Problematic Calibration of the EU Banking Sector Stress Test for Ireland

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The details for the calibration of the EU-wide bank stress test are now available. Looking only at Ireland, and only at one of the key variables in the stress test, the calibration looks problematic. It may be coincidental that the Irish adverse scenario has been badly chosen; it might be that all the other member countries have reasonable calibrations.  If the others are as problematic as in the Irish case, this is not a reliable EU banking sector stress test.

Under the adverse scenario, Irish property prices are assumed to suffer a cumulative three-year drop of 3.03%; equivalent to a decline of 1.02% each year for three years in a row. Over the period covered by CSO data, 2005-2013, Irish residential property prices had an annual sample volatility of 11.7%. This in turn implies (under reasonable assumptions) a three-year volatility of 20.27%. In risk analysis it is conventional analytical shorthand to measure adverse outcomes in “x-sigma” units defined as the outcome as a multiple of the standard deviation. For an adverse scenario calibration, the assumed outcome is usually roughly a two-sigma or three-sigma event. Using a four-sigma shock would not be unusual (due to fat tails in some probability distributions). The EBA has calibrated the adverse price shock as a 0.1492-sigma event. That is not credible as an adverse scenario in a stress test.

Keep in mind that the stress test is meant to reassure market participants that even in an adverse scenario the Irish banks are sound. This test reassures us that if property prices fall by as much as one percent a year over the next three years, the banks have enough capital. In the case of a two-percent fall, there are no promises.

As a caveat, this does not mean that the Irish banks need equity capital. They have already had a credible stress test (in 2011) and a big capital injection. Also, the Irish property market although very volatile has a maximum likelihood price change which is positive over the next three years. However the asset class also has considerable “downside” potential and continued high volatility. Conventionally, at least in the case of portfolio risk analysis, the unconditional mean of a stressed variable is set equal to zero for risk analysis purposes. The EBA has chosen to build in a big positive benchmark price rise for Irish property assets, and this is part of the reason that the adverse scenario is unacceptably mild. In any case, this calibration is extremely mild as an adverse scenario and not reassuring for the EU-wide test.

9 Responses to “Problematic Calibration of the EU Banking Sector Stress Test for Ireland”

  1. BeeCeeTee Says:

    Perhaps the EBA is reassured in its assessment of prospects for Irish property prices by the Irish State’s effective monopsony in property supply. It directly owns a large property portfolio and controls a large part of the potential flow of privately-owned property onto the market through the influence its portfolio of financial institutions exercises over the ability or willingness of private owners to sell.

  2. John Foody Says:

    I thought the adverse scenario for property was a typo. One can easily see risks ahead for Ireland, even outside the Euro crisis re-flare up potential.

    Of the top of my head:

    Increase in interest rates to a more normal level would squeeze those tracker boom time buyers and/or lowering of Dirt may divert those cash buyers to savings account. Seen as over half the small amount of property sales per year are in cash…

    The OECD could recommend tax changes highly unfavorable to the Irish NMC sector and the young Google professionals (half of which are non Irish nationals) could leave and so stop propping up rental demand. Not to mention the loss of a high skilled/paid jobs could destroy twice as many more in the SME sector.

    Has anyone noticed the census showing a decrease in numbers 30 something year olds coming down the line, aren’t those the house buyers? The same group on worse pay,T&C and job security than the previous generation, the same group that have to pay circa 1100 for childcare per month per child. The same group looking down the line and seeing 3rd level fees increasing at multiples of the rate of inflation.

    Or the 2nd prediction of Dr. Morgan ‘Doom’ Kelly could come true and the SME sector could get destroyed.

    Then again the future could be grand for the rent seekers, they do have Michael Noonan on side and the states support in general.

  3. BeeCeeTee Says:

    Aagh. That should be “monopoly”.

  4. grumpy Says:

    It would be ironic if the message from this were taken to be that in the unlikely event that Irish RE prices were to fall by what would, for the Irish market, be a hardly noticeable 5% or more from those used, prudent investors should pull their deposits and sell their bank bonds pronto since a major point of the exercise was not just general marketing to investors this time, but also to convince taxpayers any future capital shortfalls would lead to haircuts rather than bailouts.

    Of course none of that matters while asset prices drift upwards, which is what they do most, but inconveniently not all, of the time

  5. Brian Woods Snr. Says:

    “This test reassures us that if property prices fall by as much as one percent a year over the next three years, the banks have enough capital.”

    Its not a real test until it is ‘past tense’ – and we have a reliable (statically) estimate to hand.

    “In the case of a two-percent fall, there are no promises.”

    Except maybe one should have a supply of Pampers at the ready!

    Reading this weeks Property Supplements I was instantly transported back to 2006. And look how that ended! The yields on commercials v residentials seem to somewhat divergent. Now I wonder why?

  6. Michael Hennigan - Finfacts Says:

    Trends in the US, UK and European economies are key and the halt in growth in Q1 in the US (weather & exports) shows that the biggest economy almost 5 years into a recovery, remains fragile.

    New OECD tax rules would have minimal impact in the short to medium term: Apple, Google, Microsoft, PayPal, Oracle and Facebook employ about 13,000 people and there would still be a reason to centralise European services in a low tax rate economy of 12.5%.

    @ Brian Woods Snr

    Those features with high price houses – it helps if it belongs to a celebrity- are back and of course whatever reason the vendor has given for selling should be taken with a pinch of salt.

  7. DOCM Says:

    The editor of the FT on banking and bankers.

    http://blogs.ft.com/businessblog/2014/05/can-banking-clean-up-its-act-a-speech-by-lionel-barber/

  8. DOCM Says:

    More academic advice as to how the EU should be doing it.

    http://www.voxeu.org/article/saving-bank-resolution-eurozone

    This against the background where there is (i) no comparable level of federal integration at a European level which would bear out the contention that the US can provide an appropriate model and (ii) there is as yet no agreement on how to divide the cost of funding the SRF, inadequate as it is.

    http://www.latribune.fr/actualites/economie/union-europeenne/20140318trib000820574/union-bancaire-divergence-franco-allemande-sur-la-constitution-du-fonds-de-resolution.html

  9. DOCM Says:

    The views of the departing Secretary-General of the DOF.

    http://www.irishexaminer.com/business/recapitalisation-lsquowill-not-be-shock-to-systemrsquo-268018.html

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