Ireland's big bang banking plan failed to convince investors on Friday it can shoulder its soaring debt burden given grim prospects for growth and a lack of expected extra support from the European Central Bank.
Shares in Bank of Ireland rose on the government's commitment to make it one of the pillars of a new two-bank system, while the government's retreat on a threat to impose losses on some bondholders pushed senior bank debt higher.
Government plans to recapitalize the financial system by up to 24 billion euros are designed to draw a line, once and for all, under a crisis that has ravaged Ireland's economy and reputation and forced it into an EU-IMF bailout.
But the lack of any reaction on government bond markets was an ominous sign that investors do not believe Ireland can grow fast enough to deal with a debt that will soar above 100 percent of GDP if the forecasts of Thursday's stress tests come true.
If our economy goes well, if we get back to growth, get to full employment, then we can pay this easily, central bank governor Patrick Honohan told a TV interview. If economic growth is weak, then it won't be so easy.
The cost of Irish sovereign borrowing remained elevated with 10-year bond yields still hovering over 10 percent as the European Central Bank's (ECB) pledge to give Irish banks continued access to liquidity fell short of expectations.
European clearing house LCH.Clearnet also raised the margin requirement it charges on Irish bonds to 45 percent from 35 percent on Friday, weighing on the market by making it more expensive to trade Irish debt.
The ECB's assurance means that the banks are still accessing short-term loans, totaling 89 billion euros at the end of last month, and are exposed to future rate hikes and falls well short of the formal medium-term funding facility investors had been expecting.
We still need confirmation that the overdraft we are depending on will stay in place, said Gavin Curran, a bond trader at Dolmen Securities.
The ECB has suspended collateral requirements for Irish sovereign and Irish guaranteed debt but if Standard & Poor's strips Ireland of its last A rating, as expected, Frankfurt will still apply an extra discount of 5 percent on Irish debt.
Finance Minister Michael Noonan said the ECB's commitment was the best Ireland could hope for.
But analysts said Europe would still need to provide longer-term liquidity facility for struggling euro zone banks.
If that is everything the ECB does then it would turn into a significant issue, said Holger Schmieding, economist at Berenberg, arguing the ECB would not be able to withdraw its overall emergency support for European banks at a time when it is set to raise euro zone interest rates.
The ECB should really go toward targeted support for specific banks or banking systems, under conditions, he said.
Ireland's debt levels have quadrupled on the back of a devastating property crash that brought down its banks and hollowed out its coffers as tax revenues slumped and dole queues ballooned.
Noonan is hoping that he can cap the state's contribution to the 24 billion euros bill at around 16 billion euros, which can be funded out of the 17.5 billion euros Irish government contribution to the 85 billion euros EU-IMF bailout.
If Ireland has to pump the full 24 billion euros into the banks its debt to GDP ratio would rise to 111 percent by 2013 from around 100 percent currently, a finance official said.
But official Irish growth forecasts are viewed as overly optimistic after a sharp contraction at the end of last year and they are expected to be cut in the next few months, increasing the debt burden on the 1.8 million strong workforce.
The plans for a two-bank financial system and the stress tests were given a broad thumbs up by markets with shares in Bank of Ireland up nearly 40 percent to 31 cents.
Shares in bancassurer Irish Life & Permanent slumped by nearly three quarters to an all-time low of 11 euro cents as plans for a sell off its the life business via an IPO keft its banking rump likely facing state control.
(Editing by Patrick Graham)