Indications suggest that Ireland may be beginning to emerge from one of the most difficult economic eras in its history. Now the latest statistics seem to show that even the banking sector is showing signs of recovery. The three domestic banks have ended 2013 in a much-improved position than 12 months ago. Ironically, it’s beginning to appear that one of the biggest impediments to further progress could be the regulating influence of the European Central Bank.

Ireland austerity

Ireland’s banking sector still under watchful eye of the ECB

With the ECB set to take over administration of the entire banking sector in 2015, it was deemed necessary to carry out pan-European assessments of all major financial institutions within its jurisdiction. Following the balance sheet assessments of Bank of Ireland (ADR) (NYSE:IRE) (LON:BKIR), Allied Irish Banks PLC (ADR) (OTCMKTS:AIBYY) and Permanent TSB Group (OTCMKTS:ILPMY) in November, none were required to raise new capital. However, all have been told to increase their loan loss provisions.

In the case of Bank of Ireland (ADR) (NYSE:IRE) (LON:BKIR), loan loss provisions had to be increased by €1.3 billion. This came as a blow to the bank, its shareholders and investors, as BOI was getting ready to go to the markets for the €1.8 billion required to redeem the government’s preference shares in the bank.

In the end, the bank raised the money from a €580 million share placing and €1.3 billion in preference shares sold on to private investors. Result: the government’s stake has been reduced to 14% and it even stands to make a €2 billion profit on its €4.8 billion rescue of the bank.

Trying times ahead for Permanent TSB?

Things may not be so simple at Allied Irish Banks PLC (ADR) (OTCMKTS:AIBYY) and Permanent TSB Group (OTCMKTS:ILPMY). Both remain 99.8% state owned and loan loss provisions required by these two banks won’t be known until end-of-year statements are published. What we do know is that mortgage and consumer loan losses are still making their way through the system and the introduction of new insolvency and bankruptcy legislation will hasten the recognition of losses sitting on balance sheets.

Despite the stabilization of house prices and falling unemployment, tracker mortgages are a massive problem for the banks – totaling some €48 billion. Historically low interest rates, set by the Central Bank have exacerbated the punishing effect of these trackers on the banks’ balance sheets. Allied Irish Banks PLC (ADR) (OTCMKTS:AIBYY) will find it easier than Permanent TSB Group (OTCMKTS:ILPMY). Fitch expects both it and Bank of Ireland to return to profitability this year. AIB is already looking at ways to redeem its government preference shares. If it does so, it will be in a good place.

However, the Permanent TSB Group (OTCMKTS:ILPMY) has €15 billion in trackers on its books. Unless a restructuring plan to split the bank into a good bank and an asset management unit to wind down its loss-making assets is approved by the European Commission, the outlook looks very bleak for the troubled institution.

If some sources are correct and the Central Bank is considering turning one of the three institutions into a wind-down bank, then Permanent TSB Group (OTCMKTS:ILPMY), at present looks, to be the most obvious candidate.

Is the Central Bank about to open up a new can of worms?

But, perhaps the biggest issue facing the banking sector in the lack of clarity on the methodology used in stress testing by the Central Bank. We just don’t know what criteria are being used or how stringent the testing is. The full results of stress testing in other countries won’t be made public until the end of 2014, but it seems more than likely that some other European banks will come under scrutiny as a result of the assessments.

In the week that Ireland announces its return to the 10 year bond markets, it’s not impossible that the conclusion of the ECB’s stress testing will lead to a whole new dilemma for the European banking sector in the year to come.