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

Why should Donald Trump or Gillian Tett worry about US’s public debt when the experts, the bank regulators, assign it a 0% risk?

Sir, Gillian Tett, making it a Democrat vs. Republican issue, expresses anxiety about the US debt and suggests “a new version of the bilateral Simpson-Bowles Commission” “Investors start to fret about ballooning US public debt” November 9.

Sir, you know the regulators, for the purpose of bank capital requirements, assigned a risk weight of 0% to the sovereign debt of the USA and one of 100% to unrated American citizens (except when buying houses). That translates into that the interest rate politicians see is a subsidized interest rate, not its real cost. That dooms the US public debt to become, sooner or later, unsustainable… and especially so if markets begin to feel the US is losing its absolute military supremacy.

The bilateral Simpson-Bowles Commissionin 2010 presented many important recommendations that should be pursued, but it did not even mention the need to eliminate the regulatory subsidy to public debt.

Sir, unfortunately, getting rid of that distortion is no easy task, as regulators have really painted themselves into a corner. Can you imagine if regulators where to announce that the risk weight of US debt has been increased from 0% to 0.01%?

PS. In 1988, when with Basel I, statist regulators assigned that 0% risk weight the US debt was $2.6 trillion, now it is more than $22 trillion... but what has that to do with anything?

 

@PerKurowski

Three reasons to break the bank-sovereign doom loop: Safety, market signals and fighting crony statism

Sir, Thomas F Huertas, when commenting on Isabel Schnabel’s “How to break the bank-sovereign doom loop” of August 29 presents good reasons for why impose some capital requirements on banks when holding sovereign debt, in order to make the bank system safer. “Bank holdings of sovereign debt need scrutiny” September 6.

But making the bank system safer is not the only reason for why that should happen. 

The fact that banks need to hold less capital against sovereign debt translates into a subsidy that: a. impedes the market to send the right interest rate signals on these debts and b. favors the sovereign’s access to bank credit over that of the citizens… something that could only be of interest to redistribution profiteers or those wishing to engage in crony statism.

The horrible problem regulators now have is, after painting themselves into a corner with the 0% risk weight how do you get out without detonating that sovereign debt bomb?

PS. In November 2004, in a letter published by FT I asked: “how many Basel propositions it will take before they start realizing the damage they are doing by favoring so much bank lending to the public sector?” August 29,  I sent FT the following letter commenting on Isabel Schnabel’s article. As I am considered obsessed with the issue, it was of no interest to the editor.

@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