Ireland's financial regulator told the country's banks on Friday that they must make substantial progress this year to deal with unsustainable mortgages, particularly given looming Basel III rules will likely force them to require more capital.

Noting recent data on mortgage arrears as concerning, Matthew Elderfield said arrears are likely to continue to rise throughout 2012 and that it would take time to work out the exact scale of the problem and years to resolve it.

With banks struggling to return to profitability ahead of the so-called Basel III rules which will gradually require them to hold greater capital buffers by 2019, Elderfield said lenders needed to face up to the unsustainable mortgage problem and accelerate their work in the area.

We already know that over the medium term, in the period leading up to implementation of Basel 3 in 2019, that the banks will likely require more capital, Elderfield said in a speech to Ireland's Harvard Business School Alumni Club.

Therefore, the sooner the banks can be restored to profitability then the better they will be able to meet these medium term targets, ideally from market sources.

Following the injection of 64 billion euros (53.4 billion pounds) of state cash, Irish banks are among the best capitalised in the world and Elderfield said the current core Tier 1 solvency ratios of its top banks - Bank of Ireland , Allied Irish Banks and Irish Life & Permanent - stood at 14.3, 16.98 and 19.08 percent respectively.

He said that, following strict stress tests last year, the banks have a substantial capital buffer with which to absorb losses on their mortgage portfolios and that the Central Bank believed it was time for them to do just that.

Recent central bank data showed that the number of problem mortgages in Ireland grew sharply in the last three months of 2011 and with one in seven Irish home loans now not being fully repaid, Elderfield described mortgage arrears as one of the biggest remaining challenges for Ireland.

MANY YEARS TO RESOLVE

Elderfield, who is also a deputy governor at the central bank, provided an equally downbeat assessment for homeowners in negative equity, saying that it would remain an unpleasant reality for many borrowers for years to come.

While he said recent clarity from the government on new debt

settlement and bankruptcy laws was extremely important and very welcome, there would be considerable uncertainty regarding their impact on borrower behaviour.

He added that the outlook for employment, house prices and the economy in general added to the uncertainty over future arrears trends.

Elderfield said the central bank had worked through mortgage arrears resolution strategies that it requested from the banks last year and said that while there had been a major gearing up of resources, the banks have been largely lacking sufficient operational targets or key performance indicators.

His comments followed a warning by Ireland's central bank governor earlier on Friday that the lack of credit being advanced by banks in Ireland is likely to be a more serious drag on the recovery than it ought to be.

This is a difficult problem and it will take many years to resolve it. It is important that everyone plays their part, Elderfield said.

(Reporting by Padraic Halpin; editing by Ron Askew)