Q&A on Stress Tests

By Eoin Fahy, Friday, 1st April 2011 | 0 comments
Yesterday’s blog entry (click here to read) contained a quick summary of the stress test results, and some initial reactions. Today, as the dust settles, I set out my more detailed views, in question and answer format.
Q: Are the economic assumptions behind stress tests severe enough?
A: The tests assume a very very poor outcome for the economy and – even more so – for house prices.   House prices are assumed to fall 16% this year, then another 19% next year. In contrast, a Reuters survey of economists showed that the consensus expectation is for a fall of 5% this year, and increases of 2% and 4% in 2012 and 2013. So the stress tests assume that house prices fall by 35% from here, while the consensus is for house prices to be broadly flat. The tests also assume a 20% fall in commercial property prices, and a significant further decline in GDP.
While nobody can ever say with 100% confidence that this outcome is the worst conceivable outcome, it is certainly a very negative outlook indeed. I can think of no justification for the tests to have been any tougher than they were.
Q: Are the loan loss estimates realistic?
A: For this exercise, the losses were calculated not by the banks, but by an external consultancy house who looked at the loan books of the Irish banks in great detail. They used comparisons from the UK and the US, not Ireland, to work out how bad the loan losses could be. This is very important because history tells us that loan losses (and repossessions etc) have been far lower here than in other countries, presumably because Irish people are much more attached to their house and their land than other cultures.  Also Irish banks tend to be much slower than in other countries to foreclose on homeowners who get into difficulty. But these factors are explicitly NOT taken into account in the stress tests.
Turning to the actual numbers, the forecast for loan losses on mortgages over the lifetime of the loans is put at 12%. In other words, for every €100,000 of mortgages outstanding, the expected loss on that mortgage is expected to be €12,000. In contrast, the banks themselves say that - even using the same assumptions for growth etc - they think the total loss would be only 4.5%. For loans to large businesses, the lifetime loan losses are forecast to be 5.8%, in the stress test scenario, while for small businesses the forecast write off is a very large 19%. Loans to consumers (ex mortgages) are expected to see write-offs of  27%.
In total, for all loans, the external consultants forecast losses of 14.6% over the lifetime of the loans, while the banks’ own forecasts were far smaller, at 8%.
Over the next three years alone (the period of the stress tests), the expected losses of the four banks would be 10.1%, or €28bn.
As with the economic forecasts, it is impossible to say with 100% confidence that the eventual outcome could not possibly be any worse than that. But certainly these are very, very, pessimistic assumptions, and in the absence of a further very large and dramatic downturn in the economy in the next year or so, it’s hard to see how the eventual outcome could in the end be worse than these forecasts.
Q: Is this the last time the banks will need more capital?
A: Again, nobody can be 100% sure of this. But as I have said above, both the economic assumptions and the expected loan loss assumptions are very pessimistic indeed, and the tests were carried out by consultants completely independent of the banks (unlike previous times). So on the whole I genuinely do not see further capital being required for these banks (though Anglo is another matter, see below), but it would be a very foolish person who would completely rule it out!
Q: What is the cost to the taxpayer of the €24bn being put into the banks?
A: Of the €24bn, about €8bn is estimated to be in the form of new borrowing. Some of the remainder will come from the National Pension Reserve Fund, and some from further write-offs of bank subordinated bonds. The cost to the taxpayer, per year, of the additional €8bn that will be borrowed from the EU/IMF, will be about half a billion euros per year. There is also a further ‘notional’ or opportunity cost, in the sense that the money being taken from the pension fund would presumably have made a return, that will now not be made.
Q: Does the EU/IMF deal have to be renegotiated, as the banks now need all this extra capital?
A: No. The deal always had a provision for a definite €10bn to be given to the banks in extra capital, and a possible further amount of up to €25bn, giving a total of €35bn. The tests yesterday concluded that the amount required was €24bn. This was some €11bn less than the maximum envisaged under the EU/IMF deal, so the deal has not been breached.
Q: Is it disappointing that the ECB has not provided (as rumoured) a medium-term financing arrangement for the Irish banks?
A: Yes. Essentially the Irish banks have what might be described as an “emergency overdraft” from the ECB. It was strongly rumoured this week that this overdraft was, in effect, to be converted to a long-term loan, but this has not happened. While the ECB announced last night that it is easing the rules for Irish banks wanting to access that overdraft facility, that is definitely not as reassuring as if the ECB had announced a full conversion to a proper medium term loan. The ECB is of course expected to continue funding the Irish banks, but “expected to” is not as good, obviously, as “legally committed to”. This was a genuinely disappointing aspect of yesterday’s announcements.
Q: Why are unguaranteed senior bank bondholders escaping without any losses?
A: In short, because the ECB is afraid that if Ireland sets a precedent of not paying back bank bondholders, other banks across Europe might do the same, and then the whole European banking sector (which holds large amounts of those bonds) could be in serious trouble.
Frankly, this is daft. The same people in Germany and the ECB in particular who on the one hand are insisting that in future any bailouts for countries that get into difficulty must be accompanied by write-offs for sovereign bond holders, are at the same time insisting that lenders to banks today which are already insolvent, or close to it, must be paid back in full. But daft or not, the Irish authorities just don’t seem to be able to overcome the ECB’s (absurd) opposition, so the question of unguaranteed senior bank bondholders taking some pain seems to be completely off the table. It makes no sense, but we are stuck with it.
Q: Why are Anglo and Irish Nationwide not included?
A: The answer given by the authorities is that “Anglo and INBS were not included in the stress testing exercise…as the institutions were in the process of implementing the restructuring plan” [the plan submitted to the EU for approval in Jan 2011].
They also stated that once the two banks are merged, they will have a core tier one ratio of 12.5%, which is high. Interestingly, the central bank applied the results of the stress tests for the other banks, to the Anglo loans, and concluded that the most recent capital assessment for Anglo already had more pessimistic outcomes built in than the results of the stress tests.
While not formally stated, it may well be the case that given that these banks will not be making any new loans, they do not need as much capital as the banks that are still alive and lending to customers.
Q: Why was AIB picked to merge with EBS, instead of Bank of Ireland, given that Bank of Ireland is stronger?
A: I don’t believe that the authorities have formally answered this question, but presumably it is because the state controls almost all of AIB, but less than half of Bank of Ireland, and so it is significantly easier to implement a merger with AIB (which the state already owns and controls).
Q: Where do we go from here?
A: The stress tests obviously deal with the banking sector and the capital required for that. But the other half of Ireland's problem is its ongoing, day-to-day, deficit, which will amount to around €18bn this year, leaving aside any money for the banks. The next big challenge is to address that deficit - not an easy task!

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