Ireland: Financial Sector Assessment Program: Technical Note-Stress Testing the Banking System

International Monetary Fund
2016 IMF Staff Country Reports  
IRELAND 2 INTERNATIONAL MONETARY FUND CONTENTS Glossary ___________________________________________________________________________________________ 4 EXECUTIVE SUMMARY ___________________________________________________________________________ 5 INTRODUCTION __________________________________________________________________________________ 8 SOLVENCY STRESS TESTS ______________________________________________________________________ 10 A. Macro-financial risks and Macroeconomic Scenarios
more » ... __________________________________ 11 B. Credit risks in the scenario analysis ____________________________________________________________ 16 C. Market risks in the scenario analysis __________________________________________________________ 22 D. Results of the solvency stress tests based on macro scenarios ________________________________ 24 E. Market and macro risks based on sensitivity analysis _________________________________________ 29 F. Concentration risk: Failure of a number of large corporate exposures ________________________ 32 G. Operational risks ______________________________________________________________________________ 33 LIQUIDITY STRESS TESTS _______________________________________________________________________ 34 A. LCR-based stress test __________________________________________________________________________ 35 B. NSFR-based stress test ________________________________________________________________________ 38 C. Outflow analysis stress test ____________________________________________________________________ 38 INTERCONNECTEDNESS ANALYSIS AND CONTAGION RISKS _______________________________ 40 A. Domestic interbank contagion risks ___________________________________________________________ 40 B. Cross-border contagion and interconnectedness analysis ____________________________________ 41 CONCLUSION ___________________________________________________________________________________ 55 References _______________________________________________________________________________________ 69 BOXES 1. BIS International Banking Statistic _____________________________________________________________ 45 EXECUTIVE SUMMARY The FSAP stress testing exercise took place at a turning point for the Irish financial system. The Irish economy is quickly rebounding, the banking system returned to profitability in 2014, and banks' exposures to the volatile commercial real estate market have declined significantly. However, the banking system is still healing from the latest financial crisis, with a very large stock of nonperforming loans. The design of the stress tests incorporated the main potential external risks. These risks arise mostly from a protracted period of weak growth in advanced economies, particularly in the euro area, which would affect the Irish economy through lower investment and direct investment inflows. Moreover, a surge in global financial market volatility could increase interest rates and raise funding costs as investors may reassess underlying risks and move to safe-haven assets. Finally, the planned U.K. exit from the European Union (EU) could cause disruption to trade, labor mobility, and financial interaction with the EU and in particular between Ireland and the U.K. The tests also incorporated potential key domestic risks. First, domestic factors could amplify the effects of external shocks, such as a domestic confidence shock translating into a consumption and investment collapse, or a house price decline bringing back prices towards those experienced during the financial crisis. Moreover, financial imbalances from protracted periods of low interest rates could eventually generate overvaluation and risks of future correction in commercial real estate prices. The stress tests examined the resilience of the Irish banking system to solvency, liquidity, and contagion risks. The stress tests included top-down (TD) and bottom-up (BU) exercises based on macroeconomic scenarios and sensitivity analyses. The tests based on macroeconomic scenarios assessed the impact of these extreme but plausible external and domestic shocks on the economy over a three-year horizon (2016)(2017)(2018), based on data available through June 2015, with capital figures updated based on December 2015 data. The effects of these shocks on individual banks' profitability and capitalization were assessed using satellite models and methodologies developed by the Central Bank of Ireland, the ECB and Fund staff. In addition, sensitivity stress tests assessed vulnerabilities of the banking system to individual shocks. The TD liquidity tests assessed the capacity of banks to withstand large withdrawals of funding, using a maturity ladder analysis and supervisory information, both on an aggregate basis and by currencies. The contagion tests covered interbank exposures between the three largest domestic banks, and cross-border interlinkages with the BIS International Banking Statistics and market data. Results of the solvency stress tests reveal several sources of vulnerabilities, although these remain manageable at the macro level. In the severe stress scenario on a fully-loaded Basel III basis, two banks become undercapitalized with regard to the total CAR and Tier 1 capital ratio hurdle rates of 8 percent and 6 percent, respectively; three banks would have a leverage ratio below the hurdle rate of 3 percent in 2018, and four banks would not meet the Common Equity Tier 1 (CET 1) level of 7 percent, representing the combined minimum CET1 ratio and the capital conservation
doi:10.5089/9781475542226.002 fatcat:vpaxa537nbdrffynk62q47auli