Banking needs more robust stress tests than these

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Shamefully, the purpose of current stress tests in the financial sector is not to ensure that depositors’ money is safe or that taxpayers will not be called on again, but to reassure banks and their shareholders that they will not be required to provide significant additional capital.

Stress tests should be subject to stress tests. Would the banks that passed the version of the test imposed by Europe’s financial regulators be able to fund themselves adequately if implicit or explicit state guarantees of their non-deposit liabilities were withdrawn? This further test should be applied to each bank individually, and for the group of systemically important banks as a whole. The outcome would indicate how far Europe’s banks have progressed in being able to survive without public subsidy. Not far, I suspect.

The concept of stress tests is derived from the procedures used to ensure the robustness of complex engineering structures. There are three stages. You begin by testing each component in conditions considerably more demanding than it is likely to encounter. Then, you review system design to ensure that, even if several elements break down simultaneously, this does not jeopardise the integrity of the whole structure. Third, and most importantly, you test the total system for outcomes far outside the range of experience. You do not ask, “Will the bridge survive a strong gust of wind?” You ask, “Will it survive a gale worse than any at this site in the last century?”

There is much that the finance sector could learn from this, but no indication it has done so. The adverse scenario of the bank stress tests, far from being outside the range of experience or expectation, is not far from the mean. Sovereign default is not considered, since politicians have decreed it will not happen, although allowance is made for the possibility that pesky markets might not believe that assertion. Any risk manager in a bank who has not considered far more extreme developments than those in the stress tests should be fired.

And that illustrates a problem. One of many adverse consequences of the Basel capital requirements was that banks that held more than the regulatory minimum came under pressure to justify their “surplus” capital. It is easy to imagine the board of a bank feeling reassured when told that their institution is secure against the most adverse scenario postulated by their external regulator – the stress tests are designed to provide precisely that reassurance to capital markets. So the risk manager whose job is in jeopardy today is not the one who fails to insist on more pessimistic assessments than the stress tests: it is the one who does.

Worse, the stress tests are self-referential. Their purpose is to show, not that the bank is sound, but that it meets the requirements for regulatory capital. But one lesson of 2008 was that capital adequacy was almost irrelevant in a crisis. Most institutions met their regulatory capital obligations on the day they failed. Queues formed outside the branches of Northern Rock only weeks after the bank had announced (but before it had implemented) plans to return its “surplus” capital to shareholders.

Depositors were not satisfied by the assurance that the bank was compliant, and they were right. When the Tacoma Narrows Bridge collapsed in 1940, experts said the bridge had satisfied the highest engineering standards even though it had unfortunately fallen down.

Engineers have learned the lesson, but financial regulators have not. Capital adequacy was designed for a world in which a lender of last resort would turn the good but illiquid assets of a solvent bank into cash. But when uncertainty about the value of complex assets and liabilities becomes so great that the bank itself, far less any central bank or external lender, cannot reliably ascertain the true position, capital and cash are very different things.

Shamefully, the purpose of the stress tests is not to ensure that depositors’ money is safe or that taxpayers will not be called on again. The purpose is to reassure banks and their shareholders that they will not be required to provide significant additional capital. The lesson – perhaps the only lesson – of the stress tests is that Europe’s politicians and regulators have not begun to address, far less resolve, the issues posed by the crisis of 2008.

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