## _cr06292

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### Executive Summary — overall assessment and recent performance
- Financial institution profitability and capitalization are currently very strong; Irish banking sector profits described as "amongst the highest in western Europe."
- Major Irish banks receive "upper medium- to high-grade ratings."
- Outlook for 2006–07 described as "very strong," but macro-risks could affect asset quality.
- Mission conclusion: financial system appears well placed to absorb the impact of a downturn in either house prices or growth more generally, supported by capital buffers evidenced in stress tests.

### Key macrofinancial risks and transmission channels
- Sustained rapid credit growth driven largely by record increases in mortgage credit accompanying the housing boom.
- Household debt to GDP ratios are "now amongst the highest in Europe."
- A significant slowdown in growth, while "seen as extremely unlikely in the near term," would adversely affect employment, housing demand, and the construction sector, with expected deterioration in corporate and household loan quality.
- Lack of recent experience with a major downturn in Ireland makes likely magnitudes of deterioration uncertain.

### Financial sector structure and selected key statistics
- Domestic banking sector asset growth: "around 25 percent" annual growth.
- As at December 2005, composition of total bank lending:
  - Residential mortgages: "37 percent"
  - Commercial property: "17 percent"
  - Construction: "5 percent"
- Selected indicators (deposit-taking institutions, 2001–2005):
  - Regulatory capital to risk-weighted assets (All Banks): "13.2", "14.4", "15.0", "14.6", "13.6" (percent for 2001–2005)
  - Regulatory Tier 1 capital to risk-weighted assets (All Banks): "10.7", "10.7", "10.8", "10.9", "10.6" (percent for 2001–2005)
  - Nonperforming loans to total gross loans (in percent): "1.0", "0.9", "0.9", "0.8", "0.68" (2001–2005)
  - Total provisions for loan losses (in percent of total loans): "1.14", "1.05", "0.90", "0.70", "0.50" (2001–2005)
  - Annual credit growth rates (to private sector): "15.1", "15.0", "17.9", "26.6", "28.8" (2001–2005)
  - Annual mortgage credit growth rates: "17.8", "23.1", "25.5", "26.5", "28.5" (2001–2005)
  - Household debt to GDP (in percent): "38.9", "43.2", "49.3", "61.2", "72.0" (2001–2005)
  - House prices (euro): "181,697", "205,898", "234,066", "254,215", "277,852" (2001–2005)
  - Mortgage loans to total loans (in percent): "26.9", "31.0", "34.5", "37.0", "36.8" (2001–2005)
  - Real estate loans to total loans (property-related lending) 7/: "38.0", "43.2", "49.7", "54.4", "57.5" (2001–2005)
  - Liquid assets to total assets (All Banks, liquid asset ratio): "30.0", "30.0", "33.6", "33.0", "34.2" (2001–2005)
  - Return on assets (in percent): "0.9", "1.0", "0.9", "1.0", "1.4" (2001–2005)
  - Return on equity (in percent): "16.0", "18.0", "17.8", "20.7", "21.8" (2001–2005)

### International diversification, funding structure, and liquidity risks
- The two largest banks each have an almost equal amount of domestic and foreign assets; a significant part of foreign assets are property-related.
- Banking system lending growth has exceeded deposit growth; domestic private-sector loans-to-deposits ratio was 1.7 (as of August 2005) versus the Euro area median of 1.3.
- ECB data: Irish banks had the lowest customer deposits-to-assets ratio of all western EU member countries as at end-2004.
- Four major Irish banks fund between 35 and 53 percent of total funding on the interbank and securities markets.
- Irish banks’ exposure to capital market funding, at 30 percent of assets, is among the highest in the EU.
- Derivatives notional values approached 900 percent of total assets in 2005.
- Covered bonds issuance increased since 2001 legislation; Ireland is ranked sixth in terms of outstanding volumes but accounts for about 2 percent of the total.
- Recommendation: strengthened monitoring of credit risk transfer activities in Ireland.

### Macroeconomic outlook and downside risks
- Staff Report economic baseline described as positive; momentum driven by employment growth, record migration, and increased participation.
- Near-term supports: continued strong employment and income growth, fiscal stimulus in 2006, withdrawals from maturing SSIAs beginning mid-2006.
- Risks that could lead to a sharp slowing:
  - Substantial increases in Euro interest rates in excess of 200 basis points generally incorporated in banks’ stress tests.
  - Private sector credit annual growth reached 29 percent in December 2005.
  - Real estate prices rose about 10 percent per year on average since 2000.
  - Continued deterioration in competitiveness: unit labor cost and CPI-based REER appreciated substantially between 2001–05.
  - Further increases in oil prices could adversely affect growth via reduced demand from major export markets.

### Household sector and mortgage market vulnerabilities
- Household gross indebtedness—primarily mortgages—has risen sharply; household debt to GDP ratios almost doubled over the previous five years and "would double again over the next three years" if current growth rates persist.
- Mortgage market metrics:
  - Average mortgage servicing cost for first-time buyers rose from an estimated 25 percent of average earnings in 2000 to about 29 percent by 2004.
  - Loan-to-value ratios (LTVs) grew from around 80 percent on average to around 92 percent for first-time buyers.
  - Average mortgage maturities grew from around 20 years to 27 years.
  - Most mortgages are variable rather than fixed rate.
  - Simulations: a two percentage point increase in interest rates would raise repayment burden for first-time buyers by 5–6 percentage points from around 30 percent of average earnings, and 25 percent of disposable income, at present.
  - Nonperforming loans (NPLs) for mortgages are currently 0.45 percent.
  - Authorities will require higher risk weights for mortgage loans with LTVs above 80 percent from May 2006 onwards.
  - Some banks offer 100 percent LTV and interest-only mortgages to a limited range of customers.
- Short-term housing supports: maturing SSIAs in 2006 expected to free up funds amounting to 20 percent of consumption and continued strong immigration.

### Corporate sector position
- Credit to nonfinancial corporates rebounded since 2002; commercial property-related lending was the largest component of outstanding loans to nonfinancial corporates in 2005.
- Nonfinancial corporate sector debt-to-GDP ratio increased by 5 percentage points in 2004 to 90 percent.
- Rate of potentially insolvent liquidations fell in 2004 and 2005 and remains below long run average.
- Distribution of corporate debt skewed to a small number of large international firms; much of that debt likely sourced from abroad.

### Banking sector performance, soundness, and prudential metrics
- Sector described as retail/mortgage focused, well capitalized, relatively efficient, highly liquid.
- Irish banks are among the most profitable in the EU despite relatively low net interest margins.
- Loan-loss provisions cover more than 85 percent of NPLs; mortgage-specific provisions are 0.03 percent of total loans.
- Liquidity asset levels are good; maturity mismatch has not changed significantly over five years.
- Liquid Assets and performance metrics indicate Irish banks and Ireland-IFS series outperform Euro Area and EU aggregates in source figures.

### Stress-testing framework, scenarios, and main results
- Two approaches: Bottom-Up (BU) by 11 retail institutions (9 banks and 2 building societies) and Top-Down (TD) by the CBFSAI using an EU-15 panel for provisioning relationships.
- Coverage: BU covered institutions representing 95 percent of the mortgage market and 88 percent of the non-government deposit market using end-2005 data.
- Two main shock scenarios (calibrated with CBFSAI macroeconometric model):
  - Scenario 1: sharp downturn in the housing market, large interest rate increase, significant deposit withdrawals, equity price fall, and 25% euro appreciation versus U.S. dollar; includes a 40 percent fall in house prices in some variants.
  - Scenario 2: substantial increase in interest rates following a mild economic downturn (cumulative increase of either 1.25 percentage points or 2.50 percentage points assumed by banks).
- Selected baseline and shock macro series (reported):
  - BASELINE series examples: GDP 4.85.24.7; House Price Inflation 7.06.36.1; Unemployment 4.34.34.3.
  - SHOCK SCENARIO 1 series examples: GDP 3.2-0.3-4.8; House Price Inflation -13.0-8.71.1; Unemployment 4.56.69.7.
  - SHOCK SCENARIO 2 series examples: GDP 3.61.0-2.0; House Price Inflation -13.0-8.71.1; Unemployment 4.56.28.7.
- TD test (EU-15 model) with Scenario 1 implies an increase in NPLs by 80 percent assuming LGD=50 percent; did not cause any bank CAR to fall below the 8 percent minimum given very low initial NPLs.
- BU tests indicate NPLs could rise to 3.13 (almost 400 percent over three years) under severe Scenario 1; such an outcome would significantly hit CARs if no other adjustments to capital were made.
- TD vs BU comparison:
  - TD model predicts underlying increase in NPLs of 1.57 in 2008; BU produced 3.13 in 2008 under Scenario 1.
  - In TD case with LGD=50% and NPLs between 2.61 and 3.48 percent, three banks accounting for 9 percent of assets would fall below CAR minimum of 8 percent.
  - If BU 2008 NPL increase (0.8 in 2006 to 3.13 in 2008) were written off 2006 regulatory capital with LGD=50%, CARs would fall by 1.04 percentage points.
- Specific TD findings:
  - Mortgage stress: provisions would cover a 25 percent fall in house prices; even if mortgage NPL ratio rose to 5 percent after a 40 percent fall, banks’ existing capital buffer would absorb the loss.
  - Market risk: a 400 basis point tightening of interest rates brings down system CARs by only a small amount; a 30 percent fall in equity prices reduces CARs by 0.54 (reported ranges elsewhere show -0.62).
  - Liquidity risk: a 30 percent reduction in private sector deposits would exhaust 15 percent of liquid assets; a 10 percent haircut on assets would push CAR down to just over 9 percent.
- Methodology notes:
  - TD tests used EU-15 panel (496 banks, 1996–2004) to estimate provisioning sensitivity; provisions most sensitive to log of unemployment (+), less to output growth (-) and real house price inflation (-).
  - BU tests are more dynamic (allowing lags and trading income offsets); TD tests are more conservative ("worst case") as modeled.

