Explainer: Bank stress tests and what they mean

AIB and Bank of Ireland are likely to fare worse than many other European banks

 

Banks in the Republic and across Europe will learn at around 5pm on Friday how they fared in the latest round of stress tests run by the European Banking Authority.

What are stress tests? They are a way of regulators establishing how well individual banks can stand up to a recession or an economic downturn.

What Irish banks are involved? AIB and Bank of Ireland are among 48 European lenders that underwent the tests in recent months.

Who carried them out? The European Banking Authority, which safeguards the EU’s financial stability, at the behest of the European Central Bank.

How do they work? The EBA takes the banks’ December 31st 2017 balance sheets and uses them as a basis to establish how well prepared they are to deal with a major recession or downturn.

What impact could a recession or downturn have on banks? The key problem they would face is an increase in the number of bad debts and borrowers with difficulty in repaying their loans, which could in turn lead to losses and loan writedowns.

What measures should banks have in place to deal with this? They should have enough capital to absorb any losses that could result from a recession in order to ensure that they remain solvent.

Is there a “pass” or “fail” mark? No, there is a ranking for each bank according to how it performs.

So what is the actual significance? The key thing for all banks is whether the test results indicate that they need more capital to give them a sufficient buffer against any losses that could result from a recession.

How would they get more capital? The obvious way is to raise more money from investors. Other options include limiting or not paying dividends to shareholders until they have built up enough cash to ward off a recession.

How are Irish banks likely to perform? It is thought that they will underperform most other European lenders. They already have a lot of bad debts left over from the 2008 financial crash and recession. Also, the EBA is assuming that a recession here could be sharper than in other EU countries.

Why is the EBA making this assumption? Recessions hit countries differently and the Republic faces specific risks of its own, such as Brexit, while, as an open economy, it was among the worst affected by the last downturn.

What should we look out for from AIB and Bank of Ireland once the results have been published? Any indication from either bank that the results mean they need more capital. If they did, it would hit their share price immediately as they would either have to issue more stock to raise cash, or cut dividend payments to shareholders, limiting returns to investors.

Details of the Irish banks’ performance will be published on Irishtimes. com shortly after the European Banking Authority releases the results.