Central Bank to base stress test on foreign repossession levels

THE CENTRAL Bank will base its stress tests of Irish lenders on the level of repossessions in the British and US housing markets, the bank’s governor Prof Patrick Honohan has indicated.

The analysis of the likely levels of loan defaults in the Irish mortgage market will take into account the rate of foreclosures in those countries rather than the Irish experience, where the number of repossessions has been low as a result of an official policy of forbearance on mortgage arrears.

Critics of the stress testing process say one effect of this policy has been to mask the true level of difficulties in the mortgage market.

As a result, it is argued, the banks should be required to hold higher levels of capital in order to account for potentially widespread defaults.

In a speech to the International Centre for Monetary and Banking Studies yesterday, Prof Honohan said the Central Bank was “determined” to present a stress test to the market that would be “better insulated against surprises by using aggressive stress assumptions and modelling”.

He said the emphasis would be on determining the appropriate capital levels to meet stresses.

“We will seek to largely free the tests of any excessive expectations from Irish exceptionalism in loan-loss recoveries,” he said.

The 2011 stress tests, which are due to be published at the end of the month, will reference the experience of foreclosures in downturns in Britain and the US, “though not slavishly so”, and “lead us to choose new tougher capital levels for the banks sufficient to convince the markets”, Prof Honohan added.

The Central Bank governor defended the 2010 stress tests, saying one of their underlying assumptions had been “unluckily undermined” within months of their publication as a result of timing issues.

“We had to go public on them part-way through the big programme of loan purchases by the State property company Nama,” he said.

“With hindsight, it would have been great to have built in more insulation by providing for even tougher haircuts; but at the time it would have seemed an arbitrary and hard to justify exercise of regulatory powers.”

Prof Honohan also stressed the need to create an alternative line of funding for the Irish banks, which have borrowed €187 billion from the European Central Bank (ECB) and the Irish Central Bank.

The EU-IMF finance package is not structured to reduce the “significant tail risk” to Irish bank debt, he noted.

“If I am right in saying that the market’s reluctance to finance Ireland is down to the exposure to tail risks that they fear, then restoring Ireland’s access to market funding needs to address those risks.”

Financial instruments that could, it has been suggested, improve Ireland’s position – such as GDP-linked bonds, tail risk insurance and bank equity – are “not as easily taken off the shelf as plain vanilla lending”, Prof Honohan said.

“In particular, any insurance contract is beset by moral hazard problems. While these could be addressed, unfortunately no pre-existing template exists for intergovernmental arrangements of this type, and most observers are sceptical that one could be put in place soon.”