Stress Tests

The next milestone in Ireland’s crisis resolution efforts will be the March 31^st stress tests. In addition to revealing important information to financial markets, the results of the tests are likely to impact the political debate about the appropriate crisis resolution strategy, not least the contentious issue of default. At the moment, there appears to be a lot of confusion about what the stress tests are all about, which is important to clear up in advance to prevent the release being counterproductive in terms of the political debate. I offer some thoughts after the break, but I hope others will weigh in on the thread.

One confusion is already evident in the reporting on the macro scenarios released this week (see here). The scenarios include a “baseline case” and an “adverse case”. However, the latter is unhelpfully reported in the media as a “worst case”. There is of course a (joint) probability distribution over possible scenarios. The adverse case is simply a point on this distribution, presumably at the 95^th percentile. It should be made clear what this percentile is in the official view of the distribution, allowing interested parties to form their own view on whether the presumed distribution is appropriate. To a significant extent, the precise point on the distribution is not important, as long as it is made clear what this point is.

The value of a stress test is it provides an estimate of the implications of the given scenarios for the size of the bank losses. To the extent that the scenario-based examination of the balance sheets is credible, the findings on hypothetical losses provide valuable information on the broader distribution of possible losses. The partial outsourcing of the stress testing is meant to increase this credibility. Given lingering doubts, however, it will be critical to give market participants as much information as possible on the composition of the balance sheets and the detailed assumptions used so that people can form their own judgements. This is especially important in light of Patrick Honohan’s emphasis in his ICMBS speech on the damage uncertainty is doing to Ireland’s creditworthiness.

It would seem we are being prepared for some quite bad news on the size of the needed capital injections. While we can expect that the markets will interpret this news properly, there is a danger that the numbers will be misinterpreted in the broader debate.

Simplifying just a bit, there are three components to the bank losses that will fall on the State given the guarantees: (i) losses beyond the capital of a guaranteed bank (notably the Anglo and INBS losses to date); (ii) losses on previous injections of State capital; and (iii) the losses on NAMA. A key focus will be the additional capital required for AIB and Bank of Ireland. It is reported that the capital target will be set so that core tier 1 ratio does not fall below 10.5 percent under the adverse scenario (SBP article here). While the stress tests are likely to reveal real additional expected losses, the bulk of the additional capital will be going to meet a very demanding capital standard, and should not be simply added to the calculation for aggregate bank losses.

It is valid to ask why the markets are demanding such high capital levels, which could reflect a very different estimation of the underlying losses than the official view to date. (On this alternative view, the current positive market valuation of one or both of main banks would largely be a reflection of option value due to limited liability given the high underlying uncertainty—a limit that does not benefit the State given the guarantees.) At least in part, however, the market requirement for capital reflects increased risk aversion (interacting with the high level of uncertainty about bank losses), doubts about the State’s willingness and ability to meet guarantees, and doubts about the ECB’s willingness to continue to act as lender of last resort.