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Last Thursday, the Central Bank of Ireland (CBI) and the Irish government announced new capital requirements for four Irish banks following the publication of the Prudential Capital Assessment Review (PCAR) and the Prudential Liquidity Assessment Review (PLAR). The result of these reviews is that four banks, Allied Irish (AIB), (Ba2 review for downgrade; D-/Ba3 negative), Bank of Ireland (NYSE:IRE) (Ba1 review for downgrade; D/Ba2 negative), EBS (Ba2 review for downgrade; D-/Ba3 negative), and Irish Life & Permanent (OTCPK:ILPMF), (Ba2 review for downgrade; D-/Ba3 negative), must raise 24 billion euros of capital. The capital increase is a clear credit positive for the banks. However, the additional recapitalization costs that arise to the government in connection with the PCAR are credit negative for Ireland’s sovereign creditworthiness (Baa1 negative).

Impact on the Banks: The PCAR stress tests determined three-year (2011-13) provision charges totaling 27.7 billion euros for the banks, including provision charges on the assets to be deleveraged as part of the PLAR process. Capital levels were set such that the banks have a core Tier 1 capital ratio of 6% after incorporating the adverse stress scenario. This incorporates a 60% peak-to-trough decline in residential house prices and a 70% decline in commercial property values. These PCAR provision charges were then used to calculate the total capital requirement of 24 billion euros.

Although we expect some of this capital will be raised from the disposals of subsidiaries from existing shareholders, and further burden sharing with subordinated bondholders, the Irish government is likely to provide most of the capital. This is likely to mean that the government will have majority ownership stakes in at least five of the domestic banks, with only Bank of Ireland potentially being able to keep government ownership below 50%.

The objectives of the PLAR process is to deleverage the banking system, reduce banks’ reliance on short-term funding, and prepare the banks for the new Basel III liquidity requirements. The four banks have identified over 70 billion euros of non-core assets to be sold or run off between now and 2013, enabling them to meet a 122.5% loan-to-deposit ratio target by the end of 2013. The banks will be split into core and non-core divisions, with governance structures put in place to ensure that the non-core businesses are managed to meet those loan-to-deposit ratio targets.

We view the plans to deleverage the system as credit positive, as they will reduce the high reliance on central bank funding, even though this will be a challenging process given the amount of assets to be sold or run off. In a related announcement, the European Central Bank (ECB) said last Thursday that it will now accept all debt instruments backed by the Irish government as collateral against ECB loans, another credit positive for the banking sector.

Sovereign Implications: From a sovereign perspective, the PCAR results are credit negative as they induce a further crystallization of bank contingent liabilities on the government’s balance sheet. However, we expect the increase in general government gross debt in connection with these recapitalization requirements to be significantly lower than 24 billion euros, as we expect a 5 billion euros offset as a result of the planned burden sharing with subordinated bondholders. Moreover, 10 billion euros of the recapitalization is set to be funded by the National Pension Reserve Fund (NPRF), and thus will not affect Ireland’s gross debt figures. Considering also the 7 billion euros cash balance commitment articulated by the Minister of Finance, the actual increase in gross debt is approximately 2 billion euros (1.3% of 2010 GDP).

Source: Stress Tests Positive for Irish Banks, Negative for Sovereign Debt