Results of bank stress tests is anybody’s guess

The waiting is finally over for Irish banks, who now know what is expected of them by the European Banking Authority if they are to come through the EU-wide stress tests, which they have been fretting over for some time.

These tests are being carried out in conjunction with the European Central Bank in advance of the establishment of the Single Supervisory Mechanism (SSM) for euro zone banks.

The stress test is designed to assess banks’ resilience to hypothetical external shocks, with a view to identifying remaining vulnerabilities in the EU banking sector and providing a high level of transparency into banks’ exposures. It is regarded as a stiffer measure of the banks’ financial strength than similar exercises carried out in recent years.

In theory, the Irish banks should sail through this process. They’ve been put through their paces a few times since the spectacular crash of the Irish economy in 2008. This has included regular updates for the EU-IMF troika as part of our bailout programme.

Having also gone through the trauma of transferring billions of euros of property-related loans to Nama in 2010 and having submitted detailed restructuring plans to the European Commission following their State aid, you would be forgiven for thinking there is little about their balance sheets that could surprise the Irish banks.

They’ve also been hoarding cash to give themselves a sufficient capital buffer ahead of these tests.

However, so complex are the rules and scenarios around the tests that none of the State-backed Irish banks – AIB, Bank of Ireland, or Permanent TSB – was willing to offer a comment yesterday on the criteria laid down by the EBA. They all said they needed time to study carefully the methodology being applied.

Too many variables

Analysts were similarly reticent to offer a definitive view on the implications for

the Irish banks. There are simply too many variables to consider for a snap judgment to be reached, they said.

There is certainly a lot to be considered. The EBA has released the macroeconomic scenarios, developed by the European Systemic Risk Board, that will be used to assess the impact that changes in the economic environment have on EU banks.

These relate to GDP growth, inflation, unemployment levels, residential and commercial property values and sovereign bond haircuts.

At a bank level, assumptions have to be made around a number of metrics, including revenues, provision coverage levels and wholesale funding costs.

The reality is we won’t know the results until we know the results, which will be some time in October. The SSM will then begin its work in November.

There are essentially two strands to the process – an asset quality review (AQR) undertaken by the European Central Bank and the national regulators, and the stress tests by the EBA.

The AQR is already under way and is a similar exercise to the balance sheet assessments (BSA) carried out by the Central Bank last year on behalf of the EU-IMF troika. It’s a point-in-time exercise that tests the balance sheet strength of each bank.

In theory, the Irish banks should be ahead of the game given that they went through the BSA exercise last year. The result of that test was that all of them were required to increase their provisioning levels but all of them were also found to be sufficiently capitalised.

Sufficiently capitalised

Being sufficiently capitalised is of importance to Irish taxpayers, who have already been tapped for €64 billion in bailout funds for the banking sector since 2008.

Minister for Finance Michael Noonan, the financial regulator Cyril Roux and the various bank chief executives have all said in recent times they have no reason to believe the Irish banks will need additional capital as a result of the Europe-wide stress tests.

At the end of last year, their core equity tier 1 ratios were comfortably ahead of the 8 per cent level required from these tests and the initial reaction of analysts was that they would comfortably clear this hurdle.

Just last week, Bank of Ireland chairman Archie Kane told the company's annual shareholder meeting he believed the bank to be sufficiently capitalised. But that was before the criteria had been made public.

It’s worth remembering that last year, AIB, PTSB and the regulator gave no hint of the extra provisioning that had resulted from the BSA exercise. It was only because Bank of Ireland went so public in its disclosures of the BSA results that there was any indication something was awry.

At the time, AIB and PTSB stated they had come through the assessment without the need for any additional capital but remained silent on the provisioning issue.

AIB’s 2013 annual results showed it booked a provision of €1.9 billion, which was substantially related to the BSA exercise. PTSB’s figure also came to light in its annual results.

At lunchtime today, the Central Bank will publish its annual report. Hopefully, it will shed some light on the likely implications of the AQRs and stress tests for the banks here. Otherwise, we might have to wait for AIB’s interim management statement in May to gain some insight on the matter.

Whatever they say, the reality is we will be kept guessing for another six months.