Tests have revealed no new problems with the banks


The conservatism of the assumptions which underpin the stress tests ought to command the respect of the markets, writes GARRET FITZGERALD

THE CENTRAL Bank’s financial measures programme is set out in an 86-page document which, because it has had to be a model of transparency, is necessarily very complex. It includes every detail of the stress tests carried out for the Central Bank by BlackRock Solutions, a leading specialist in analysing potential loan losses under stressed conditions, which the Central Bank employed for this purpose.

And all this work was overseen by the Boston Consulting Group, whose assessment of BlackRock Solutions’ work it describes as “satisfactory. . . the results being appropriately conservative”.

Although this did not emerge in yesterday’s media coverage, this new study has revealed no new problems with the banks.

The increase of €8.7 billion in predicted banking capitalisation needs in the period to and including the year 2013 – an increase from €10 billion when the last attempt to assess the scale of our banking problem needs was made to €18.7 billion – is accounted for by two principal factors.

First, this study includes provision for losses on the sale of €73 billion of the banks’ non-core assets – an element which for some reason was not built into earlier assessments.

The rest of the difference is accounted for by the fact that much stricter criteria were applied on this occasion – especially in relation to losses on residential mortgages. All mortgages likely to be in negative equity are written off in this study, although in practice a fair proportion of these will continue to be serviced. Residential mortgages account for over half of all bank loans.

(For the purpose of this study the banks had to furnish the Central Bank with their average interest income forecasts for Irish owner-occupied residential mortgages over the next three years. These forecasts were challenged by the Central Bank, which required the banks to increase these estimates where they were judged to have been “overly optimistic or unrealistic” or inconsistent with the Central Bank’s projections for the economy and for house prices).

The Central Bank has decided to add to this €18.7 billion estimate of future bank capitalisation needs a further €5.3 billion, of which €3 billion is a provision for possible, but improbable, banking needs after the year 2013. This will involve no net interest burden on taxpayers because in the intervening period the banks will pay a substantial interest rate to the State on this. Then after 2013 if it turns out that this sum will not be needed it will be returned to the Government.

As for the remaining €21 billion, between €5 and €6 billion of this is to be recovered by selling Irish Life and Permanent or at the expense of subordinated bonds held by all the banks. This would leave between €15 and €16 billion to be found elsewhere. Some €10 billion of this is to come from our own resources – exchequer balances and the National Pension Reserve Fund – leaving only €5-6 billion to be borrowed from the EU-IMF bailout fund, which at an interest rate of 5.8 per cent will cost us at most €350 million a year.

(Moreover, when allowance is made for all this, the amount of non-guaranteed loans that are not being “burned” will be about €16 to €17 billion – not the €35 billion that Vincent Browne has been citing on his television programme).

The very conservative assumptions employed for the purpose of this study are:

That our GNP will fall by almost 3 per cent this year and next, and that it will grow by only 1.2 per cent in 2013.

That private consumption will fall by 5 per cent in the next three years, Government consumption by 12 per cent, and investment by a further 3 per cent. It is assumed employment will fall a further 3.5 per cent.

That unemployment will rise to almost 16 per cent.

House prices will fall by a further 24 per cent.

The Central Bank remarks that “using this unlikely adverse scenario ensures that the capital basis of the institutions is appropriately stringent”.

On that very conservative basis, this new stress test shows that the banks will need €8.7 billion more than the €10 billion that we were already committed to investing in them. That would use only one-third of the €25 billion provided for this purpose in last November’s EU-IMF bailout.

However, the Central Bank has decided that, as a further element of conservatism, this €18.7 billion injection to the banks is to be increased by 30 per cent, thus providing a total of €24 billion new bank finance. Happily this figure lies well within the €35 billion total that was provided in last November’s bailout for bank financing purposes.

The conservatism of the assumptions that underpin this study certainly ought to command the respect of the markets. It remains to be seen, however, to what extent it actually does so.

Factors that could work against this include last year’s undermining of confidence in our banking system; the lack of any specialised knowledge of the Irish economy both on the part of those who rate our debt and those who buy sovereign bonds; and the damage done to our financial reputation by some of our more vocal domestic commentators.

Part of our problem has been, and regrettably still is, the fact that “the markets”, (ie the international firms which evaluate credit risks as well as those which buy bonds issued by sovereign states), lack the capacity to assess adequately the financial situation of smaller states like Ireland. It is only in relation to larger sovereign borrowers that these firms employ specialists with detailed knowledge of the economy of a particular state.

For smaller states like Ireland they depend on second-hand information. This includes often ill-informed media reports, which in our case have involved reports of some of the “celebrity economists” who have been seeking publicity by claiming that our problems are so great that we will eventually have to default.

Some have indeed proposed that we should take that course now despite the impact this could have on our only current source of future borrowing – the EU-IMF bailout.

The damage to our standing abroad by such irresponsible statements has been incalculable. It is difficult enough for our own people to distinguish between serious economic commentators in Ireland and irresponsible voices – it is impossible for foreign observers of our finances to do so.

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