### Insurance, reinsurance, and securities supervision
- Insurance supervision significantly improved since 2000 FSAP; IFSRA plans early transposition of the EU Reinsurance Directive in 2006.
- IFSRA proposals include adoption of an economic capital model, actuarial valuation of liabilities, and consideration of solvency and disclosure requirements for finite and captive reinsurers.
- IFSRA to introduce quarterly statutory reporting by end-2006.
- Securities market developments:
  - ISE main market reached about Euro 94 billion market capitalization as at end-2005.
  - Collective Investment Schemes: number increased to 964 (3798 including sub-funds) in 2005; assets reached Euro 584 billion in 2005.
- IFSRA institutional features:
  - Unified regulator (IFSRA) within CBFSAI from May 1, 2003; operational and budgetary autonomy.
  - IFSRA receives 50 percent of funding from CBFSAI and 50 percent from supervised institutions.
  - New administrative sanctions regime established in 2004.

### International Financial Services (IFS) sector — scale, linkages, vulnerabilities
- About 450 international institutions operate from Ireland; over 50 percent of the top 50 global financial institutions present.
- IFS sector employment and fiscal numbers:
  - Employs more than 21,000 people (about 38 percent of those employed in financial sector).
  - Direct tax yield from IFS companies €663 million (about 12 percent of total corporate taxes).
- Balance-sheet scale:
  - Large gross levels of foreign assets and liabilities (each well above 600 percent of GDP).
  - IFS banks’ assets held against Irish residents represent about 30 percent of GDP; liabilities with Irish residents account for 40 percent of GDP.
- Sector composition (December 2005):
  - 51 banks in the IFS sector accounting for about 37 percent of total bank assets.
  - Regulatory capital ratio for IFS banks at 16.5 percent as at end-2005 (down from 19.1 percent in 2000).
  - NPLs low: 0.3 percent of aggregate loans as of end-December 2005.
  - Loan-to-deposits ratio (including financial intermediation) high at 2.7.
- Linkages and contagion assessment:
  - IFS institutions deal primarily with cross-border customers; contagion avenues to domestic institutions remain limited but may increase as linkages grow.
  - Recommendation: consider including IFS institutions in future stress tests.

### Supervisory capacity, resources, and recommendations (selected)
- Ongoing and short-term priorities:
  - Continue to develop expertise and ensure adequate staff resources for supervising a more sophisticated financial system (Basel II, Solvency II, reinsurance).
  - Enhance on-site supervisory program to strengthen assessment of insurers' risk management and corporate governance.
  - Implement enhanced public disclosures by insurers in line with IAIS best practices.
  - Strengthen monitoring of credit risk transfer activities.
  - Consider upgrading the position of the Prudential Director as regards IFSRA Board membership, on par with the Consumer Director.
  - Move toward higher specialization, formalized internal information sharing, and consider centralization of supervisory policy and model evaluation functions.
  - Build capacity on investigations/enforcement and provide explicit legal powers to deal with significant owners and key functionaries failing fit and proper tests.
- Stress-testing enhancements:
  - Continue to upgrade CBFSAI’s stress testing framework.
  - Conduct coordinated bottom-up stress testing exercises at least once every two years and upgrade BU test templates leveraging richer bank models.
  - Consider extending tests to banks’ foreign exposures given sizeable cross-border linkages.
  - Use experiences of other countries to help quantify links between macro scenarios and loan-loss provisions for Ireland.
- Insurance supervision:
  - Strengthen oversight and independence of actuaries; review Statement of Actuarial Opinion requirements.
  - Assess scope and intensity of on-site visits to insurers.
  - Given further developments and EU Reinsurance Directive transposition, undertake a full reassessment of the IAIS Core Principles once transposition is complete.

### Appendix: stress-test scenarios and selected quantitative results
- Scenario 1 (extreme) shock components (as reported):
  - sharp downturn in world trade by 6%
  - appreciation of the Euro by 25%
  - machinery and equipment investment 25% lower than baseline
  - housing output reduction to 50,000 units from 80,000 units
  - separately a 40% decline in house prices built into scenario variants
  - policy interest rates unchanged; scenario takes effect beginning of 2006Q3; joint probability < 1%
- Scenario 2 (less extreme):
  - euro appreciation of 10%
  - contraction of housing construction and FDI of same magnitude but more gradual
  - cumulative nominal short-term interest rate increases of either 1.25 percentage points or 2.50 percentage points above current level
- BU Test weighted-average impacts (selected, Table 4):
  - Scenario 1 — NPLs: 0.31 (2006), 1.19 (2007), 2.28 (2008); CAR (2006) 0.27; ROA (2006) 0.02; CAR (2007) 1.00; ROA (2007) 0.03; CAR (2008) 1.30.
  - Scenario 2 — six banks (1.25% interest rate increase, 69.9% of total assets): NPLs 0.41 (2006), 1.12 (2007), 2.54 (2008); CAR (2006) 0.33; ROA (2006) 0.03; CAR (2007) 1.01; ROA (2007) 0.08; CAR (2008) 1.43; ROA (2008) 0.09.
- TD Test sensitivities (selected):
  - Scenario 1 (EU-15 model) implies increase in NPLs by 79 percent assuming LGD=50% (weighted average impact on CAR -0.440 pp).
  - 100 percent increase in PD with LGD=50% → weighted average impact on CAR -0.561 pp.
  - 100 percent increase in PD with LGD=75% → weighted average impact on CAR -0.851 pp.
  - Interest rate risk: 200bp downward parallel shift impact on CAR -0.050; 400bp upward parallel shift impact on CAR 0.110.
  - Liquidity risk: 10% haircut on debt securities & government bonds impact on CAR -1.522; 20% haircut impact on CAR -3.104.
- Mortgage LGD methodology and results:
  - LGD benchmark assumes hypothetical average mortgage with 90 percent LTV at origination and applies house price decline scenarios of 25 percent, 40 percent, and 55 percent to outstanding LTVs across origination buckets.
  - Provisions at end-2005: the value of provisions set aside for mortgage loans was 12 percent of profits at end-2005.
  - Coverage: 12 percent of provisions would cover losses from a 25 percent fall in house prices and up to 10 percent default rates.
  - Considering a 50 percent regulatory risk-weight for mortgage loans as an additional capital buffer, mortgage provisions plus that buffer would cover up to a 55 percent fall in house prices and a 10 percent default.

*Source: _cr06292 (excerpts provided).*

### Executive Summary ......................................................................................................

### Executive Summary

### Overall assessment and recent performance
- The Irish financial sector has continued to perform well since the 2000 FSAP.  
- Financial institution profitability and capitalization are currently very strong, with Irish banking sector profits "amongst the highest in western Europe."  
- Major Irish banks receive "upper medium- to high-grade ratings" from international ratings agencies.  
- Outlook for 2006–07 described as "very strong," while noting macro-risks that could affect asset quality.

