Author: John McHale

Anti-gloom on the stress tests

While having to put another €24 billion into the banks is hard to stomach, I am still surprised by the overwhelming negativity in the reaction to the release of the stress test results.    I think there were three big questions going into yesterday:  

(1)  Would we get the information necessary to reduce the large range of uncertainty about ultimate banks losses that has been weighing so heavily on the creditworthiness of both the banks and the state?  The detailed information on bank balance sheets and projection assumptions used allows anyone interested to reengineer the calculations as necessary, and is a step change from the kind of information analysts were working with before.   The bank balance sheets and loan loss projections are now far less of a black box. 

(2)  Would the banks end up sufficiently well-capitalised to overcome the difficult funding environment?   By my calculations, allowing for the capital buffers, Core Tier 1 is close to 10 percent under the stress scenario and close to 17 percent under the base scenario.   [Note that the stress scenario is binding for all four tested banks this time round; see Table 16]   We will have very well capitalised banks. 

Continue reading “Anti-gloom on the stress tests”

A few more thoughts on the stress tests

Following on Kevin’s post, here are a few more thoughts for possible discussion in advance of the stress test results.

1.   I think the criticism of the insufficiently adverse assumptions for 2010 has been overdone.   While it does raise questions about our ability to forecast the future when we have such a hard time estimating the past, getting 2010 wrong really shouldn’t matter.   If BlackRock are taking as hard a look at the balance sheets as we are led to believe, current conditions should already be incorporated in the loan loss estimates.  The value of the baseline and adverse scenarios is in understanding how things might evolve from here.   In other words, it is the delta from 2010 that matters.

2.  A related criticism is that the ESRI/TSB house price index is underestimating the true decline in house prices (the index has house prices down by 38 percent from peak by Q4 of 2010).    But again the current state of the housing market should be reflected in the current state of the loan book.   If house prices are really down 50 to 60 percent, then the declines under the adverse — or even the baseline — scenario truly get us into Morgan country.

3.   There appears to be a “my (preferred) stress tests are more stressful than yours” attitude to the choice of the adverse scenario in the stress-testing exercise.   But I think this sometimes reflects a misplaced view of the purpose of the adverse scenario.   In addition to seeing what bank losses would be under an adverse (but somewhat arbitrary) scenario, the adverse scenario plays an important role in triggering recapitalisation.   In the current exercise, my understanding is that recapitalisation will be triggered if the Core Tier 1 falls below 10.5 percent (please do correct me if this is not correct as the documentation is not that clear).  Thus the toughness of the test must be judged by looking at the combination of the adverse scenario and the target ratio under that scenario.   A 10.5 percent target is an extremely tough target by any measure.    Under the last round of tests, the baseline target was 8 percent and the stress (adverse) scenario was 4 percent.   The former has been raised by 4 percentage points to 12 percent; the latter has been raised by 6.5 percentage points to 10.5 percent.   

It is noteworthy that IL&P was the only one of the tested banks to fall foul of the 4 percent stress scenario last time round (see here).   It is not really surprising that they are in deep trouble with a stressed target of 10.5 percent.   This sensitivity to the stress scenario must reflect the importance of mortgages (and in particular buy-to-let mortgages) on the balance sheet of IL&P, and also the large additional assumed declines in house prices under this scenario. 

The Grand Bargain

Having been a bit tough on the FT yesterday morning, I would like to echo commenter DOMC in drawing attention to a very good article by David Oakley (see here; related piece here).   While our attention has naturally been on the Ireland-specific aspects of negotiations over the crisis-resolution mechanisms, the Grand Bargain on the ESM is probably far more significant for our creditworthiness.  

David Oakley notes that market conditions are improving for Italy and Spain.   This is consistent with the idea of a self-fulfilling equilibrium: if you look like your will need a bailout no one wants to lend to you (and get caught up in a later “bail-in”), and so you end up losing market access and forced into a bailout.   This is what seems to be happening to Portugal at the moment; Italy and Spain have been able to stay out of the critical region — at least for now.   A problem for Ireland is that improving your fundamentals looks less effective once already in the bailout mechanisms.   Can it make sense to have this “black hole” (potentially) spreading from the periphery?   Hardly a Grand Bargain.

Lex — Ireland: sharing the debt burden

The FT’s Lex renews its call for bondholder burden sharing in today’s column (see here).   I know many readers are fans of the FT’s stance on dealing with the Irish banks.   A consistent feature of this stance, however, has been to throw out strong recommendations for burden sharing, but with little discussion of the practical challenges involved.   Today, the suggestion is to put losses partly on unguaranteed but secured senior bondholders; and, true to form, there is no discussion of the practicalities of imposing losses on the subset of banks that will be well-capitalised after the stress tests.   I know space is tight, but I think we have reason to expect better from the FT.   The closing couple of paragraphs:

Some €21bn of that total consists of senior bonds issued and guaranteed since January 2010, and, therefore, probably untouchable. Another €7bn is subordinated debt on which holders are already taking a haircut. The rest is senior bonds, of which €16.4bn are unguaranteed and unsecured, and €19bn are unguaranteed but are secured on bank assets.

It is here that burden sharing should be concentrated, and the government needs to start the bidding as high as possible. Only if both classes of unguaranteed bonds, amounting to 23 per cent of GDP, are included can the resulting savings make a real difference to Ireland’s otherwise ballooning debt/GDP ratio, which could hit 120 per cent without burden sharing. Thursday’s stress test results on Irish banks will indicate how much extra capital they need. The taxpayer’s contribution must be as little as possible. Irish senior bank bonds trade at prices that discount some burden sharing. The case for it is compelling.

Jeff Sachs: Stop this Race to the Bottom on Corporate Tax

Jeff Sachs weighs in on the corporate tax rate question in a Financial Times op-ed.