Stress testing of Irish banks

On Friday (23 July) all major banks in the European Union underwent a stress test.  The test was conducted by the Committee of European Bank Supervisors (CEBS) and was designed to measure the banks’ ability to withstand a double-dip recession and sovereign debt shock.

In order to pass the test a bank was required to have a tier one capital ratio of at least 6%.  The official result was that out of 91 banks tested 7 failed with a total capital shortfall of €3.5bn.  Not much in the context of the entire EU budget.

The 2 Irish banks tested, Bank of Ireland and AIB, were both reported to have passed: Bank of Ireland with a tier 1 capital ratio of 7.1% and AIB with 6.5%.  So, we can all breathe a sigh of relief.  Or, maybe not.

Bank of Ireland seems to have passed fair and square.  AIB, on the other hand, may be a different matter.

AIB passed because the CEBS assumed that AIB would be able to raise an additional €7.4bn in capital through the disposal of its overseas interests and the issue of new equity.  If it fails to raise adequate funds the Irish Government will make up the shortfall.

In other words if the CEBS did not make this assumption AIB would have failed the test.  Its capital shortfall would have been twice the reported shortfall of all 7 banks that officially failed the test.

This was supposed to be a test to determine the robustness of the EU banking sector in the face of a double dip recession and sovereign debt shock.  If both these were to happen would AIB be able to raise the €7.4bn?  It may be able to dispose of its overseas subsidiaries but probably at a discount as potential purchasers’ buying power would be reduced.  Its ability to raise sufficient funds on the markets would also be affected.  This is obviously the view of the Irish Government as it has stated that it will underwrite the equity issue (if there was no problem it wouldn’t need to underwrite it).  This means that the Government will buy any shares that bank can’t sell on the open market.  This could result in the nationalisation of the AIB.

I would have thought the purpose of a stress to test would be to determine the ability of those being tested to withstand a sudden shock.  Relying on Government support to withstand it is hardly truly withstanding it.  A sudden shock by definition would happen without warning.  By giving AIB credit for capital yet to be raised seriously undermines the credibility of the exercise.

It appears AIB passed because it will be nationalised if it cannot meet the required capital levels.

The Irish media seems to have completely overlooked this.  The Financial Times reported that AIB passed on a technicality.  It described AIB as a “near-fail” and classed it with banks that “scrapped through” the test.

Brian Cowan complained during the week of “pervasive negativity” in the media.  Based on the reporting of AIB’s “pass”, it seems the Irish media have listened and responded to this.  You’ll have to tackle the UK media next Mr Cowan.

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