### Key macrofinancial risks and channels
- Sustained rapid credit growth driven largely by record increases in mortgage credit accompanying the housing boom.  
- Household debt to GDP ratios are "now amongst the highest in Europe," raising concerns about household sector credit risk.  
- A significant slowdown in growth, while "seen as extremely unlikely in the near term," would adversely affect employment, housing demand, and the construction sector, with expected deterioration in corporate and household loan quality.  
- Lack of recent experience with a major downturn in Ireland makes likely magnitudes of deterioration uncertain.

### System resilience and stress testing
- Stress tests undertaken through the Central Bank and Financial Services Authority of Ireland (CBFSAI) and major lending institutions indicate major domestic lending institutions have "adequate capital buffers to cover a range of large but plausible hypothetical shocks" reflecting the above risks.  
- Mission recommends continued enhancement of stress testing frameworks and coordinated exercises (see Box 1 recommendations below).

### Developments in regulation and supervision
- Good progress achieved since the 2000 FSAP in strengthening the regulatory and supervisory framework.  
- The Irish Financial Services Regulatory Authority’s (IFSRA) strategy: unified approach to risk with common elements across sectors, differentiated where necessary, is "being put into practice well" and helps prioritization and planning.  
- Insurance regulatory regime has been "significantly improved since the 2000 FSAP" and is being further enhanced.  
- Financial institutions have improved risk management practices, improving the system’s capacity to identify and manage risks.

### Remaining vulnerabilities and supervisory priorities
- Need for continuous review of adequacy of supervisory regulatory resources to account for market and regulatory developments and growth of the international financial services (IFS) sector.  
- Scope to undertake more robust on-site visits to insurers, especially independent assessments of risk management and corporate governance.  
- Introduction of a formal regulatory regime for the reinsurance industry will be a challenge.  
- Given further developments in insurance and reinsurance supervision and revision of IAIS Insurance Core Principles to cover reinsurance, a formal reassessment of the IAIS Principles is warranted once the EU Reinsurance Directive has been fully transposed.

### Box 1 — Ireland: FSAP Recommendations

Financial stability framework / stress testing
- Medium term:
  - Continue to upgrade the CBFSAI’s stress testing framework.
  - Conduct coordinated bottom up stress testing exercises at least once every two years and investigate upgrading the templates used for bottom up stress tests, taking advantage of the richer models that banks are developing in preparation for Basel II.
  - Consider extending the tests to the banks’ foreign exposures, given the sizeable cross-border linkages of domestic credit institutions.

Regulatory framework
- Ongoing:
  - Continue to develop the necessary expertise and ensure adequate staff resources for supervising an increasingly sophisticated financial system, especially taking into account ongoing regulatory developments (Basel II, Solvency II, and the regulation of reinsurance).

- Short-term:
  - Enhance the current scope and intensity of the on-site supervisory program, in particular to strengthen the assessment of the risk management and corporate governance practices of insurers.
  - Implement enhanced public disclosures by insurers, in line with the best practices established by the IAIS to allow for effective market discipline.
  - Consider upgrading the position of the Prudential Director as regards IFSRA Board membership, on par with the Consumer Director.
  - Strengthen monitoring of credit risk transfer activities by financial institutions.

- Medium term:
  - Have a full reassessment of the IAIS Core Principles undertaken, once sufficient time has passed so that transposition of the EU Reinsurance Directive can be effectively assessed.

### Financial sector structure and key statistics (selected figures from Table 1 and text)
- Banking sector asset growth: "around 25 percent" annual growth in assets (domestic banking sector).  
- As at December 2005, composition of total bank lending:
  - Residential mortgages: "37 percent"
  - Commercial property: "17 percent"
  - Construction: "5 percent"  
- Table 1 selected indicators (deposit-taking institutions, 2001–2005):
  - Regulatory capital to risk-weighted assets (All Banks): "13.2", "14.4", "15.0", "14.6", "13.6" (in percent for 2001–2005)
  - Regulatory Tier 1 capital to risk-weighted assets (All Banks): "10.7", "10.7", "10.8", "10.9", "10.6" (in percent for 2001–2005)
  - Nonperforming loans to total gross loans (in percent): "1.0", "0.9", "0.9", "0.8", "0.68" (2001–2005)
  - Total provisions for loan losses (in percent of total loans): "1.14", "1.05", "0.90", "0.70", "0.50" (2001–2005)
  - Annual credit growth rates (to private sector): "15.1", "15.0", "17.9", "26.6", "28.8" (2001–2005)
  - Annual mortgage credit growth rates: "17.8", "23.1", "25.5", "26.5", "28.5" (2001–2005)
  - Household debt to GDP (in percent): "38.9", "43.2", "49.3", "61.2", "72.0" (2001–2005)
  - House prices (euro): "181,697", "205,898", "234,066", "254,215", "277,852" (2001–2005)
  - Mortgage loans to total loans (in percent): "26.9", "31.0", "34.5", "37.0", "36.8" (2001–2005)
  - Real estate loans to total loans (property-related lending) 7/: "38.0", "43.2", "49.7", "54.4", "57.5" (2001–2005)
  - Liquid assets to total assets (All Banks, liquid asset ratio): "30.0", "30.0", "33.6", "33.0", "34.2" (2001–2005)
  - Return on assets (in percent): "0.9", "1.0", "0.9", "1.0", "1.4" (2001–2005)
  - Return on equity (in percent): "16.0", "18.0", "17.8", "20.7", "21.8" (2001–2005)

### Mission conclusions
- Financial system appears well placed to absorb the impact of a downturn in either house prices or growth more generally, supported by capital buffers evidenced in stress tests.  
- Recommendations focus on further enhancements to supervision, stress testing, and resources rather than addressing fundamental systemic weaknesses.

*IMF Executive Summary (FSAP Update) — Ireland*

### 7.      Further, while international diversification of bank’s assets is increasing, with

### _cr06292 - 7.      Further, while international diversification of bank’s assets is increasing, with

### International diversification and asset concentration
- The two largest banks each have an almost equal amount of domestic and foreign assets.
- A significant part of the foreign assets are property-related, exposing these banks to any general downturn in world property prices.

### Funding structure and liquidity risks
- Banking system lending growth has exceeded deposit growth for some time.
- ECB data indicate that Irish banks had the lowest customer deposits-to-assets ratio of all western European Union (EU) member countries as at end-2004.
- Growing share of banks’ funding has been from other financial institutions, including from off-shore; heavy reliance on wholesale funding potentially increases liquidity risk.
- Off-shore funding is diversified (as shown in Figure 1 of the source).
- The domestic private-sector loans-to-deposits ratio was 1.7 (as of August 2005) versus the Euro area median of 1.3.
- The four major Irish banks currently fund between 35 and 53 percent of total funding on the interbank and securities markets.
- Irish banks’ exposure to capital market funding, at 30 percent of assets, is among the highest in the EU.
- Wholesale funding is generally more expensive than deposit funding—the margin of lending rates over wholesale funding costs for Irish banks decreased further toward end-2005.
- Funding has become increasingly geographically diversified, and Irish banks’ funding needs are small relative to the size of the liquid Euro market.
- Issuance of covered bonds has increased since new Irish legislation in 2001 broadened eligible collateral; Ireland is ranked sixth in terms of outstanding volumes of covered bonds in Europe but accounts for about 2 percent of the total.
- Derivatives notional values approached 900 percent of total assets in 2005; data on credit risk transfer (CRT) activities are limited and available only with lags.
- Recommendation: strengthened monitoring of credit risk transfer activities in Ireland.

### Regulatory and supervisory developments
- Financial sector supervision was unified under the IFSRA, within the CBFSAI, from May 1, 2003.
- The integrated supervisory framework is intended to support better information flow between supervisors and those monitoring systemic risks, and to facilitate coordination among supervisory and monetary authorities.
- Strong emphasis on improving consumer protection as regards financial services.
- Insurance supervision framework significantly overhauled since the 2000 FSAP; prior responsibility rested with the Department of Enterprise, Trade and Employment.
- Authorities’ supervisory priorities include:
  - implementation of Basel II,
  - introduction of a formal regulatory regime for the reinsurance industry,
  - implementation of the EU Solvency II Directive when it is finalized.
- The CBFSAI has commenced publication of a regular Financial Stability Report (FSR) and formed a financial stability committee that oversees stability analysis and conducts crisis simulation exercises.
- The CBFSAI has undertaken public education regarding risks to borrowers arising from the house price boom and the expected rise in interest rates.
- The preferential corporate tax rate applying to financial institutions in the IFSC was abolished from January 1, 2006 (in line with EU requirements).
- IFSC institutions have always received full licenses to operate in Ireland; removal of the differential tax regime could over time lead to growing business between these institutions and residents.

