Bank stress tests: Shareholder relief but challenges remain

The Republic’s two biggest banks, their shareholders and regulator presumably breathed sighs of relief on Friday night after both institutions were found to have enough capital to withstand a recession.

The European Banking Authority (EBA) released the results of its latest stress tests late on Friday. Both AIB and Bank of Ireland emerged with figures showing that they have enough capital to absorb the impact of a sharp downturn in the economy.

The authority, whose main function is safeguarding the EU’s financial stability, spent almost a year running the rule over the balance sheets of 48 banks that account for 70 per cent of the business done by the bloc’s lenders.

It wanted to establish how well-prepared those banks were for a severe recession that would involve the EU’s economy shrinking by 2.7 per cent over three years, property prices tumbling by 20 per cent and millions of workers losing their jobs.

Ireland’s two biggest banks can withstand a recession, EU stress tests show

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Explainer: Bank stress tests and what they mean

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The risk that this poses to banks is that their income falls while the number of borrowers who either struggle to repay loans, or cannot repay them at all, rises, leaving lenders facing increased losses as a result. If banks do not have enough capital to soak up these losses, they could face insolvency, with severe consequences for everyone else.

The key measure of a bank’s preparedness for a recession is its capital ratio, the proportion of capital – namely investors’ money and its own income – that it holds relative to the amount of money it has loaned to customers.

In AIB’s case the key ratio, based on its December 31st, 2017, balance sheet, was 17.48 per cent. In the sharp recession test that the EBA applied, this would fall to 11.83 per cent at the end of 2020. The EU’s legal limit is 4.5 per cent.

Hypothetical downturn

This was an improvement on the previous test in 2016, when the comparative figures were 13.1 per cent at the beginning of that year, falling to 4.3 per cent by the end of 2018 in a hypothetical recession.

Bank of Ireland also improved its performance. Its key ratio stood at 13.82 per cent at the end of last year. The EBA calculated that this would fall to 8.93 per cent on December 31st, 2020, should a severe economic storm strike. The lender's comparative figures in 2016 were 11.3 per cent falling to 6.1 per cent.

From the banks’ point of view neither needs to raise more capital. This is good news for their share price, as they won’t have to issue more stock to shore up their reserves, and their investors, who are more likely to receive dividends.

The Republic’s growth helped both banks improve on their 2016 results, but other factors contributed as well. The State sold 29 per cent of AIB last year to raise €3.4 billion. The bank has offloaded billions worth of euro in loans that are heavily in arrears or not being repaid.

AIB cut the level of those bad debts by 27 per cent to €7.5 billion in the first half of this year. Bank of Ireland has cut its bad loans to €5.9 billion by the end of June.

Nevertheless, those bad debt figures are higher than the Central Bank of Ireland, the regulator, would like. They show that both banks remain vulnerable. A recession on the scale envisaged by the EBA would leave AIB nursing a €1.55 billion loss in in its first year and force the bank to write almost €2.9 billion off the value of its assets over three years. Similarly, Bank of Ireland would lose €1.5 billion in the same scenario and write €3 billion off its assets over three years.

Clearly, Central Bank director Mary-Elizabeth McMunn, said on Friday, challenges remain.