Stress tests for banks, performed by mighty regulators, signify dangerous systemic risks, as well as useless predictors

Sir, Caroline Binham reports on how “Andrea Enria, the outgoing head of the European Banking Authority, who is set to become the Eurozone’s top banking regulator, has questioned the value of its stress tests of lenders’ balance sheets, arguing that elements of them are no longer ‘tenable’ and need a redesign” “European regulator questions value of stress tests” November 16.

I could not agree more for two reasons:

First: Stress tests introduce a systemic risk. The fact that banker know their banks will be the object of stress tests causes them to distract their attention from what they might think to be more dangerous, in order to concentrate more on what they think regulators might think more dangerous.

Second: The stress tests are useless since they avoid stress testing many real stresses. In 2003 the United States General Accounting Office (GAO), in its study of the IMF’s capacity to predict crisis concluded, among other things, that of 134 recessions occurring between 1991 and 2001, IMF was able to forecast correctly only 11 percent of them. Moreover, when using their Early Warning Systems Models (EWS), in 80 percent of the cases where a crisis over the next 24 months was predicted by IMF no crisis occurred. Furthermore, in about 9 percent of the cases where no crisis was predicted, there was a crisis.

Much of that has to be a consequence of that if IMF forecasts a crisis; it could quite possibly be blamed for detonating that crisis. Similarly, regulators will avoid to stress test the risks they might be blamed for having produced. For instance when will they stress test the banks on the possibility that their risk weight of 0% to sovereign would have to be increased, and the market reactions to that news. Never! They have painted themselves into a corner.

Sir, when it comes to banks, and their regulations, worry much more about what might be perceived as safe than about what is perceived as risky. In that respect, if I were to perform stress tests on banks, I would look to stress test the risks that seemingly would least need to be stress tested.

@PerKurowski

We need banks that profit by taking reasoned risks; and that have capital to cover for a good chunk of the unexpected.

Sir, I refer to Dan McCrum’s and Thomas Hale’s “Stagnation saps enthusiasm for Europe’s banks” August 6.

It includes contradictory statements like “the financial architecture appears solid” and “most people accept there is enough capital in the system now. Not just investors, but regulators as well” with that of “a rounding error of just 1 per cent on European asset values would wipe out More than a third of European bank equity, the all-important number determining ability to absorb losses.”

The ex ante perceived risk-weighted capital requirements for banks has introduced total confusion into banking. Not only with respect of these having reasonable equity, but also with respect to their business. Over the last decades, banks have looked to maximize their returns on equity much more by reducing the capital required, than by analyzing gross risk/reward ratios as such. And that must come to an end.

First EBA’s recent stress tested European banks indicated that they were leveraged almost 24 to 1, and that makes them clearly undercapitalized, not so much in terms of the expected, but in terms of the unexpected, which is what bank equity should be there for.

And secondly, we urgently need banks to assume their more traditional role of earning their profits by taking reasoned risks in the real economy… that economy in which a unit of capital is a unit of capital, independently of it being invested in something safe or something risky.

To avoid risks, especially when currency does not carry negative interest rates, a mattress seems to suffice. And for the society (taxpayers) to support banks that make their profits by avoiding taking risks, and not by helping it to build future, is stupid.

Some tweet sized conclusions:

The last decades banks have earned huge returns on equity mostly by minimizing equity, that has to stop.

European banks are severely undercapitalized, not that much in terms of the expected, but in terms of the unexpected.

Banking should be about helping society to take risks, not avoiding these. For that mattresses suffice.

Bankers capable of reasoned audacity are magnificent. Equity reducing bankers, are, at best, absolutely tedious.

Just looking at their dumb risk-weighted capital requirements, bank regulators should be disgraced by society.

@PerKurowski ©

FT, when banks have less capital against assets, how can you be sure their capital positions have strengthened?

Sir, Thomas Hale and Richard Blackden write: “The weakness this month comes in spite of stress test results on Friday from the European Banking Authority, which showed banks’ capital positions have strengthened over recent years”. “European bank shares fall in brutal start to August” August 2.

Yes, if we are to use the regulators’ risk weights, one could say “the capital positions have strengthened over the recent years. But why should we? The risk weights of 20% given by regulators to AAA rated securities and sovereigns like Greece were not that correct. 

The real truth is that, unfortunately, the real gross undistorted capital position of banks, the assets to equity leverage, has, according to EBA, deteriorated from 19.2 to 23.8 to 1.

​

@PerKurowski ©

The most stressful banks to me are those who least help the future of our real economy.

Sir, Laura Noonan, Rachel Sanderson and James Shotter present EU’s bank stress test results. “Bank stress tests single out the usual suspects” August 1.