### Macroeconomic sources of risk and outlook
- Economic outlook described in the accompanying Staff Report is positive; domestically originated macro risks to the financial system are limited.
- Economy’s momentum driven by strong employment growth boosted by record migration and increased participation.
- Going forward, support from continued strong employment and income growth, fiscal stimulus in 2006, and withdrawals from maturing special savings incentive accounts (SSIAs) that will begin in the middle of this year.
- Business investment expected to remain robust; residential investment expected to expand further in 2006 before leveling off in 2007.
- Risks that could result in a sharp slowing in growth include both domestic and external factors:
  - Substantial increases in Euro interest rates, in excess of the 200 basis points generally incorporated in banks’ stress tests of individual loans, would pose risks given household indebtedness levels.
  - Private sector credit rose to record levels in 2005 with the annual growth rate reaching 29 percent in December.
  - Ongoing rise in debt levels over the past decade has placed Ireland above the average household debt-to-income ratio for Euro area countries, only surpassed by the Netherlands and Luxembourg.
  - Real estate prices have risen by about 10 percent per year on average since 2000, consistently faster than household average income.
  - Central expectation is for an orderly slowing in the housing market; a sharp correction cannot be ruled out and would have adverse consequences for employment, growth, and debt servicing capacities.
  - Continued deterioration in competitiveness could dampen external demand and foreign direct investment: economy-wide unit labor cost and CPI-based real effective exchange rates appreciated substantially between 2001–05.
  - Further increases in oil prices could also adversely affect growth prospects through reduced demand from Irish major export markets.

### Household sector risks and mortgage market
- Private sector credit has increased very rapidly since 2000, with fastest growth in personal and commercial real estate finance.
- Household gross indebtedness—primarily house mortgages—has risen sharply; household debt to GDP ratios have almost doubled over the last five years.
- If current growth rates persist, household debt to GDP ratios would double again over the next three years.
- Average mortgage servicing cost for first-time buyers rose from an estimated 25 percent of average earnings in 2000 to about 29 percent by 2004.
- Loan-to-value ratios (LTVs) grew from around 80 percent on average to around 92 percent for first-time buyers.
- Average mortgage maturities grew from around 20 years to 27 years.
- Table 2 (Mortgage Terms for First-Time Buyers, 2000–04) shows term distributions summing to Total = 100.0 across regions (Outside Dublin and County Dublin and City).
- Most mortgages are variable rather than fixed rate; simulations indicate a two percentage point increase in interest rates would raise the repayment burden for first-time house buyers by 5–6 percentage points from around 30 percent of average earnings, and 25 percent of disposable income, at present.
- Some banks offer 100 percent LTV and interest-only mortgages, mainly to a limited range of customers with high earning potential; maximum debt service to income ratios imposed by most banks mean the majority are ineligible for 100 percent LTV loans.
- Nonperforming loans (NPLs) for mortgages are currently 0.45 percent.
- Authorities will require Irish banks to assign higher risk weights to mortgage loans with loan-to-value ratios above 80 percent from May 2006 onwards.
- Short-term supports for the housing market include maturing SSIAs in 2006 expected to free up funds amounting to 20 percent of consumption and continued strong immigration.

### Corporate sector
- Credit growth to nonfinancial corporates rebounded across all sectors since 2002; commercial property-related lending was the largest component of outstanding loans to the nonfinancial corporate sector in 2005.
- Lending growth strongest for retail, transport, and service sectors; manufacturing lending recently started to grow after a flat period.
- Corporate sector credit risks remain low: nonfinancial corporate sector debt-to-GDP ratio increased slightly over 2004 by 5 percentage points to 90 percent.
- Rate of potentially insolvent liquidations fell in both 2004 and 2005 and remains significantly below its long run average.
- Distribution of debt is skewed, with a small number of large international firms holding the majority of the debt; CBFSAI judged that much of this debt is likely sourced from abroad, reducing implications for the Irish banking system.

### Banking sector performance and soundness
- Banking sector continues to perform well amid rapid credit growth, low interest environment, and strong house price inflation.
- Sector characteristics: retail/mortgage focus, well capitalized, relatively efficient, highly liquid.
- Irish banks are among the most profitable in the EU despite relatively low net interest margins (partly due to heavy reliance on wholesale funding).
- Loan-loss provisions cover more than 85 percent of NPLs; mortgage-specific provisions are 0.03 percent of total loans.
- Liquidity asset levels are good; maturity mismatch of funding and loans has not changed significantly over the last five years.
- Liquid Assets (in percent of assets) and other comparative metrics are presented in Figure 8 (data as of end-2004).
- Return on Equity and Return on Assets metrics in Figure 8 show Irish banks and Ireland-IFS series outperforming Euro Area and EU aggregates in the source figures.

*Source: _cr06292 (excerpts provided).*

### 30.      As part of the FSAP Update, the mission and the CBFSAI agreed on a series of

### _cr06292 - 30.      As part of the FSAP Update, the mission and the CBFSAI agreed on a series of

### Stress-testing framework and coverage
- Two complementary approaches: (i) bottom-up (BU) tests by a sample of systemically important lending institutions; and (ii) top-down (TD) tests by the CBFSAI.
- Institutions covered by both sets of tests: the set of large lending institutions judged to be potentially systemically important (nine banks and two building societies).
- Two main shock scenarios calibrated with the CBFSAI’s macroeconometric model using end-2005 balance sheet positions:
  - Scenario 1: sharp downturn in the housing market, a large increase in the interest rate, significant withdrawals of customer deposits, a fall in equity prices, and a depreciation of the Euro/U.S. dollar exchange rate.
  - Scenario 2: substantial increase in interest rates following a mild economic downturn.

### Methodology notes
- TD tests used EU-15 panel data to proxy the relationship between macroeconomic shocks and provisioning because Ireland’s extended period of strong performance made direct estimation difficult.
- BU tests are more dynamic (allowing lags and ongoing trading income to offset shocks); TD tests are more conservative and may be interpreted as “worst case” (entire possible impact of a shock written off capital with no offsets).

### Main results — credit risk, capital adequacy, and resilience
- TD and BU tests produced broadly consistent results: banking system resilient to a range of shocks, with the first shock scenario having the largest impact.
- Under both scenarios: downturn in GDP growth → bank asset growth (especially loan growth) slows considerably → declines in operating income growth and nominal profit growth → high increase in NPLs.
- TD test (EU-15 model) with first shock scenario implies an increase in NPLs by 80 percent, assuming that loss-given default (LGD) remains at 50 percent.
  - Given extremely low NPL levels in Ireland, this 80 percent increase did not cause any bank’s capital adequacy ratio (CAR) to fall below the 8 percent minimum.
- BU tests suggest NPLs could rise to 3.13 or by almost 400 percent over three years (as suggested by the BU tests); such an outcome would significantly hit CARs (assuming no other adjustments to capital).
- Both sets of tests indicate the banking sector seems resilient to severe shocks, but credit risk is deemed the most important risk factor given rapid credit growth.

### Specific TD stress-test findings on mortgage, market, and liquidity risks
- Mortgage stress:
  - Current provisions for mortgage lending would cover a scenario of a 25 percent fall in house prices.
  - Even if the mortgage NPL ratio increased from the current 0.45 percent to 5 percent after a 40 percent fall in house prices, banks’ existing capital buffer would adequately absorb the resulting loss.
- Market risk:
  - A 400 basis point (bp) tightening of interest rates brings down system CARs by only a small amount, with balance sheet effects on bond portfolio partially offset by a positive income effect on banking and trading books.
  - Repricing risk from an increase in wholesale rates was not considered meaningful because most loans are at variable rates and banks could pass increases on.
  - Direct balance sheet effect of exchange rate changes is negligible; indirect foreign-exchange-induced credit risk effect of a 30 percent euro appreciation is also small.
  - A 30 percent fall in equity prices reduces CARs by 0.54 (effect likely an overestimation due to lack of data on net open positions in equities).
- Liquidity risk:
  - A 30 percent reduction in private sector deposits would exhaust 15 percent of liquid assets.
  - Main wholesale liquidity test: a 10 percent haircut on sale of assets such as debt securities and government bonds—losses arising from the haircut would push overall CAR down to just over 9 percent.
  - Banks appear to have generally appropriate contingent liquidity arrangements to address tightening access to wholesale markets.

