03 April 2011

Implications of Irish Bank Stress Test

On 31 March the Central Bank of Ireland came out with the long awaited stress test results for Irish banks (The Financial Measures Programme Report), incl. capital and funding assessments. Most importantly, the four tested banks (Allied Irish Banks, Bank of Ireland, EBS Building Society, and Irish Life & Permanent) were told to require an additional EUR 24.0 billion fresh capital, this on top of the EUR 46.0 billion bailout cost for Irish banks so far.

When compared to the analysts’ expectations, the number looks reasonably big. Of course, one could always argue if the scenario was severe enough, if the assumptions were reasonable or consistent, or if it’s at all possible to provide reliable loss estimations in case of pyramid-scheme like money creation principles and reflexive relationships. However, considering all the expertise and quality checks involved (BlackRock, central banks of various countries, Boston Consulting Group) let’s take the result at face value at least for a moment and instead focus to the other implications of Irish Bank Stress Test. I mean what messages can regulators, bank analysts and others read out from Irish Bank Stress Test beside what is explicitly stated in the above referred report.

First it’s perhaps the size of capital ratios after the proposed recapitalisation of banks: pro forma Core Tier 1 ratio (assuming immediate capital injection) for Allied Irish Banks (AIB) is 21.9%, for Bank of Ireland (BOI) 16.1%, for EBS Building Society (EBS) 22.6% and for Irish Life & Permanent (ILP) 32.4%, and this to stay above the minimum capital targets of 10.5% Core Tier 1 in the base scenario and 6% Core Tier 1 in the stress scenario plus necessary buffers to secure access to funding. The numbers look large compared to Basel II or even Basel III requirements. Basel III countercyclical capital buffer within a range of 0%-2.5% is ridiculously low when compared to the 11.4% that e.g. AIB needs above the base scenario capital target of 10.5% (and this on top of all the losses that the bank has suffered so far). Furthermore, the other European banks with Core Tier 1 capital ratios around 10% claim that they are well capitalised. Yes, they do not have their main business in Ireland, but if the thing started to unravel in Europe (starting from the defaults of PIIGS countries) several of them would be in not much better position...

Another point to note is the sustainable Loan to Deposit ratio that Irish Central Bank has agreed with the External Partners: 122.5% for the aggregate domestic banking system (180% currently). Well, if the sustainable ratio for Ireland is to be taken as benchmark, then we have more too leveraged countries and banks in Europe... Do they manage to deleverage quietly? What are the consequences to the economy?

When continuing reading The Financial Measures Programme Report, we note that banks’ own estimates of real estate loan losses and provisions are considerably lower than those derived by Central Bank based on BlackRock forecasts. The difference is said to come from the use of different methodologies: when estimating the losses, banks put more emphasis on customers’ repayment capacity and employment, while BackRock focuses to collateral market values and Loan-to-Value (LTV) ratios. As Bank of Ireland states, the approach applied by BlackRock (the so-called “repossess and sale” approach) is materially different to the methodologies of their own and those of leading international risk consultants. Considering that at the end the banks’ own forecasts were replaced by BlackRock’s numbers, we should ask: are the methodologies applied by the banks and by leading international risk consultants reliable enough? The rhetoric now probably goes that stress test results are ought to be conservative. However, it’s hard to believe that they are unreasonably conservative – Irish authorities just do not have excess nice-to-have capital to inject into the banks.

One further question goes: can we extrapolate the estimated loan losses of the stress tested Irish banks to the Irish exposures of the other banks like Ulster bank, the subsidiary of Royal Bank of Scotland (RBS)? Considering that over the coming three years (2011-2013) the loss ratio could be around 10% of the loan portfolio as of 31 December 2010, further losses of Ulster bank could amount to GBP 3.7 billion, that is almost twice as much as they have been since 2008 (based on 2010 Annual Report of RBS, the lending volume of Ulster bank was GBP 36.9 billion).

In short: in the light of Irish Bank Stress Test several questions arise about the other (European) banks and the financial systems of other (European) countries. And more importantly, those are not only the questions of critical analysts but the questions that monetary authorities have already publicly asked about the financial system in such a developed country like Ireland. How much capital do the banks actually need? What is the sustainable Loan to Deposit ratio? Are the “best practice” loan loss estimation methodologies good enough?

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