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 would all benefit from algorithms tempering our bank regulators’ human judgments.

Sir, Sarah O’Connor, discussing the use of algorithms when for instance evaluating personnel writes: “The call centre worker told me the software gives lower scores to workers with strong accents because it doesn’t always understand them.”, “Management by numbers from algorithmic overlords” February 7.

What, should we assume that the capacity of someone in a call center being understood would not be one of the most important factors considered by a human evaluator?

And when O’Connor refers to “the subtle flexibility of human judgment; decisions tempered by empathy or common sense; the simple ability to sort a problem out by sitting down across a table and talking about it.”, I must state that is absolutely not what happens all the time.

Any reasonable algorithm, with access to good historical data, would never ever have concluded, as the human Basel Committee did, that what is perceived as risky is more dangerous to our bank systems than what is ex ante perceived as safe.

PS. Could we envision a world in which more predictable algorithms managed our wives reactions… and, if so, would we then not miss their lovable unpredictability?

@PerKurowski

The Basel Committee for Banking Supervision is the stupidest and most failed oracle of our times

Dan McCrum writes about predictions, “How to grab hold of the conversation with a bold prediction” December 16.

Sir, I just want to notice, for the record, for the umpteenth time, that the risk weighted capital requirements for banks, more risk more capital – less risk less capital, are de facto a prediction by the regulators based on what they believe is the most dangerous for our banking system.

As is, from their desks, they predicted that what is ex ante perceived as risky, is risky ex post. Clearly that must be one of the stupidest and senseless predictions of our times.

Anyone with the slightest understanding of what happens on Main Street, would know that what poses dangers to the banking system is unexpected events, like devaluations, criminal behavior, or excessive exposures to what was ex ante perceived as safe but that ex post turned out very risky.

Sir, I’m sorry but I have to ask, since you seem to have swallowed that prediction hook, line and sinker, has anyone in FT’s establishment ever walked on Main Street?

Sir, you doubt it? Then dare ask the regulators the following questions and observe their silence.

@PerKurowski

And good luck to them!

Sir Ms Gail Easterbrook in his letter “Act locally to embed the right attitude to risk” November 17 when referring to giving new regulatory powers to IMF to provide “early warning” of risk to the global economy summarizes it adequately with an “And good luck to them.”

The case for more humility and lower expectations with respect “early warnings” is laid out with crude clarity by the United States General Accounting Office (GAO) in its study of the IMF’s capacity to predict crisis, published in June 2003 (SecM2003-03-734). In it, GAO states, among other things, that of 134 recessions occurring between 1991 and 2001, IMF was able to forecast correctly only 11 percent of them, and that it was similarly bad in forecasting current accounts results. 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.

Ms Gail Eastebrook also receives my warmest nod of approval when reminding us that we need to embrace risks and that “without risks there are no rewards”. This is something our financial regulators should have thought upon before they so arrogantly decided to drive risks out of banking, with their minimum capital requirements for banks based on a vague concept of risks of defaults, and that, because it also led the regulators to empower the credit rating agencies, created the current crisis when these lousy pipers led us into the swampland of badly awarded mortgages to the subprime sector.