### Observations on stress-testing practice and data constraints
- Both CBFSAI and banks have conducted stress tests regularly since 1999, but methods are still evolving and coordinated BU test frequency is relatively low.
- Data issues constrain the power of stress tests; authorities should develop methodologies that guide data collection needs.

### Suggested enhancements to stress-testing framework
- Use experiences of other countries’ banking systems with economic downturns to help quantify links between macro scenarios and loan-loss provisions in Ireland.
- Increase frequency of BU stress tests to at least once every two years.
- Extend tests to banks’ foreign country exposures given sizeable cross-border linkages.
- Upgrade BU result templates provided to banks to include more details and tests, leveraging richer models banks may already be using for Basel II preparation.

### International Financial Services (IFS) sector — summary findings
- 2000 FSAP: linkages between IFS institutions and domestic system were limited; risk to domestic system negligible.
- 2006 update: IFS institutions still deal primarily with off-shore customers; contagion avenues to domestic institutions remain limited.
- Recent abolition of favourable tax regime for IFS institutions has lowered barriers to stronger financial linkages with the domestic sector.
- Soundness problems at IFS institutions could cause reputational effects and declines in sector activity (lower employment and taxes).
- CBFSAI may wish to consider including IFS institutions in future stress tests given growing importance for employment and fiscal revenues and potential for greater linkages (practice consistent with jurisdictions like Luxembourg).

### Supervisory and regulatory framework developments
- Two significant changes since 2000 FSAP: (i) creation of a unified financial regulator (the IFSRA) as from May 1, 2003; and (ii) substantial upgrading of insurance supervision framework.
- IFSRA preparations:
  - Advanced stage of preparation for implementation of the revised EU Capital Requirements Directive (CRD) to implement Basel II from 1 January 2007.
  - IFSRA contributed to Committee of European Banking Supervisors (CEBS) work and established an implementation forum (established in July 2005; has met five times to date).
  - Major banks upgrading internal risk rating models; working groups on model validation, pillar 2, and prudential reporting.
- IFSRA institutional features and achievements:
  - Established as a distinct legal entity within the CBFSAI with operational and budgetary autonomy.
  - Creation in November 2004 of the Financial Services Consultative Industry Panel and the Financial Services Consultative Consumer Panel enhanced public accountability.
  - Significant progress in market conduct regulation; cross-sectoral consumer protection code expected mid-2006.
  - Financial Services Ombudsman’s Bureau set up in 2004 to deal independently with unresolved consumer complaints.
- Challenges:
  - IFSRA has not yet been tested by failure of a significant financial institution.
  - Maintaining adequate and effective supervision amid increasing complexity requires continuous staff skill upgrading in a tight labor market.
  - Consideration could be given to upgrading the position of the Prudential Director to full IFSRA Board membership (on par with the Consumer Director) to clarify relative importance of functions and potential trade-offs.

### Box 2 — Supervisory Framework—Recommendations (selected points)
- General
  - Continue to monitor and improve efficiency, effectiveness and consistency of prudential supervision across all sectors regulated by the IFSRA.
  - Continue to ensure adequate resources for supervising an increasingly sophisticated financial system, and international regulatory developments such as Basel II, Solvency II, and reinsurance.
  - Consider upgrading the position of the Prudential Director as regards IFSRA Board membership, on par with the Consumer Director.
  - Move toward higher specialization and a more formalized approach of internal information sharing; develop a tracking system for supervisory activities.
  - Consider some centralization of functions, especially in supervisory policy and evaluation of risk models.
  - Build capacity on investigations/enforcement and establish clear authority and decision making processes under the Administrative Sanctions regime.
  - Provide explicit legal powers to the IFSRA to deal effectively with significant owners and key functionaries who no longer meet fit and proper requirements.
- Banking
  - Continue to develop expertise necessary for Basel II implementation, especially supervisory review process and assessment of management awareness.
- Insurance
  - Review scope and intensity of on-site supervisory programme for independent assessment of risk management and corporate governance.
  - Review regulatory requirements for the Statement of Actuarial Opinion on technical reserves of non-life insurers and strengthen oversight and independence of actuaries.
  - Implement enhanced public disclosures by insurers in line with IAIS best practices.
- Credit unions
  - Continue to develop the regulatory framework for supervision of credit unions, especially risk management of investment activities; consider bringing supervision under the Prudential Director over time.

*Source: FSAP Update material in content unit _cr06292 (selected excerpt).*

### 58.      Good progress has been made in strengthening the off-site and on-site prudential

### _cr06292 - 58.      Good progress has been made in strengthening the off-site and on-site prudential

### Insurance supervision: progress and ongoing measures
- Prudential regulatory requirements are sound and in line with the relevant EU directives and IAIS Core Principles.
- The IFSRA has established guidelines and standards to enhance insurers’ corporate governance and is updating its fitness and probity framework.
- Plans to introduce quarterly statutory reporting by all insurers by end-2006 to facilitate continuous monitoring and timely regulatory interventions.
- Recommendation: Give due consideration to the appropriate scope and intensity of prudential on-site visits to enable independent assessment of risk management and corporate governance practices of insurers.

### IFSRA powers and enforcement
- The IFSRA has been empowered, since 2004, to exercise a range of regulatory sanctions in a proportionate manner.
- FSAP view: IFSRA’s ability to sanction persons who no longer meet the fit and proper tests could be strengthened.

### Actuarial oversight and use of actuarial certification
- Since 2002, the IFSRA has expanded the role of actuaries in certifying the financial performance and condition of insurers.
- Appointed actuaries of life insurers are required to present financial condition reports (FCR) once every three years, aimed at identifying plausible threats to satisfactory financial condition and related risk mitigation measures.
- There is scope for the IFSRA to collaborate with the actuarial profession to strengthen the oversight and independence of actuaries, while exercising reasonable reliance on their professional judgment.

### Reinsurance market, solvency frameworks, and disclosure
- Ireland is among the most important reinsurance jurisdictions in the world, prompting IFSRA plans for early transposition of the EU Reinsurance Directive in 2006.
- IFSRA proposals include:
  - Adoption of an economic capital model to assess solvency of reinsurers as an indicator to bridge the gap between Solvency I and Solvency II.
  - Active discussion with the Society of Actuaries to introduce actuarial valuation of liabilities.
  - Consideration of appropriate solvency and disclosure requirements for finite and captive reinsurers.
- Recommendation: Implement international best practices on public disclosure standards by insurers established by the IAIS to further facilitate effective market discipline.

### Supervisory resources and capacity
- Effective supervision of the significant and sophisticated reinsurance market will hinge on adequacy of supervisory staff with relevant training and experience.
- The impending quarterly statutory reporting for insurance companies and the adoption of a more risk-focused approach to supervision will have significant resource implications.

### Assessment and timing
- Given significant expected further changes to Ireland’s insurance supervision regime, the FSAP Update team recommends a formal reassessment of the IAIS Core Principles.
- The reassessment should allow sufficient time after Ireland’s transposition of the EU Reinsurance Directive so as to properly assess implementation.

### AML/CFT issues (summary)
- An evaluation by the Financial Action Task Force (FATF) in July 2005 was drawn upon by the FSAP mission.
- Main FATF issues:
  - Irish guidelines are not legally enforceable (but appear to be followed and "enforced" in a traditional supervisory sense).
  - Question whether the Irish supervisor had sufficient sanction powers to deal with infractions of the AML/CFT law by institutions it supervises.
- FSAP mission understanding: Both issues should be addressed by the Irish authorities, to the extent necessary, in the context of implementing relevant EU directives.

### Annex: factual updates — banking and securities supervision (selected findings)
- Basel Core Principles (BCP) update:
  - 2000 FSAP found a high degree of observance of the BCPs; main challenges were ensuring continuation of high standards and strengthening risk-based supervision.
  - Establishment of a unified Irish Financial Services Regulatory Authority (IFSRA) in 2003; implementation of the Capital Requirements Directive (Basel II) identified as the main upcoming challenge.
  - IFSRA has operational and budgetary autonomy; accountability mechanisms include board appearances before parliament and prior approval of annual budget, strategic plan, and annual report by the Minister of Finance.
  - The IFSRA receives 50 percent of its funding from the CBFSAI and 50 percent from the institutions supervised.
  - IFSRA intensified banking supervision: substantial consultation papers, intensified off-site review and on-site inspections, and a dedicated inspection unit performing cyclical, theme, and unscheduled inspections.
  - A risk factor rating system was introduced to guide resource allocation, frequency and scope of on-site inspections, and regulatory action programs; applied at the individual institution level to date.
  - IFSRA has legal power to take a sufficient range of enforcement actions including an administrative sanctions regime established in 2004.

- IOSCO / securities regulation update:
  - Since 2000, the ISE main market (the Official list) grew by about 18 percent in terms of market capitalization to reach about Euro 94 billion as at end-2005.
  - ISE market developments: launch of ITEQ (technology stocks) in 2000; in April 2005 IEX launched to replace the DCM and ESM markets.
  - ISE moved to electronic trading primarily conducted on the ISE Xetra platform in equities and on the EuroMTS platform in the Government bond market.
  - Collective Investment Schemes:
    - Number increased from 824 (2355 including sub-funds) in 2000 to 964 (3798 including sub-funds) in 2005.
    - Assets reached Euro 584 billion in 2005.
  - Since 2003, IFSRA regulates securities markets under the CBFSAI Acts 2003 and 2004; EU Directives (Prospectus, Market Abuse, Transparency) have been, or will shortly be, transposed into Irish law.
  - IFSRA structure for capital markets supervision: Market Supervision Department (MSD), Investment Service Providers Supervision Department (ISPS), Financial Institutions and Funds Authorization Department (FIFA).
  - Staffing and funding:
    - Since 2003, 50 percent of IFSRA’s budget from CBFSAI and 50 percent from the industry.
    - Staff numbers in SES and FIFA increased from 88 in 1998 to 120 in 2005 (56 in SES and 64 in FIFA).
  - Enforcement and cooperation:
    - New administrative sanctions regime introduced, providing flexibility beyond criminal prosecution.
    - IFSRA entered into further Memoranda of Understanding (MOUs) with other securities regulators, including U.S.A’s FINEX and the Commodity Futures Trading Commission.
  - Market infrastructure and operations:
    - ISE moved to electronic trading and reporting via ISE Xetra; alliance with Deutsche Börse allowed operation on a special segment of the Xetra platform in Frankfurt, addressing prior delays in timing of information.
  - Product and supervisory distinctions:
    - Collective investment schemes authorized as a product; insurance companies authorized as a company—possible divergence in rules for similar products noted.
    - A new disclosure regime for life insurance products has come into effect and is being reviewed and updated.
  - Market intermediaries:
    - Recruitment strain on brokerage operations alleviated by outsourcing back-office operations.
    - Revised general and supervisory requirements, advertising requirements, client money requirements and the Code of Conduct issued in a Handbook to all supervised firms.

*Factual update and findings as presented in the source content.*

### Appendix I. Status of 2000 FSAP Recommendations

### Appendix I. Status of 2000 FSAP Recommendations

### General
- Recommendation: Introduce a single regulatory authority, commence supervision of reinsurers, and ensure adequate resources to evaluate internal models and supervise derivative activities.
- Implementation: Single regulatory authority came into being in 2003. Supervision does not differentiate between IFSC and domestic institutions. Work is ongoing to commence supervising reinsurance in line with the forthcoming EU directive and to improve resource availability and skill levels for supervision.
- Recommendation: Further adapt and refine CBI stress tests to facilitate comparability across institutions and encourage internal testing.
- Implementation: The CBFSAI now calibrates its macro scenarios using its macro econometric model prior to giving them to the banks for BU stress tests. BU tests are done only once every 2-3 years. One big bank out of the top three Irish banks is about to start a comprehensive internal stress test and one building society has an affordability model used to create an affordability index for each borrower.
- Recommendation: Compile and publish data on overall and regional real estate transactions and price developments.
- Implementation: The Department of the Environment, Heritage, and Local Government publishes annual and quarterly housing statistics bulletins, which contain house price statistics and loan and borrower profile data.

### Banking system
- Recommendation: Continuously adapt the regulatory and prudential framework to changes in the banking environment.
- Status: The regulatory and prudential framework is sound and in line with the relevant EU Directives. Current challenge: implementation of an action plan so credit institutions will be in a position to take on additional responsibilities under the Capital Requirements (Basel II) Directive (CRD).
- Recommendation: Ensure banks follow prudent credit analysis guidelines; consider stricter provisioning or capitalization for riskier lending if moral suasion is insufficient.
- Status: Ensuring prudent credit analysis is a focus of enhanced off-site and on-site supervision. Further progress is expected from CRD implementation. Implementation of International Financial Reporting Standards is likely to result in a decrease in provisioning due to an incurred loss model. Shortfalls of expected losses over impairment provisions will result in a deduction from regulatory capital under the CRD regime.
- Recommendation: Perform more frequent on-site inspections.
- Implementation: A dedicated unit performs more frequent on-site inspections. Introduction of a risk management system for every institution supervised and a significant increase in staff have improved prudential supervision and early problem identification.

### Insurance
- Recommendation: Strengthen staffing for insurance supervision and shift to a more comprehensive risk-based approach while maintaining consumer protection focus.
- Implementation: Prudential supervisory staff increased from 17 to 30 (planned 35), of which 5 are currently involved in formulating the formal regulatory regime for reinsurance.
- Recommendation: More rigorous application of IAIS principles and standards; strengthen supervisory resources to meet supplementary criteria, particularly for risk management.
- Status: The IFSRA has made significant progress in market conduct regulation and supervision. Ongoing need to continuously review adequacy of regulatory resources to match the size and sophistication of the insurance market and evolving market dynamics and regulatory developments.

### Securities
- Recommendation: Remove stamp duty on share purchases to develop a stronger liquid market in Irish equities.
- Status: The stamp duty has not been removed.

### Credit Unions
- Recommendation: Continue close monitoring of operations and growth; re-examine legal and regulatory framework to minimize regulatory arbitrage as products expand.
- Implementation: Regulation of credit unions transferred to Registrar of Credit Unions under IFSRA in May 2003. The Registrar carried out themed inspections covering money laundering, investments, credit, and information technology. A series of guidance notes was issued covering money laundering, investments, and governance. A guidance note relating to credit is being developed and there is an ongoing program to strengthen the supervisory framework under the IFSRA Strategic Plan.

### Deposit Insurance
- Recommendation: Consider increasing premiums to speed accumulation of funds to cover risks facing the deposit insurance system.
- Status: Premiums were not increased. Fund size increased from Euro 202 million to Euro 338 million in 2004 due to no recourse since the 2000 FSAP.

---

### Appendix II. Stress Tests

### Overview and objectives
- Tests carried out jointly by the Central Bank and Financial Supervisory Authority (CBFSAI) and a set of Irish financial institutions in consultation with the FSAP Update mission.
- Objective: Assess resilience of the Irish banking sector to a set of hypothetical shocks considered extreme but with a positive, albeit small, probability of occurrence.
- Coverage: BU tests by 11 Irish retail institutions (9 banks and 2 building societies) covering 95 percent of the mortgage market and 88 percent of the non-government deposit market in Ireland, using on- and off-balance sheet data for end-2005.
- The CBFSAI intends to publish the results of the 2006 stress testing round in their next Financial Stability Report.

### Methodology and tests
- CBFSAI performs Top-Down (TD) and Bottom-Up (BU) stress tests using framework developed in 1999.
- BU tests: 11 retail institutions ran two scenarios calibrated from a macroeconometric model developed by the central bank.
- TD tests: Single-factor sensitivity tests and scenario analysis using prudential data, institutions’ annual accounts, and Central Bank money and banking statistics. Only the credit risk test in TD is directly comparable to BU because banks were asked only to do scenario analyses, not sensitivity tests.
- A cross-country provisioning model (panel data for 496 banks from EU-15, 1996–2004) was estimated to capture variation in provisioning sensitivity to macro variables. Key findings from pooled OLS: provisions most sensitive to log of unemployment rate (+), much less sensitive to output growth rate (-) and real house price inflation rate (-).

