In a recent interview John Hurley of the Central Bank has emphasised that the Irish Banking system is sound. How does he know? Stress-testing. CB has stress-tested the banks and they look OK. Results available later.
What is stress testing? Allan Kearns of the CB has a paper which explains the methodology in detail as part of the 2006 Financial Stability Report.
He looks at banks exposure to credit, liquidity, fx, rates and equity. Liquidity took down Northern Rock, for example. I want to look at just the property related risk - credit.
Credit stress-testing involves two parameters - NPA = % of non-performing loans or assets and LGD = % Loss given default. In 2006 NPAs were just under 1%. A combination of high NPA and high LGD destroys a banks capital adequacy ratio and takes it down.
You can approximate LGD by how much property prices fall (bank forecloses and sells at a loss). Of course in a state of the world where house prices have fallen say 50%, the NPA number increases as well. More people just walk away.
On p 4 of the paper Kearns says:
Now since the 2006 Financial stability report banks have been hit by liquidity, fx, interest rates and an equity crash. House prices have fallen a minimum 20% and show no sign of stopping there. Yet the threshold for property price falls to cause banking problems was only 25% in 2006.
The central banks published stress testing methodology seems to imply that we have already crossed the threshold where banks need to raise capital or worse.