Dear Mr.

Kelly,

Thank you very much for your letter of 20 October 2010. In this letter, you first raise
a number of questions on the quality of the stress testing exercise coordinated by the
Committee of European Banking Supervisors (the CEBS stress tests) for Allied Irish
Banks (AIB), the results of which were announced on July 23, 2010. You then further
ask whether the Commission can now be certain, after the second AIB rescue
recapitalisation announced on 30 September 2010, that no more Irish taxpayers’
money will be required.

To answer your second query, the Programme for Support for Ireland which was
agreed on 28 November between the Irish government and the EC, the IMF and the
ECB, will result in further recapitalisation of Irish banks including AIB in the short
term, with the aim of strengthening the bank’s solvency over and above the
regulatory requirements in place until now.

As for your first question on the quality of the CEBS stress tests, I would like to
clarify the sequence of events which led to the announcement of the second rescue
recapitalisation for AIB in September. 

As you may know, the Irish Financial Regulator had performed in the first quarter of
2010, a prudential capital assessment review (the PCAR exercise) for all banks
benefiting from the Irish government guarantee schemes. The results of this review
were announced on 30 March 2010 and indicated that AIB needed to raise additional
capital in an amount of EUR 7.4 billion by the end of the year. What CEBS
concluded was the “the results of the exercise demonstrate that AIB and Bank of
Ireland meet the stress requirements and do not require additional capital beyond
the requirement set in March 2010 set by the Central Bank and Financial Regulator
following completion of the Prudential Capital Assessment Review. Back in March
2010, it was believed that AIB could meet the additional capital need set by the
Financial Regulator without further state capital by a combination of (i) sale of assets
(Polish US and UK subsidiaries) (ii) market capital raising exercise and (iii)
conversion of a portion of the State existing €3.5 billion Preference Shares (which
had been injected in 2009 for the first recapitalisation.

Since then a number of unforeseen developments led to the recapitalisation having

to be increased and financed entirely by the State.  First, the recapitalisation amount
had to be increased by €3 billion as a result of the revision of the haircut used in the
PCAR exercise for the transfer of NAMA assets. As a matter of fact, the valuation
exercise performed for the second tranche of assets resulted in a higher discount
then for the first tranche. The assumption used in the PCAR exercise for the transfer
of all NAMA loans was, however, based on the haircut used for the transfer of the
first tranche. This triggered the need to update the PCAR results and increase the
recapitalisation amount by EUR 3 billion.  Secondly, the sale of the UK business
proved more challenging and although the sale of the Polish and US businesses is
proceeding as expected in terms of amount and timing, this is still not the case for
AIB UK. Finally, the market perception of AIB and of Ireland as a sovereign issue
deteriorated sharply, making any attempt by AIB to raise capital on the markets
impossible. State funding of the recapitalisation became the only available option for
AIB.

In your letter you ask whether projected NAMA discounts had been taken into
account in the stress testing. The answer is yes but the magnitude of the haircut for
further tranches had been underestimated. When the PCAR exercise was
performed, no loans had yet been transferred to NAMA and the Irish authorities were
at the beginning of the valuation process for the first tranche of assets, which
resulted in an already very significant haircut. The underestimation of expected
losses for the further tranches was basically due to sharper than expected decline in
real estate prices and weaker than expected credit risk management practices in
banks (including weak collateralisation and slow collection process) The extent of
these weaknesses was only progressively revealed during “on-site” credit
assessment of the NAMA process.

I would like to underline that the Commission is not directly responsible for the
analysis of the results of EU wide stress tests. The Commission is only given the
opportunity to intervene in the discussions on the assumptions and the macro
scenarios to use in the tests. For all the other aspects and assumptions used in the
tests, the only responsible institutions are the national authorities and CEBS. In any
case, designing a set of assumptions for fair and accurate stress testing is not a
simple exercise and is even more difficult when domestic and global economic
conditions are uncertain.

I hope that these clarifications are useful.

Jauquin Almunia