And it ranks the banks based on their 2018 fully loaded common equity tier one ratio, which is CRD IV Common Equity Tier 1 capital divided by CRD IV Risk Weighted Assets. And so let us be very clear, if the risk weights used are wrong, the results are absolutely meaningless.

Sir, how long will you all play along with the current regulators as if they were geniuses setting risk weights, as if they had any idea of what they are doing? Are you totally deprived of intellectual honesty?

If you go to EBA’s stress result you will read “The EU banking sector has significant shored up its capital base in recent years leading to a starting point capital position for the stress test sample of 13.2 % CET1 ratio at the end 2015… 2% higher than the sample of 2014 and 4% higher than the sample in 2011”. 

That’s great!... sort of… because it also states that “the aggregate leverage ratio decreases from 5.2% to 4.2% in the adverse scenario”. In terms of real leverage what does from 5.2% to 4.2% leverage ratio mean? It means that in their “adverse scenario” the bank leverage of equity has increased from 19.2 to 23.8 to 1… and that’s just the average!

How is it possible, an increase of the CET1 ratio, at the same time the leverage increases? Easy, banks take on more of those assets perceived, decreed or concocted as safe that carry low risk weights, and less of those assets perceived by bankers and regulators alike like more risky that carry higher risk weights, such as loans to SMEs and entrepreneurs. The real economy will suffer the impacts of this stupid and short-sighted regulatory risk aversion.

We should of course be concerned with the safety of our deposits in our banks… but, should we not concerned with that these banks take the risks needed to offer our children and grandchildren a future at least as good as that one our parents offered us? I sincerely think so.

PS. And it not only about the young. The welfare of future pensioners depend very much too on the health of the economy.

@PerKurowski ©

When you stress test lenders, why aren’t there any stress tests scenarios for borrowers?

Sir, Caroline Binham writes that “EBA outlines stress test scenarios for lenders” February 25.

And my immediate reaction is to remind you of that those stress tests do not include, in any way shape or form, an analysis about how banks could be stressing the real economy, with an inefficient allocation of bank credit.

Again, for umpteenth time, I have always argued that the number one social function of banks is not necessarily that of repaying whatever it owes, but allocating their credit as efficiently as possible to the real economy.

But the credit risk weighted capital requirements have made it impossible for banks to fulfill that social duty.

Dare ask: How many millions of small bank loans to SMEs and entrepreneurs, has the Basel Committee’s regulations impeded worldwide?

And so any sensible stress test of banks should not only consider what is on banks’ balance sheets but also what is absent.

And those comprehensive tests would evidence that banks are no longer finance the risky future, but only refinance the safer past.

Though I admit that conclusion might be to stressful for the great distorters, the bank regulators, to bear. 

@PerKurowski ©

FT, look at the fine print of the stress tests of European banks before drawing optimistic conclusions

Sir, you write: “In 2012 the Eurozone through a near death experience… Banks were heavily invested in the debt to governments, which in turn were meant to guarantee to solvency of the same banks”… and now you hold that “this week, [because of the stress tests] has finally provided an example of some encouraging progress”, “Better way to check the health of Europe’s banks” October 28.

What if banks came out better in these stress tests, only because they were invested even more heavily into those government debts against which they are not required to hold any capital/equity? Would that change your perception on “encouraging progress”?

PS. You now want the Asset Quality Review to be repeated annually. If you were one of the consultants making a great living on that I could understand it...  but let me ask you... have you ever thought about how much of our economies and of our well being is driven by sheer blissful ignorance?

 

Europe, it is your bank regulators who most must be stress-tested!

Sir, I refer to all the writings in FT on October 27 about the stress tests of European banks in order to ask you:

If all banks that failed had only given loans to infallible sovereigns, then they would have classified as the safest. Do you really think that would have helped investors to have confidence in Europe?

Frankly, regulators who can come up with something like The Basel Committee’s Bank Stability Decree, have no moral right to test any bank.

Sir, even a hedge fund founder is quoted stating: “We now know that we can have a 5 per cent contraction in the eurozone economy and the banks will still have more than 8 per cent capital – that is very positive for the sector.”

What? If lucky, it might be more than 8 per cent of capital of the-risk-weighted assets… and that, as you should know by now, can be extremely faraway from meaning the same thing.

And, why after spending so many million dollars on consultants, did they not even give us the so easy calculated leverage ratio?

And talking about the consultants, we should have their names, so as to know who to hold accountable, as paid collaborators of what seems more to be a farce concocted by regulators to save face.

PS. Sir, you who have been so mum on this issue, show me anything perceived or officially stated as "risky" that caused the turmoils in the European banking sector. 

EAB regulators should be fired; they don’t care one iota about the real economy, as long as banks don’t go under during their watch.

