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What is a bank stress test?

Results of the Central Bank’s stress testing of four Irish lenders due out this afternoon, but what is it?

Image: Cellular Immunity via Creative Commons

THE RESULTS OF THE Central Bank’s stress tests are due out this afternoon for four of the country’s financial institutions: AIB, Bank of Ireland, EBS and Irish Life and Permanent.

Anglo Irish Bank, which released the worst results for any business in Irish corporate history this morning, has not been covered by these tests.

So, what is a stress test anyway?

Bank stress tests are supposed to determine how well a bank would be able to withstand further financial downturns or economic difficulties.

This means capitalisation is key, as the banks may have to absorb losses later while still carrying out their normal day-to-day business.

Ideally, the tests envision a ‘worst case scenario’ to see if the banks can withstand a particularly bad economic period and the parameters for the test should be based on plausible, albeit unlikely, scenarios.

In these stress tests, the Central Bank is believed to be taking the worst case scenario as a situation in which house prices have fallen 60 per cent from peak and unemployment of 16 per cent next year. Given the low proportion of repossessions in Ireland, the Central Bank is likely to base its figures on repossessions in other countries.

The tests will also examine how the banks would cope if they had to sell their assets quickly and how they would manage bad debts (ie loans that cannot be repaid by the borrower).

If passed, stress tests should reassure investors – and customers – that a bank is in good shape. However, given that AIB and BOI both passed EU-wide stress tests last summer, there is a degree of cynicism surrounding the tests.

AIB and BOI shares were suspended from trading today by the Central Bank. IL&P shares were suspended yesterday after falling dramatically on Tuesday.

Trouble ahead?

Jim Power, chief economist at Friends First, told Bloomberg that so far there had been a “total underestimation” of the banks’ losses and that the fuller picture will not become clear until all of the assumptions behind the stress tests are made known.

Power also speculated that Ireland’s national debt, including banking debts, could hit €240bn in the next two to three years – well above what the Irish economy could sustain.

The government set aside €35bn of the EU/IMF’s €85bn bailout fund (which also includes the state’s pension reserve fund) for bank support and recapitalisation, and the stress tests results should show how much funding the banks require. The four banks are expected to need funding that will eat into much of that €35bn.

Minister for Finance Michael Noonan is expected to make a statement on bank system support this afternoon, after the test results are published at 4.30pm.

The Irish government has delayed its EU negotiations for reducing the bailout interest rate until after the stress test results were out.

Meanwhile, the eurozone remains under pressure as Portugal looks increasingly likely to require a bailout, and Spain and Greece continue to struggle economically. The EU is carrying out a separate round of stress tests on European banks which are due out in June.

Poll: Are you confident that the full extent of the black hole in Irish banking will be exposed today?

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