Analysis: Will the banks stop hoarding cash and start lending?

It would have been better if Ireland, with its recent history of banking problems, could have stayed out of the spotlight completely in today’s banking stress tests. However Permanent TSB was one of the 25 banks across Europe to have failed the tests and while it will have to raise considerably less capital than the €854 million shortfall identified by the tests, its management estimates it will still have to find a minimum of €125 million.

Banks have been hoarding cash to keep the regulators happy. Will they now start lending more ? No-one expects a flood of new lending here, particularly as the banks continue to deal with the legacy of bad loans on their balance sheets to mortgage customers and SMEs and gradually move back into normal profitability levels. But at least - for the two big banks - the stress test hurdle has been jumped.

The tests looked at the quality of the assets held by the banks and whether they had enough capital to meet expected economic conditions over the next two years. All of the Irish banks got a green light from this part of the test. However the European authorities then modelled what would happen if another economic downturn hit. On this basis PTSB failed the test, and thus must raise new cash.

Statements from government and the banks had prepared the way for this and intensive discussions have been under way between the bank, the Central Bank and senior government officials in recent weeks. PTSB reacted immediately today saying that it had already met some 80 per cent of the shortfall identified by the ECB - helped by being able to count €400 million in a special government convertible instrument (know as a CoCo) leaving it with some €125 million to raise.

One issue for the government, which must agree to sell down part of its 99.2 per cent holding if PTSB is to raise cash from new investors, is how much investors will demand in terms of shares for this kind of cash. This will be bottomed out in the months ahead, with a sale scheduled for early next year. Also, the initial indications are that potential investors may want to invest more than this minimum figure and take a larger stake.

Other issues will come into play here, too , including whether some or all of the CoCo might be converted into ordinary equity. This is likely to form part of the discussion with potential investors in PTSB.

If a favourable deal cannot be struck with an investor, then the government could decide to inject the extra cash itself. This could be politically difficult, of course - yet more cash for the banks. However the option is selling down some of its shareholding at what will probably be a fairly low price, given that the bank is a long way from making profits.

A key factor will be whether the Irish economy keeps growing and Irish assets remain in fashion for international investors. If these conditions are met, then the chances of getting an investor for PTSB increase, as it is a play on the Irish economy. Growth would also help the bigger banks to continue to improve their position and engage in new, profitable, lending. As well as PTSB, the state could then start to sell down its AIB stake later next year. If growth stalls, then it all starts to look a lot harder.

In the meantime a lot of the international focus will be on Italy, where nine banks failed the tests. Ireland was one of the first countries to discover problems in its banks and inject state cash to provide new capital. Elsewhere some new holes are still emerging.