It’s going to be a stressful year for Irish banking

Next year is going to be a big one in Irish banking. For about the sixth year in a row. It's the year when Fitch expects AIB and Bank of Ireland to return to profitability for the first time since the dying days of the Celtic tiger era.

Don’t get too excited though because this won’t mean that they’ll be lowering their banking charges or dropping their saucy variable-loan interest rates.

Not with euro area stress tests just around the corner. These are due to be completed in advance of the single supervisory mechanism taking effect in November next. In effect, this will result in the European Central Bank taking over the supervision of the financial sector across the euro zone.

Much has been made about these stress tests and whether or not AIB, Bank of Ireland and Permanent TSB will require additional capital. With €64 billion already having been sunk into the financial sector here, there's an understandable reluctance on the part of the Government to give over any more exchequer funds to the banks.

Minister for Finance Michael Noonan has said repeatedly over the past number of months that there is not a shred of evidence to suggest the three banks will need a red cent in additional capital.

He’s right, of course, but largely because the parameters of the stress tests have not yet been set down. For example, we don’t know at what level the core tier 1 capital ratio will be set. In Ireland, it is currently 10.5 per cent, but it is a couple of points lower in other countries.

The rules of the stress tests are crucial. No country will want one of their banks to fail the tests and you can be sure that each one, including Ireland, will be watching this like a hawk to ensure the tests are not unduly severe.

One theory is that banks across the euro area have been building up to these tests for some time by retrenching and hoarding capital for the potential rainy day rather than participating actively in their local economies. Hence the sluggish growth across continental Europe.

Some banks will fail
All that said, for these tests to have any credibility with capital markets, some banks in the euro area will probably have to fail the tests. It's hardly credible to think that every bank in the euro area will come through with flying colours.

It’s likely the ECB will communicate the parameters of the stress tests in January.

Mr Noonan and the banks might point to the recent balance-sheet assessments and asset quality reviews by the Central Bank here as evidence that no additional capital is required at the three Irish banks.

These tests were a requirement of our exit from the troika bailout. To recap, the assessments showed that the banks don’t need any additional capital but should take more provisions for bad loans.

In essence, these were a point-in-time exercise. That time being June 30th, 2013. It remains to be seen if these assessments will be enough to satisfy the ECB or whether the three banks will have to go through them all over again.

The banks and the Central Bank here would prefer not to repeat them but a lot of water will have passed under the bridge by the time the European stress tests get under way so we might just have to swallow hard on that one.

On Monday, European Central Bank president Mario Draghi urged "decisive" action on issues revealed by the recent balance-sheet assessments before the stress tests next year. He said there needed to be adjustments for provisions and risk-weighted assets and noted the stress tests would be more rigorous. Crucially, they will be forward-looking.

His comments reminded us of the fragile state of the Irish financial sector right now. A lot of good repair work has been done but we can’t be sure the roof will stay on the next time a gale blows through town.

It is interesting that in a recent interview with RTÉ on this matter, Central Bank governor Patrick Honohan said he couldn't guarantee more capital wouldn't be needed.

Given the actions to date, any sum required would probably be of manageable proportions in the context of the Government’s resources. We still have about €6 billion in the National Pension Reserve Fund so a few billion in extra capital is not beyond our means. Selling it to voters would be another matter entirely.

Again, it’s going to be a big year for Irish banking.