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Irish Bank Stress Tests May Not Reveal All

Ireland and the rest of Europe are bracing themselves for the results of a second round of bank stress tests due to be published later on Thursday.

Dublin, Ireland
Tim Thompson | Stone | Getty Images
Dublin, Ireland

The stress tests are expected to show the country's banks need more liquidity support than first believed, but even so, some analysts said the stress tests would still be insufficient.

"The stress tests have to be credible this time," Justin Urquhart-Stewart director and co-founder of Severn Investment Management told CNBC.com.

"Previously their credibility was not good but also one of the problems you have is if you have banks exposed to property valuations in the way the Irish banks are it's very difficult to draw a line under their losses when property values are still falling. You still don't know their full exposure," Urquhart-Stewart added.

Confidence in the Irish banking sector is at such a low that Irish Life and Permanent had to suspend trading on its shares Wednesday. They lost 44 percent of their value on Tuesday on the back of a report in the Irish Times that the government would have to take a large stake in the bank as the scale of its exposure to the Irish property market was fully revealed.

The state of Ireland's finances is nothing short of dire. NCB Stockbrokers has revised its 2011 forecast downwards, with Chief Economist Brian Devine now suggesting gross national product (GNP) and gross domestic product (GDP) will fall by 1.4 percent and 0.4 percent respectively, from previous estimates of contractions of 0.7 percent and 0.3 percent.

The amount of liquidity funding that Irish banks will need, estimated by Devine, is around 22.5 billion euros ($31.6 billion), well within the 35 billion euros contingency fund created by the European Union (EU) and International Monetary Fund (IMF) back in November.

But it is still far higher than the 10 billion euros estimated in the initial stress test and set aside by former finance minister Brian Lenihan last month because of political upheaval in the country which led to a snap election and change in government.

Real Estate in Focus

Another reason the funding was set aside was because the original tests were deemed insufficiently rigid, risking undermining confidence in the rest of Europe's banks.

Up until now the banks were known to have been exposed to loans to property developers in the country but they also face significant losses in the residential property market as February's Central Bank figures revealed.

Those figures showed 5.7 percent of Irish mortgage accounts were in arrears of more than 90 days amounting to 8.6 billion euros.

The European Central Bank (ECB) has lent Ireland's banks a total of 117 billion euros to prevent their collapse and the Irish Central Bank has lent a further 71 billion euros, while 20 billion euros of bank bonds have also been guaranteed by the state through its Eligible Guarantee Scheme.

These lending figures do not even include the 67.5 billion euros lent by the EU and IMF or the contingency fund of 35 billion euros.

However, the decision by the ECB to replace its current short-term emergency liquidity funding scheme with a medium term "Facility for Banks Under Restructuring", due to be announced some time after the results of the stress tests, may provide some relief and prevent Ireland's banks being forced into fire sales of assets.

The medium-term funding facility will most likely focus on the 71 billion euros provided by the Irish Central Bank to the country's banking sector, taking that loan into the new ECB scheme, Donal O'Mahony, an analyst with Davy's Stockbrokers told CNBC.com.

Bond Haircuts?

However, while this would allow the banks to "park" their bad debts in off balance sheet special purpose vehicles, the markets' expectation that Ireland could still fully nationalize the banking sector in order to force senior bondholders to accept losses has already been evident this week as the collapse in Irish life and Permanent's share price attests.

But in doing so the Irish government could put itself under even more pressure.

"You need to recapitalize the banks to convince the markets they are solvent so they provide funding once more. You can have all the recapitalization you want but it will be for nothing if you don't repay your creditors", O'Mahony said.

For months Ireland's banks have been unable to raise funds on the money market as a result of a loan deposit ratio of around 160 to 170 percent.

This ratio was currently being supported by the 71 billion euro short-term liquidity funding from the Irish Central Bank. But by replacing that with medium term funding from the ECB Ireland's banks should be able to get funding once more from the money markets, according to O'Mahony.

"If you keep things as they are you place more stress on the state, making nationalization and the possibility of defaulting on sovereign debt more likely, meaning the banks still can't raise funds," he added.

That in turn could raise the specter of the wider threat of contagion once more with Portugal, widely expected to ask for a bailout by June, particularly vulnerable, while doing nothing to solve Ireland's banking sector problems, O'Mahony said.

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