Bank of Ireland (NYSE: IRE) has for now put to rest speculation that the Irish government could increase its 36% stake. This should come as temporarily welcome news to already nervous investors in the European bank.

The background
From an investor's point of view, the bank was fortunate to free itself from the restrictions imposed by the EU Commission regarding the payment of dividend and coupon payments on the group's capital instruments, as the dividends were due for payment shortly. As part of its bailout agreement, Bank of Ireland is required to shell out roughly 215 million euros in dividends to the Irish government. In addition, it has to raise capital to the tune of 1.4 billion euros to meet tougher capital requirements under a European Union/International Monetary Fund bailout. All this paints an unflattering picture for the company as much of its ability to raise funds is dependent on notorious government-imposed "stress tests," a topic I'll revisit in just a moment.

Of late, the bank has gone through a rough patch with operating profits taking a 25% to 30% plunge. Core tier 1 capital ratio dipped below 10.2% at the end of June 2010 -- a troubling trend, though still relatively safe from an absolute perspective. As for the additional capital requirement for dividend payments and bailout requirements, significant issues remain.

The bank has absorbed losses and impairment charges in the past when it transferred its assets to a "bad bank" run by the government. In general, it is feeling the heat from all quarters because of high costs of funding, intense competition for deposits, and various regulatory requirements. The bank is still trying to reassure investors of its stable financial health after coming out with an increasing loan-to-deposit ratio. The bottom line is that the greater situation is a bit of a mess, even before one considers the potential ramifications of a dubious stress test.

A stressful situation?
Bank of Ireland is now relying on the upcoming stress test put in place by the EU and IMF, which hopefully will clear the bank's financial position. The bank will have to ascertain whether it will need additional capital to meet regulatory requirements. It is also toying with the idea of luring private investors, although investors are skeptical about Irish financials -- understandably so given the sorry state of the economy presently. The nightmare scenario: The stress test finds that the bank fails to arrange for capital. Also, it may find itself under state control if it has no option but to obtain funding from the government.

All of these potential situations should paint a picture of a company whose stock should only be considered speculative in appeal. Fools should definitely only enter at their own risk.

Desperate times call for desperate measures
Bank of Ireland's shares have been trading relatively flat during the last several months or so as investors have seriously questioned the long-term independent viability of the bank. And survival for the bank (as least as an autonomous entity) largely depends on the outcome of these stress tests.

Critics have suggested that requirements of the stress tests are "too easy." As evidence, these same critics point to the fact that both Bank of Ireland and Allied Irish Bank (NYSE: AIB) have cleared the examination in the past, only to be asked to raise large amounts of additional capital afterward according to new international standards. Clearly, these tests are not full-proof mechanisms to determine the health of a financial entity, but they clearly push them in the right direction -- which is in the direction of more capital and less leverage.

As part of this larger mission to bolster the balance sheet, Bank of Ireland recently announced plans to sell its fund administration business to Northern Trust (Nasdaq: NTRS) for up to 60 million euros to further raise its capital level. That should help, but there's plenty more work to do to get this company prepped for independent operations.

The Foolish bottom line
This time around, the stress test should be tougher (as pledged by the EU), and it may be difficult for the bank to sail through it. Ultimately, I sense that Bank of Ireland may fall back on its last resort, which is a long-term cohabitation with the government, as a means of climbing out of this larger financial mess. But as we know, government involvement comes with many strings attached. A lack of independence will hinder the company's growth and potentially would hamper shareholder value in the coming days. Caveat emptor.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.