Stress Tests Won’t Prevent the Next Financial Crisis

Stress Tests Won’t Prevent the Next Financial Crisis
Expected losses under invented scenarios tell us little about risk and reality.
ROSA M. ABRANTES-METZ
March 18, 2014 6:58 p.m. ET
On March 26, the Federal Reserve will release the results of the “stress tests” it conducted on the nation’s 30 largest banks. The findings will purportedly reveal how well a bank can withstand a financial crisis, but the Fed’s decision to implement more complex stress tests doesn’t address what caused the financial crisis of 2008.

Banks are required to fund some fraction of their lending or securities purchases with equity capital, which can absorb losses. The riskier the asset, the more capital funding required under the Basel accords. The Fed then requires tests on how well a bank’s asset or investment portfolios hold up under different catastrophic scenarios.
But the financial crisis of 2008 wasn’t characterized by asset losses. Instead, it was a run, or a collapse of short-term funding. Banks borrowed short to lend long, sometimes leveraged 30 to 1 on their short-term assets. When short-term funding suddenly dried up, banks were immediately and collectively in a crisis.
Which is why it’s short-term overnight funding that needs regulation. Institutions should not be allowed to issue uncovered contracts—those not backed by an offsetting position to reduce risk—that are prone to runs. Banks could collateralize short-term assets with cash reserves or Treasurys and draw upon these in the event of a run. This would be a simpler, more focused and less resource intensive way to contain systemic risk.
But regulators have instead made a Rube-Goldberg attempt to control bank assets and behavior. Starting with Basel I in 1988, different assets were assigned different risk weights. These weights do not change over time through the business cycle, but risks do. Basel II, published in 2004, allowed risk weights of assets to change over time. Banks model the expected default and recovery risk of the assets, and they hold capital according to multiples of those expected losses.
But this introduces a vicious cycle. When the bank’s models say times are good, funds can flow freely to seemingly low-risk assets. When times are modeled as bad, those funds can shut off abruptly, just when they are most needed. Banks have an incentive to play down risks and not raise capital requirements properly in advance of a downturn in the cycle.
Regulators responded by introducing “stress tests.” These were meant to assess whether banks would be adequately capitalized against certain negative, but plausible, macroeconomic scenarios such as unemployment reaching 13% or a 21% drop in housing prices. Banks that appear undercapitalized are required to raise more capital. The first U.S. stress test in 2009—the Supervisory Capital Assessment Program—renewed confidence in the banking system. Of the 19 institutions evaluated, 10 had to raise additional capital.
European stress tests by the Committee of European Banking Supervisors were less persuasive. According to 2009 tests, 83 out of 90 banks were adequately capitalized. Those findings proved questionable when the European financial crisis began later in 2009. Serious stress testing and public-confidence building may be opposing objectives.
That’s because stress tests have been oversold. First, the choice of financial scenario determines the outcome. If regulators choose “falling house prices,” that will hit banks with large mortgage portfolios. If they emphasize “sharply rising unemployment,” that will hit banks with large credit-card portfolios.
The stress scenario is never—by definition—the expected scenario. It’s a risk scenario. There are many equally unexpected scenarios, but only one is picked.
Perhaps regulators have a reason: Housing prices fell by 30% from 2007-11, and overseers worry they may fall more. But why go through the trouble to model all of these complex relationships statistically? Why don’t regulators simply require banks with large mortgage portfolios to raise more capital? Why not increase the risk weight on mortgages? This might actually target risk.
Second, scenario-based stress tests are not comparable across regions. Should we run an identical unemployment scenario through the U.S. and Spanish models? Would the same scenario represent the same degree of stress? Most would say no, which means we should run different scenarios for both. But then how can we compare the results? The scenarios are different. Are they equally likely? Or are they equally stressful? How do we define that? The test is subjective.
Third, stress tests aren’t that stressful. Supervisors evaluate bank capital by the losses they expect given the stressful scenario. But it’s rarely the losses we “expect” that cause the crisis. What about the losses the models don’t expect?
Fourth, few people predict what risks will cause a crisis. Right after the U.S. housing crisis, European bank regulators failed to notice that sovereign debt might be a tad risky. And despite decades of research, no economic model has proved reliable in anticipating a significant downturn. Yet we are relying on these to control systemic risks.
Stress tests aren’t entirely devoid of merit or utility. They force banks to think through events that might hurt all of their investments at the same time. But they do little to prevent or even mitigate those events.
Ms. Abrantes-Metz is a director at Global Economics Group, and an adjunct associate professor of economics at New York University’s Stern School of Business.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: