A sudden and unexpected fall in property prices accompanied by an increased rate of mortgage defaults represents the greatest threat to the Irish banking system, according to a new report from the Central Bank.
The bank's Financial Stability Report, published yesterday, finds that while the banking system could absorb a "modest" fall in house prices, a significant fall would have more "adverse implications".
The bank calls on lenders to apply "a mixture of prudent lending standards, and conservative loan-to-value ratios" when considering mortgage applications. Households must also be "prudent" in their borrowing habits, the bank urges. Consumers should be aware, it says, that low interest rates could not be expected to last indefinitely.
The bank has tried to identify potential risks to the Irish financial system so all players in the economy can be aware of them.
The Central Bank governor, Mr John Hurley, said the bank would discuss its findings with lenders so a "common understanding" of threats to financial stability could be achieved.
"The primary aim of financial stability analysis is to try to identify any factors that might lead to crises in the future," he said.
He added that problems in the banking sector could easily overflow into other business sectors and affect consumers.
Mr Hurley said the Central Bank remained concerned about the rate of credit growth in the economy, particularly when it came to property purchases. He said this meant all loans needed to be stress-tested to see how well borrowers could handle "more challenging economic circumstances".
The Central Bank conducted its own stress test of the banking system over the past year by simulating the effect of a severe recession on banks' financial positions. This involved imagining the effect of a 6 per cent reduction in the growth of world trade, a 20 per cent drop in the value of the euro or in equity prices and a two-thirds reduction in the value of foreign direct investment coming into the Republic.
The open nature of the Irish economy makes it more vulnerable than most economies to shocks emanating from abroad, according to the bank.
"The outcome of the exercise was positive," said Mr Hurley, acknowledging that each of the 12 credit institutions that were stress tested was "very resilient" to the simulated recession.
"The system could absorb a modest fall in house prices even if it were to coincide with a modest increase in defaults," says the Central Bank.
The Irish Bankers' Federation welcomed this confirmation that the financial position of the banking system was "fundamentally sound".
However, Mr Hurley added that the stress-testing techniques used by the bank were still being developed and might be subject to "shortcomings".
The Central Bank also noted that the ability of lenders to withstand a severe recession would depend on their ability to call in the collateral value contained in mortgaged properties.