Sir, Sam Fleming reports that in order to “limit inconsistencies between the practices of different supervisors” EBA will deploy “a regulatory scoring system” of banks dependant on: “business model analysis, assessments of internal governance, risks to capital and risks to liquidity”, “EU to score lenders in push for regulatory unity” July 8.

As you see not a word about whether banks allocate credit adequately to the real economy. These regulators do not care one iota about that. All they care for is for banks not to fall under their watch… until they retire, and if the real economy has to go under in order for that to happen, so be it.

They should be fired!

Bank regulators insisting on playing risk managers for the world, evidences hubris and lunacy is still going strong.

Sir, it is indeed scary reading Brooke Masters reporting on a “Call to harmonise bank risk models”, August 6.

The average risk weight for sovereign corporate and institutional debt that European Banking Authority found in 35 big banks is quoted as being 35 percent with a standard deviation of 12 percent. This indicates how frightening badly capitalized most European big banks are.

In Basel II terms a 35 percent risk weight, applied to a generously defined 8 percent basic capital requirement, could indicate the average banks to be assets to equity leveraged about 35 to 1, and some even 55 to 1 and more.

But even scarier, is reading what EBA suggests. Bank regulators should not be risk-managers for the world and have no business concerning themselves with whether the models banks use to analyze their risk work or not. Their responsibility is to think exclusively in terms of what to do when risk-weights and risk-models do not function adequately. And, in this respect, the last thing regulators should do is precisely what the European Banking Authority calls for, which is “further moves towards harmonized rules for risk models”. That only guarantees to increase the systemic risk of many risk models being wrong at the same time. It is as if regulators have learnt nothing at all from this crisis.

All in all what the article indicates, is the need for a more simple leverage ratio type of capital requirement, which, since applied equally to all assets, makes it therefore more independent of risk models. That would of course also help to reduce the extreme distortions in the allocation of bank credit to the real economy introduced by capital requirements based on perceived risks.

Much more than a bank union, Europe needs completely new bank regulations

Sir, Alex Barker reports on Michel Barnier, the European commissioners current efforts to create a bank union in Europe, “Time to decide on bank union”, November 26 

If it is for banks to go on lending to “The Infallible”, private or sovereigns, and not to “The Risky” small businesses or entrepreneurs, then Europe does not need a banking union, since Europe will be stalling and falling anyhow. 

What Europe needs, much more than delaying Basel III, is throwing out completely those insane regulations of capital requirements, and now also of liquidity requirements, based on perceived risks. 

By the way does Michel Barnier think that a job in a triple-A rated company is worth much more for the society than a job in an unrated small business? From the regulations he supports it would seem so!

FSA, you’re on to something good. I hope all your European and American colleagues now follow suit.

Sir Brooke Masters and Patrick Jenkins report “UK banking watchdog eases reins on capital ratios” October 10, and refers to something I have been actively promoting for quite some time, namely the absolute need to get bank credit flowing again to those, who perceived as risky, have been locked out from it by the current capital requirements for banks based on perceived risk, like to small businesses and entrepreneurs.

Simon Gleeson, refers to the possibility of creating “a perverse incentive [for banks] to load up with the highest-risk corporate loans you can find, while completely ignoring that the real perverse incentives that have been in place, and which helped to cause the crisis, are those which favored banks to load up so excessively on assets officially perceived as absolutely safe. 

No, this is indeed a much welcomed development, about time, and I sure hope that other regulators now follow suit. 

Master and Jenkins qualify this though as “Banking regulators are gambling”. If they refer to regulators gambling on that bankers, if not molested by regulators, will be more able to efficiently allocate the resources in the economy than what government or regulation bureaucrats can, then that to me sounds like a very safe bet. 

Master and Jenkins also warn “if it goes bad, and a deeper recession follows, banks will have less equity to absorb the inevitable losses” Oh so scary! If a deeper recession follows then more of those absolute safe assets on the balance sheet of bank will go awry, and, in that case, I guarantee them that the lack of bank equity will be among the of their worries.

What is most appropriate, cones of shame or tarring and feathering?

Sir, in “Banks at risk” February 7, notwithstanding that you, at long last, write about the incestuous relations of banks with national government and admit that many countries see banking as an extension of the state, you mention only the taxpayers subsidies to banks, but ignore the immense subsidies governments collect, in terms of more public debt and at lower interest rates that what a free market would allow, as a result of being able to borrow from banks without generating, when compared to other borrowers, as much capital requirement. 

Current bank regulations, produced by our banking central planners, decided that the only thing that matters is that banks do not default, and this set our banks on the course of creating huge excessive exposures to what is officially deemed not risky, and to equally dangerous underexposures to what is deemed as risky. 

That our banks are now at risk? Ha! The whole Western world is at risk 

How are these regulators now best shamed, having them parade down Trafalgar Square wearing cones of shame, or would tarring and feathering be more appropriate.