Regulator Matthew Elderfield: 'downside scenario'

This week the five financial institutions participating in Nama must submit their recapitalisation plans to the Financial Regulator for approval as part of the prudential capital assessment review (PCAR), which says each bank must hold 8% core capital by the end of 2010.

The new regulatory minimum, which is twice the old inadequate level of 4%, is meant to ensure the banks can absorb forecast loan losses through 2012 and still meet prudential requirements and market expectations for solvency. The regulator has also set a target level of 4% for capital under certain "stress" conditions, to make sure the banking system can endure an especially prolonged and severe economic crisis.

The head of financial regulation Matthew Elderfield earlier this month told the Oireachtas Committee on Economic Regulatory Affairs he was confident that these new capital cushions would be deep enough to withstand even worsening conditions: "By including a stress test in our approach, we are prepared for a severe downside scenario and know that the banks can withstand a significant spike in mortgage rates. Also, there is now certainty about the maximum costs to the public debt as a result of the banking crisis. This provides important reassurance to the international capital markets."

But there are signs that, even with the unexpectedly aggressive haircuts being applied by Nama, the end of loan losses at the banks is not in sight. Considerable impairment is still expected in non-Nama property loans, mortgages and business loans in the weeks and months to come. Some analysts believe the stress scenario could easily end up becoming reality.

"Nama will not purge all bad assets from banks' balance sheets," said Ben May, European economist with Capital Economics, a leading global research consultancy, in a note on the Irish banking sector. "What's more, with unemployment still rising, the economy mired in deflation and the house price-to-earnings ratio suggesting that housing may still be significantly overvalued, some good loans will eventually turn bad."

The regulator's stress test – which was not intended to be a forecast – was based on a "hypothetical delayed economic recovery" with little GDP growth in 2011 and 2012, persistent unemployment hitting 14.7% and further house price declines of nearly 25% over the next two to three years. It also included mortage losses of 5% and non-Nama Irish property losses of 60%.

While severe, this scenario is far from a fantasy. Just last week, the International Monetary Fund forecast that the Irish economy would grow by just 1.9% in 2011 after shrinking by 1.5% this year – below the government projection of 3% growth next year. Unemployment for March hit 13.4% and has yet to stop rising. With low economic growth expected, the job numbers are unlikely to improve. This will put further pressure on the banks' retail loan books, as mortgage arrears tend to lag unemployment.

Last week, EBS chief executive Fergus Murphy revealed 5.5% of the building society's mortgage book is in arrears beyond 90 days, twice the level reported last year, and far higher than the 1.8% AIB admitted in its annual results. Murphy said last September that lenders were facing a second wave of arrears, defaults and bad debts over the next two years. He said there would be a "natural" progression of credit problems to mortgages and business loans in the medium term and that there would be a continued need for provisions through 2012.

"These second-round effects of the malaise in the economy – falling GDP, high unemployment – will result in a drip of arrears, defaults and bad debts, even after the recession is technically over," he said.

Signs have been appearing in SME lending, too. According to last week's Mazars report on small business lending for the end of 2009, more than one-third of loans to SMEs – €11bn worth – are non-performing. That means as many as one out of three business borrowers is not paying back debt.

Perhaps most significant was the revelation two weeks ago by Nama chief executive Brendan McDonagh that only 33% of the loans transferred into the state's 'bad bank' so far are being paid back at all, a factor in the unexpectedly high 47% haircut applied to the first tranche of €16bn. Having signed up to Nama last November, after AIB and Bank of Ireland had boasted that the haircuts on their loans would be considerably less than the 30% guided by finance minister Brian Lenihan, the taxpayer has every reason to be surprised by the truth.

McDonagh made the situation plain in his presentation to the Oireachtas Committee on Finance and the Public Service: "Our own detailed due diligence on a loan-by-loan examination has revealed a troubling picture of poor loan documentation, of assets not properly legally secured and of inadequate stress-testing of borrowers and loans."

This pattern of the truth ultimately being far worse than what the banks themselves are willing to admit has been going on for years. The classic example is Anglo Irish Bank's infamous 2008 accounts.

The bank faced scrutiny for hiding directors' loans and for misrepresenting deposit levels that year, but another scandal was hiding in plain sight. Anglo's record loan loss provision of €500m may have appeared aggressive and prudent, but it masked a balance-sheet problem of overwhelming magnitude. By the end of 2009 the bank had lost nearly €13bn.

Anglo's 2008 profit numbers were flattered by rolled-up interest which both concealed non-performing loans and artificially boosted income that was never going to be paid. For the bank's capital plans to come good, the policy of 'extend and pretend' – so prevalent in commercial property lending – must not apply to the non-Nama loan portfolios.

What happened to the 'third force'?

The 'third force' is the one piece of the banking puzzle that has not fallen into place since the climactic series of announcements on the sector late last month.

This financial chimera was meant to combine EBS, Irish Nationwide, Permanent TSB and even Anglo Irish Bank into one large retail and business banking institution to compete with the dominant 'big two' – AIB and Bank of Ireland.

But with EBS stalling on taking the government's capital injection while the board entertains offers from private equity, and merger talks between EBS and Irish Nationwide at a standstill, the 'third force' has not moved an inch since first being proposed over a year ago by senior industry figures and welcomed cautiously by Brian Lenihan.

Now the Department of Finance wants nothing to do with the idea and the building societies are distancing themselves from any hasty consolidation.

Irish Life and Permanent, which would dearly love to get rid of the Permanent TSB part of its business, is trying to keep the dream alive. With the bancassurer taking action on any bet going in mergers and acquisitions these days, something might yet emerge. If it doesn't, IL&P's share price will continue to suffer under the weight of its banking business. Anglo too remains interested but is understood to accept that it is unlikely to happen in the immediate future.