### Scenarios and shock sizes (as reported)
- Note: Scenario descriptions reference CBI’s Quarterly Bulletin No. 1 2006 with horizon extended to 2008.
- Shock Scenario 1 (extreme): sharp downturn in world trade by 6%, appreciation of the Euro by 25%, machinery and equipment investment 25% lower than baseline, housing output reduction to 50,000 units from 80,000 units, separately a 40% decline in house prices built into scenario based on real disposable income growth. Policy interest rates unchanged. Scenario takes effect beginning of 2006Q3. Joint probability of shocks is less than 1%.
- Shock Scenario 2 (less extreme): euro appreciation of 10%, contraction of housing construction and FDI of same magnitude but more gradual, steady rise in nominal short-term interest rates assumed by banks to yield cumulative increase of either 1.25 percentage points or 2.50 percentage points above current level.
- Reported economic activity series (BASELINE 1/):
  - GDP 4.85.24.7
  - Private Consumption 6.36.64.4
  - Gross Fixed Capital Formation 3.83.53.1
  - Exports 4.85.75.6
  - Imports 5.35.64.7
  - Inflation (average % year-on-year change in HICP) 2.22.12.1
  - Unemployment (% of labor force) 4.34.34.3
  - House Price Inflation 7.06.36.1
- SHOCK SCENARIO 1 2/:
  - GDP 3.2-0.3-4.8
  - Private Consumption 6.04.3-0.4
  - Gross Fixed Capital Formation -5.8-13.6-7.9
  - Exports 3.2-3.9-7.5
  - Imports 3.0-4.9-5.0
  - Inflation (average % year-on-year change in HICP) 2.11.71.5
  - Unemployment (% of labor force) 4.56.69.7
  - House Price Inflation -13.0-8.71.1
- SHOCK SCENARIO 2 3/:
  - GDP 3.61.0-2.0
  - Private Consumption 5.94.00.4
  - Gross Fixed Capital Formation -3.9-9.8-12.2
  - Exports 3.9-1.2-2.5
  - Imports 3.7-2.4-3.4
  - Inflation (average % year-on-year change in HICP) 2.11.81.9
  - Unemployment (% of labor force) 4.56.28.7
  - House Price Inflation -13.0-8.71.1

### Types of TD tests conducted
- Macro credit risk: sensitivity tests assuming combinations of increasing NPLs and loss-given defaults (LGD).
- Credit risk associated with real estate prices: various house price scenarios with different mortgage default rates assessed against profit and capital buffers.
- Interest rate risk: effect on net interest income based on repricing gap data on banking and trading books and maturity of bond investments.
- Liquidity risk: effect of significant withdrawal of resident private sector deposits; haircut in value of liquid assets to proxy increased funding costs from reduced wholesale market access.
- Foreign exchange risk: indirect (credit risk) effects; direct fx risk negligible.
- Equity price risk: negligible given small share of equities in banks’ balance sheets.

### Bottom-up (BU) results — key findings
- Scenario 1 outcome: drastic reduction in asset growth, increase in non-performing loans (NPLs), but almost no change in profitability (ROA) from baseline.
- Under Scenario 1:
  - NPLs grow by more than 2.5 times the baseline over three years.
  - Cover ratio (loan loss reserves as percent of NPLs) falls in the shock scenario, driven by banks’ assumptions on collateral values and recovery rates.
  - Capital adequacy rises under the shock scenario while it falls under the baseline (differences small).
  - For mortgage loans, cover ratio rises slightly from about 18 percent in the baseline to about 20 percent under the shock scenario in 2008.
- Scenario 2: milder effect on key ratios than Scenario 1. Operating income growth, ROA, and net interest margin are higher in 2008 under Scenario 2 than for Scenario 1. No clear relationship between interest rate rise and NPL growth in this scenario.

- Selected summary figures from Table 4 (BU Test Results, weighted average impacts):
  - Scenario 1 — NPLs: 0.31 (2006), 1.19 (2007), 2.28 (2008); CAR (2006) 0.27; ROA (2006) 0.02; CAR (2007) 1.00; ROA (2007) 0.03; CAR (2008) 1.30.
  - Scenario 2 — six banks (1.25% interest rate increase, 69.9% of total assets): NPLs 0.41 (2006), 1.12 (2007), 2.54 (2008); CAR (2006) 0.33; ROA (2006) 0.03; CAR (2007) 1.01; ROA (2007) 0.08; CAR (2008) 1.43; ROA (2008) 0.09.
  - Scenario 2 — five banks (2.50% interest rate increase, 30.1% of total assets): NPLs 0.13 (2006), 0.82 (2007), 0.86 (2008); CAR and ROA impacts reported as in table.

### Top-down (TD) results — key findings
- The mission team’s EU-15 model with Scenario 1 implies an increase in NPLs by 79 percent, assuming LGD remains at 50 percent (weighted average impact on CAR -0.440 pp).
- Because NPL levels are extremely low in Ireland, impact on CARs is limited; scenario does not cause any bank’s CAR to fall below 8 percent minimum.
- A 100 percent increase in PD with LGD=50% yields weighted average impact on CAR -0.561 pp.
- A 100 percent increase in PD with LGD=75% yields weighted average impact on CAR -0.851 pp.
- Interest rate risk TD results (selected): 200bp downward parallel shift impact on CAR -0.050; 400bp upward parallel shift impact on CAR 0.110.
- Liquidity risk TD results (selected): 10% haircut on debt securities & government bonds impact on CAR -1.522; 20% haircut impact on CAR -3.104.
- TD vs BU comparison: TD model predicts underlying increase in NPLs of 1.57 in 2008; BU tests produced 3.13 in 2008 under Scenario 1. With LGD at 50% and NPLs between 2.61 and 3.48 percent in TD case, three banks accounting for 9 percent of assets would fall below minimum CAR of 8 percent.
- If BU test 2008 NPL increase (from 0.8 in 2006 to 3.13 in 2008) were written off 2006 regulatory capital with 50% LGD, CARs would fall by 1.04 percentage points.

### Overall assessment
- Both TD and BU tests indicate the banking sector seems resilient to severe shocks, though credit risk is identified as the most important risk factor given rapid credit growth.
- Differences between TD and BU results reflect methodology differences and assumptions (e.g., full balance sheet treatment in BU tests versus TD prudential-data-based adjustments).

*Appendix I. Status of 2000 FSAP Recommendations (and Appendix II. Stress Tests) — _cr06292 - Appendix I. Status of 2000 FSAP Recommendations*

### 1. Default rate: 10% of fx loans + LGD:

### _cr06292 - 1. Default rate: 10% of fx loans + LGD:

### Stress-test results on market risks and CAR effects
- A 400 basis point (bp) increase in interest rates would lower the market value of the bond portfolio resulting in a 0.62 percentage point change in average CAR, and this would in any case be partially offset by small positive income effects in the banking and trading books.
- A 30 percent fall in equity prices results in -0.62 percentage point erosion of the average CAR.
- Indirect foreign exchange (FX) risk has a very small effect on CARs, even under the assumption of severe shocks.
- The direct balance sheet impact of exchange rate change on net open fx position is negligible and not reported.

### Liquidity risk test and outcomes
- Test assumptions:
  - A 30 percent reduction in sight deposits.
  - A haircut on the stock of debt securities and government bonds held by banks to proxy the impact of attempting to sell the entire liquid assets portfolio.
- Findings:
  - A 30 percent reduction in sight deposits would exhaust 15 percent of liquid assets.
  - A 10 percent haircut would push overall CAR to 9 percent.
- Mechanism described: The withdrawal was benchmarked against the total value of liquid assets to see whether it could be met out of the existing stock of liquid assets; the haircut proxies market losses from forced liquidation to meet sudden liquidity needs.

### Mortgage stress test methodology (LGD estimation) and scenarios
- LGD calculation:
  - LGD is calculated from the existing mortgage book and applied to various default rates.
  - Benchmark typical LGD: assume a hypothetical average mortgage with 90 percent LTV originated in each of the years for the last 10 years; amortize each loan through the years till 2006; calculate outstanding LTV by using current average house price.
  - Very conservatively assume all loans in each origination-year bucket had LTVs 90 percent or above at origination.
- House price shock scenarios applied to outstanding LTVs to compute typical LGD:
  - 25 percent nominal house price decline.
  - 40 percent nominal house price decline.
  - 55 percent nominal house price decline.
- Application:
  - Actual mortgage loan book divided into buckets by origination year.
  - Hypothetical LGD applied to calculated LTV in each bucket under the three house price-decline scenarios.
- Note on exclusion:
  - House price declines are excluded from a related table because the methodology for that test was different.

