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

Flags need also to be raised, when influential multilateral financial institutions help to blow up bubbles

Agustín Carstens, the general manager of the Bank for International Settlements writes: “A decade of unusually low interest rates and large-scale central bank asset purchases may have left many market participants unprepared, and contributed to a legacy of overblown balance sheets” “It is precisely when pressure starts to build that flags need to be raised” June 26.

Indeed, but to that we should add the presence of extraordinary low capital requirements for banks when lending to what’s perceived as safe, like to house buyers and sovereigns. These have helped to explode the exposure to this type of loans, as well as distort the signals sent to the markets, something that of course has also helped to inject a lot of liquidity. 

Carstens also opines: “At the BIS, we have come to appreciate how unrewarding it can be to flag risks when markets are running hot. Yet that is precisely when risks tend to be highest.” 

Indeed, that is the same difficulty all influential institutions like the IMF face since, whenever they flag a risk, they could be accused for helping to set off a crisis. But now they all have themselves to blame for making the flagging problem so much worse. By assigning risk-many sovereigns a risk weight of 0% they painted themselves into a corner. When you know that risk weight is absolutely wrong, how do you go about to change it without scaring the shit out of the markets?

@PerKurowski

For now I will not buy Sebastian Mallaby’s risk averting potion, it might even enhance the risks.

Sir, I refer to Sebastian Mallaby’s “Economics must heed political risk” November 7. There he mentions the idea that “The familiar statistics on gross domestic product [could be] coupled with an index of financial risk-taking, so that the usual focus on growth would be tempered by a measure of the danger that growth might suddenly implode” and creating “a forecast of output divided by a measure of the risks to the forecasts; [something akin to] a Sharpe ratio for economic growth. 

Questions: Would that increase or decrease the risks? How would that help? Could that not also result into some risks becoming exaggeratedly considered? 

Quite recently, too radical academic finance regulators, believed they could control risks in banking, by setting up capital requirements based on ex-ante perceived risk of bank assets. And, what happened? Absolute disaster! 

Not only did they ignore that a bank has other purposes than just avoiding risks, but also, worse, the risk of default became excessively considered. It was taken into account when banks set their interest rates, amounts of exposure and other terms, and so to use precisely the same ex-risks to also set the capital requirements was sheer lunacy… though the responsible geniuses, seem not to have realized it yet. 

And how on earth does Mallaby suggest the IMF gives outlook projections that are not based on some simple assumptions, but based on a more diffuse concept of political risk? Would that be more accurate, or more believable? I doubt it. It is hard enough for the IMF as is. 

The US GAO Report in 2003, subtitled “Challenges Remain in IMF’s Ability to Anticipate, Prevent, and Resolve Financial Crises” stated: “Internal assessment of the Fund’s EWS (Early Warning System) models shows that they are weak predictors of actual crisis. The models’ most significant limitation is that they have high false-alarm rates. In about 80 percent of the cases where a crisis was predicted over the next 24 months, no crisis occurred. Furthermore, in about 9 percent of the cases where no crisis was predicted, there was a crisis.” From reading the report it is easy to understand that one of IMF’s problems is that what it opines, becomes a political and an economic risk too. 

Finally Mallaby seems to completely ignore the issue of retro alimentation of risk perceptions. When writing that if “eurozone authorities fail to contain sovereign and banking risk… Capital will flee from Europe’s periphery to the centre and from risky corporates to the remaining comparatively safe sovereigns”, he forgets that being the receptor of all that “”hot capital” flight, also carries enormous risks. 

Anyone should be free to manage risks the way he likes, and if someone wants to buy from an economic growth political risk ratio from Mallaby, he should feel absolutely free to do so. But, to sell us the institutionalization of a risk-neutralizing product, right now when our economies have been so neutralized by one of these, sounds to me too much like selling us magical potions on a country fair. So, no thanks!