Q&A

What happened yesterday?

The stress test results were the culmination of two interrelated processes that have been ongoing over the last number of months – the PCAR and the PLAR exercises.

PCAR (Prudential Capital Assessment Review) – or capital test – looked at the capital requirement of the banks, ie, how much cash they need. Banks must reach the 12 per cent capital threshold set by the regulator – ie, banks need to have €12 in reserve for every €100 they have out on loan.

In addition, banks must have enough capital in place to withstand “worst-case” scenarios, such as worse than expected economic outlooks and unemployment. Patrick Honohan emphasised yesterday these adverse scenarios are very unlikely to occur and should not be seen as economic forecasts. In addition the capital test was informed by a loan loss assessment exercise performed by consultants BlackRock.

The PLAR (Prudential Liquidity Assessment Review) or liquidity test focused on the funding- liquidity requirements, looking at loan-to-deposit ratios, and working out what loans and other assets the banks need to sell in order to shrink and “deleverage” their balance sheets. Thus the major restructuring of the banking sector announced yesterday can be seen to come broadly under the liquidity test framework.

Have we not been here before?

Yes, the first capital test exercise was announced with much fanfare exactly a year ago, followed by a revised capital test in September. These were separate to the various banking stress tests undertaken by Europe.

These latest stress tests were a condition of the €85 billion IMF-EU deal. The Memorandum of Understanding between Ireland and the EU-IMF stipulated that the stress tests should be completed by March 31st. They also emphasised that the tests should use “stringent stress-test scenarios”.

In a slightly new departure, these tests looked at potential losses on home loans and buy-to-let mortgages, in contrast to last year’s stress tests which focused on the losses incurred by banks on their development loans as they transferred them to Nama.

What did the results reveal?

The capital tests revealed that the four banks need an additional €24 billion. This is the element that is likely to be of most interest to Europe/international investors.

However, it is the radical reshaping of the banking sector that indirectly emerged from the liquidity test exercise which is arguably of most interest to us here. Yesterday’s announcements present nothing less than a momentous restructuring of the Irish banking sector. Two new banking entities are to be created – a restructured Bank of Ireland and a merged AIB and EBS.

In addition, Irish Life and Permanent will sell its profitable life and pensions business, probably by way of a stock market flotation, and the Government is likely to take a majority stake in it.

What about Anglo and Irish Nationwide?

These tests looked at four institutions: Bank of Ireland, AIB, EBS and Irish Life and Permanent. Anglo and Irish Nationwide are already in wind-down mode and were excluded from the exercise. While it is envisaged that no extra capital will be required for these banks, a further assessment of their capital requirements will be available in May.

Results for Anglo out yesterday morning showed the defunct bank lost €17.7 billion in 2010, mainly as a result of the losses taken on loans transferred to Nama and impairment costs.

How much has the banking crisis now cost?

Yesterday’s €24 billion capital hole brings the total cost of the bailout to €70 billion – one of the costliest banking crises in history, according to Central Bank governor Patrick Honohan.

The National Treasury Management Agency points out that the net cost of the extra €24 billion will probably be €19 billion – €3 billion is a buffer and junior bondholders will burden-share anything up to €5 billion.

However, the Government has said it is not in favour of imposing losses on senior bondholders for the four institutions – something that the investment community will welcome, but taxpayers may question as they continue to foot the bill.