### Mortgage stress-test findings on capital buffers and provisions
- Provisions and buffers at end-2005:
  - The value of provisions set aside for mortgage loans was 12 percent of profits at end-2005.
- Coverage results:
  - 12 percent (provisions) would cover losses from a 25 percent fall in house prices and up to 10 percent default rates.
  - If the 50 percent risk-weight for mortgage loans is considered as an additional capital buffer for unexpected losses, then this mortgage capital buffer along with mortgage provisions covers even a 55 percent fall in house prices and a 10 percent default.
- Notes on presentation:
  - The graph (Figure 9) shows losses from mortgage loan defaults at various default rates and house price declines; the kinks on the lines are due to a non-uniform x-axis scale.

### International Financial Services (IFS) sector: introduction and background
- Key context:
  - Over the last two decades, Ireland promoted itself as a centre for financial services companies, driven by an attractive fiscal and regulatory environment and a highly educated workforce.
  - About 450 international institutions are currently operating from Ireland, including over 50 percent of the top 50 global financial institutions.
- Historical fiscal changes:
  - Initial IFSC incentives included a reduced corporate tax rate of 10 percent and relief from local municipal taxes, capital expenditure taxes, and rents on property.
  - Phasing out of preferential IFSC regime by January 1, 2006, implemented in conjunction with the introduction of a new 12.5 percent Irish corporate tax rate starting from January 1, 2003.
  - Result: no fiscal distinction between IFSC and non-IFSC institutions as of those changes.

### IFS sector scale, structure, and key statistics
- Employment and tax yield:
  - IFS sector currently employs more than 21,000 people, or about 38 percent of all those employed in the financial sector, up from 8 percent in 1993.
  - Direct tax yield from IFS companies is €663 million (or about 12 percent of total corporate taxes), up from €4.7 million in 1989.
- Balance-sheet scale and domestic linkages:
  - Large gross levels of foreign assets and liabilities (each well above 600 percent of GDP).
  - IFS banks’ assets held against Irish residents now represent about 30 percent of GDP.
- Sector composition (as of December 2005):
  - 51 banks in the IFS sector accounting for about 37 percent of the total bank assets.
  - Of those, 22 banks were foreign banks’ branches benefiting from the EU passport established in 1994.
- Table 6 summary (Billion of euros):
  - Bank assets 348.8
  - Net asset values of funds administered in Ireland 874
    - of which: Irish domiciled 513.9
    - Non-Irish domiciled 360
  - Assets under management 270
  - Cross-border life assurance premiums (2004) 9.4
  - Cross-border gross non-life premiums (2003) 14
- Funds and exchanges:
  - Number of authorized funds around 3800 (2,120 Undertakings for Collective Investment in Transferable Securities).
  - Net asset value of Irish-domiciled funds estimated at over €500 billion.
  - Over 4,000 funds and sub-funds listed on the Irish Stock Exchange (ISE), making the ISE the largest exchange in the world for fund listing, ahead of Luxembourg.
  - Assets under management (AUM) in Ireland represent only about 0.5 percent of global AUM.

### IFS sector geography and activity composition
- Dominant domiciles (Table 7 shares, in percent):
  - U.S. 20.4
  - Ireland 19.7
  - U.K. 9.7
  - Germany 9.7
  - Italy 7.4
  - Netherlands 5.2
  - Bermuda 4.9
  - France 3.8
  - Belgium 2.5
  - Luxembourg 2.2
- Sector activities:
  - IFS sector dominated by credit institutions and investment funds.
  - IFS sector is one of the largest funds administration and custody centers in the world.
  - Insurance sector is a major activity: Ireland is Europe’s largest cross-border life insurance center and one of the largest reinsurance markets in the world.

### Linkages between IFS and the domestic economy
- Balance-sheet linkages:
  - Total liabilities with Irish residents account for 40 percent of GDP.
  - Assets held against Irish residents stand at about 30 percent of GDP.
- Funding and lending composition:
  - IFS banks are net borrowers in the Irish interbank market.
  - Borrowing from Irish financial institutions accounts for 9.6 percent of IFS banks’ liabilities.
  - Borrowing from other Irish residents accounts for about 2 percent of IFS banks’ liabilities; about one-third of that borrowing is intra-IFS and mainly in foreign currency.
  - IFS banks’ domestic lending accounts for about 5 percent of IFS banks’ assets.
  - Domestic lending composition (Table 8, as of September 2005):
    - Financial intermediation 88.9 percent of lending to Irish residents; 9.7 in percent of GDP
    - Construction 2.4 percent; 0.3 in percent of GDP
    - Real estate and business activities 2.4 percent; 0.3 in percent of GDP
    - Manufacturing 1.6 percent; 0.2 in percent of GDP
    - Electricity, gas and water supply 1.5 percent; 0.2 in percent of GDP
    - Transport, storage and communications 1.2 percent; 0.1 in percent of GDP
    - Wholesale/retail trade and repairs 1.2 percent; 0.1 in percent of GDP
    - Other 0.8 percent; 0.1 in percent of GDP
- Contagion assessment:
  - Linkages have increased but remain limited; contagion risks are small because non-Irish counterparts remain the main sources of interbank funding for both IFS and non-IFS institutions.
  - Even a severe deterioration of domestic macroeconomic conditions is likely to have a limited impact on IFS banks as their exposure to the domestic industrial sector is small.

### Vulnerabilities and soundness of IFS banks
- Exposure profile:
  - Total assets and liabilities with non-Irish residents account for over 80 percent of IFS banks’ balance sheets.
  - On the asset side, exposures concentrated to Italy, Germany, the U.K., and the U.S.
  - Largest currency exposure is to the U.S. dollar, which accounts for about 30 percent of IFS banks’ cross-border business.
- Funding structure and sectoral exposures:
  - Interbank and securities are main sources of funds: interbank accounting for 41 percent, securities about 21 percent of total assets.
  - IFS banks conduct about half of their interbank lending and borrowing activities with European financial institutions.
  - Liability-side exposures concentrated to the U.K., Germany, and Belgium, and to a lesser extent the U.S.; largest interbank exposures with counterparts in Belgium and Italy.
- Capitalization, liquidity, profitability, and asset quality:
  - Regulatory capital ratio stood at 16.5 percent as at end-2005, down from 19.1 percent in 2000; a large fraction of total capital composed of Tier I capital.
  - Nonperforming loans (NPLs) are low: as of end-December 2005, NPLs accounted for only 0.3 percent of aggregate loans, while the ratio of NPLs net of provisions to capital was -0.7 percent.
  - Liquidity is high and well above the minimum statutory requirement.
  - Loan-to-deposits ratio (including financial intermediation) is high at 2.7, reflecting reliance on wholesale funding.
  - Profitability (ROA and ROE) is lower than banks in EU-13 countries, reflecting an implicit low-risk strategy.

### Key sectoral distribution of lending to non-Irish residents (Table 9; as of December 2005)
- Financial intermediation 60.2 percent; 31.7 in percent of GDP
- Real estate, renting, and business 11.6 percent; 6.1 in percent of GDP
- Transport, storage, and communications 10.6 percent; 5.6 in percent of GDP
- Electricity, gas and water supply 3.9 percent; 2.1 in percent of GDP
- Manufacturing 3.5 percent; 1.8 in percent of GDP
- Personal (private households) 2.6 percent; 1.4 in percent of GDP
- Construction 2.2 percent; 1.2 in percent of GDP
- Other 2.2 percent; 1.2 in percent of GDP
- Other community, social, & personal services 2.2 percent; 1.2 in percent of GDP
- Wholesale/retail trade and repairs 1.1 percent; 0.6 in percent of GDP

### Conclusions and policy recommendations
- Vulnerabilities and potential impacts:
  - IFS institutions deal primarily with cross-border customers and therefore are vulnerable to economic factors and cycles in other countries and reputational risks.
  - Financial sector failures in IFS banks are unlikely to have as strong an adverse impact on Ireland as would failures in domestic Irish institutions, but an IFS bank failure could trigger reputational problems for the IFSRA.
  - Any major decline in the volume of financial sector activities would have repercussions on the domestic economy through reductions in banks’ profits and fiscal revenue, lower employment, and underutilization of services infrastructure.
- Recommended supervisory actions:
  - Continued supervisory vigilance is essential as the IFS sector is expected to become more sophisticated and linkages with the domestic financial system may grow.
  - The regulatory authority should consider conducting stress tests on IFS institutions to identify those institutions that are vulnerable to particular shocks and implement corrective action measures; this would be consistent with practice in other jurisdictions with large IFS sectors—for example, Luxembourg.

*Source: _cr06292 - 1. Default rate: 10% of fx loans + LGD:*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06292.pdf_