Irish Banking Stress Tests May Lead to Further Cash Injection

Here’s a thing you probably last thought about at the age of eight: which comes first, the chicken or the egg?

That, essentially, is the question being discussed by the Irish government and the ECB. Far from being a matter of childish fun, the answer is crucial to Ireland’s attempt to draw a line under its banking-turned-sovereign-debt crisis.

For its part, the government is looking for a commitment from the ECB to extend to the medium term the emergency short-term liquidity it provides for Ireland’s banks. It wants the ECB to provide €60 billion in medium-term funding to part-replace the €71 billion in emergency funding that the central bank has been forced to lend to the banks over the past six months. And it needs an answer fast. Stress test results are due later this week. At the time of writing there is no way of knowing their outcome, however the suspicion is that they will be far more rigourous than the last tests. These were so mild that no sooner had they given the Irish banks a clean bill of health than all three were hit by a run. Following a farce like this it’s perfectly possible that the new tests could give rise to the need to inject tens of billions of additional capital into the banks.

Should this happen, the debate with the ECB will take on crucial importance.

If the government can persuade it to agree to provide €60 billion of medium-term funding the task of recapitalising the banks will become easier. For one thing the need for immediate deleveraging would lessen. This is important since deleveraging would require the sale of chunks of the banks’ loan books. At the present time, any such sales would almost certainly give rise to sizable losses which would need to be financed by additional capital injections. Because no one in the private sector would dream of subscribing capital to the banks in their present state, the additional capital will have to come from the State.

No wonder the government is keen to persuade the ECB to provide funding.

It’s a safe bet though that the ECB thinks that recapitalisation should come first. At around 170 per cent, the Irish banks’ average loan-to-deposit ratio is far higher than it would like. A spate of deleveraging could reduce this to a more acceptable level of 120 per cent or so. Moreover, the ECB is horribly over-exposed to Ireland as it is. It currently provides around €100 billion in short-term loans to the banks together with a further €71 billion to the Irish central bank. So much for theory. In practice, the ECB is said to have accepted that immediate deleveraging would worsen the banks’ capital positions. In the circumstances it may have no choice but to cut a deal on medium-term financing with the government.

The ECB’s problem is that it is dealing with not just an Irish banking crisis but also with a Eurozone banking crisis. European bank balance sheets are fragile and private investors show no sign of wanting to help recapitalise them. Take the experience of the first round of stress testing last year. Of the 90-plus banks that underwent the tests, only Deutsche Bank subsequently raised a significant level of new equity. The remainder soldiered on without improving their capital positions. Additional equity from private sources is a clear necessity. But for private equity to start flowing the results from the forthcoming stress tests need to be credible and the banks will need a higher level of solvency than in the past as insurance against bank runs. But this is only half the story.

The issue that really causes sleeplessness at the ECB’s HQ in Frankfurt is bigger than mere bank solvency.

Because the European banks own large amounts of sovereign debt issued by peripheral countries that are now in trouble, the possibility of sovereign-debt restructuring must also be considered. Now that’s an altogether bigger chicken and egg puzzle.