Budget to provide a financial “buffer” in the medium term.

Mr Noonan said he would achieve it through a “rainy-day fund”. He committed to placing €1 billion aside for this fund, each year from 2019. However, in one of the first decisions made by the new Cabinet under Taoiseach Leo Varadkar, the fund was effectively halved to €500 million per year. The completion of this report predated that decision.

The report concludes that under the ESM’s early warning system, Ireland faces no difficulty in meeting its lone service repayments.

“Nonetheless, maintaining a prudent fiscal policy stance in line with the debt target and building up a fiscal buffer would ensure that Ireland will have the scope to pursue growth-supporting countercyclical fiscal policies in future downturns.”

Greece remains the ESM’s only active programme country. “The country had to tackle bigger problems than others to modernise its economy, and the interruption of this process in early 2015 was extremely costly. But Greece too can stand on its own as long as it implements reforms agreed with its creditors,” it states.