SCENARIO STRESS TESTING OF GLOBAL FINANCE

New banking regulations (Basel II and especially the economics of it) introduced in the last 5 or so years, has been trying to change the risk culture and economics awareness of banks. Banks are inveterate herd animals. It is not unrealistic to describe what we Basel II risk experts (and IFRS7 accountants) are trying to do with the surreal analogy of trying to teach cows how to swim like dolphins!
The main purpose of Basel II, which is a comprehensive set of banking regulations (several thousands of pages worth that have the power of law) to be applied to all of the world's internationally active banks has been to try and make these banks not only comply with basic solvency standards, but to force them to become astutely sensitive to economics, with the twin capabilities of understanding their own business economics fully as well as how those respond to and reflect the economies in which they operate. Understanding the economic context of traditional banking should be relatively intuitive and straightforward, but of course it is not, not when banks have to make realistic forecasts of economic and credit cycles, and also be able to calculate the effects of extreme economic shocks of the kind we are currently experiencing, what some describe as a 1 in 80 year set of interconnected events. To then also apply economic analysis and forecasting to FX, money markets, bonds, equities and commodities markets, their derivatives and their underlying 'cash' markets, both on-exchange and off-exchange (over-the-counter) is even more fraught with unique and intellectually difficult challenges. I know that the authors of the Basel II regulations have been shocked at how these fortresses of rocket scientists with supposedly unlimited research and computing resources, able to pick and choose among the world's cleverest Ph.Ds, have proven themselves wholly inadequate, not only in the economic modeling of Basel II Pillar II, but even unable to safely complete the accounting requirements of Pillar I. This is what, for example, destroyed Fortis Bank and others.
These challenges are not something banks can choose to do or not. In the EU it is a matter of law that they must do them and indeed make the tasks and the content second nature to how from here on in professional bankers understand banking. Unfortunately nearly all banks have found the challenges too great and have responded in error-prone or simply inept ways, for example using only mathematics and monte-carlo analysis, rarely integrated models and even more rarely with fully worked out macro-economics models. To understand is not to excuse. But, I do understand how difficult it is for banks to do anything very new without resorting to how and what they have done in the past. There are many reasons for failure in Basel II, and we can expect the solutions to have to go through several generations of system solutions before complete solutions are found. It probably needed a massive systemic failure such as the current crisis to really galvanise bank managements and staff to allocate resources to the correct priorities?
In almost every case I know of (and that's many) the economists that many banks have available to them were left out of the reckoning undertaken by finance and risk teams. Bankers have a severe cultural mistrust of economists and it shows in their economic stress-testing solutions. Third party suppliers of solutions have proved themselves to be little better, as usual pandering to the ignorance of their clients, even in such vitally important matters. The auditing firms too have deemed this area to be beyond their legal requirements to address. Consequently, the most important parts of Basel II financial regulations have ended up being either ignored or traduced.
As we have seen, as anyone can see, banks, insurance companies and other financial institutions, even hedge funds and ratings agencies some of whom prided themselves on their economics, have not been up to the job, or at least not in time to be ready to anticipate the present set of crises, the 'credit crunch' and subsequent economic recessions. Financial regulators, government treasury departments (finance ministries) and central banks have been better prepared, but not that much better! In recognition of the general problem, Tim Geithner, the US Treasury Secretary, as part of the next set of the Obama administration's bank bailout measures and fiscal policies to kick-start flagging zero or negative growth economies, and as part of the G20 proposals to create a new financial world order, has decided to carry out a gigantic 'stress test' of US banking. Other countries including the European Union and each of its member states are expected to do the same! However they do this must form a template or reference benchmark for the banks, to show them the way to know what the issues are and to then make similar test calculations using macro-economic models for their own banks. Each bank must construct an 'economic capital model' and 'holistically' calculate what is the worst that can happen to their capital reserves, credit risk losses, market risk losses, asset write-downs and wholesale funding problems (liquidity risk and liabilities). In fact while they must try and forecast for the next months and years, this is of course no longer a theoretical exercise for some indeterminate time in the future. The work that has to be done by everyone is to forecast in effect what is happening right now and where this will go? Back in October 2007 when Northern Rock experienced the first UK 'bank run' in a century (it was nationalised in February 2008) the Financial Services Authority (FSA) admitted that it had failed in its duty to check the bank's stress-testing. As the BBC reported, "The FSA is responsible for supervising financial institutions such as banks and it was asked why it was only doing a full review of Northern Rock's finances every three years. Conservative MP Michael Fallon said: "You are dealing with a bank whose lending has quadrupled from £25bn to £100bn - it was taking one in five mortgages - and you were not doing a full assessment for three years." Mr Sants (FSA CEO) replied: "I think there are lessons to be learned here with regard to our supervisory practice and I do think we need to look at our engagement with this company." The last FSA full review of Northern Rock was in February 2006 although FSA officials had visited the company in July to question their "stress testing". This is a process where banks and regulators examine what would happen to a bank's finances in a range of crisis scenarios. Mr Sants agreed that there were problems with the stress testing which were not picked up earlier."We were uncomfortable with their scenarios but regrettably it was late in the day," he said. In the year since then, despite the all too obvious importance of economics to banks now as most economies are near to or actually in recession, it is not hard to conclude that little progress has been made. This is my professional experience from looking at many banks. And certainly, there had been little or no evidence of the FSA or other major national regulators producing the templates and guidelines to any sufficient level of detail for banks to now knmow what to do and how to do it!
Andrew Haldane, deputy director at the Bank of England for financial stability has yesterday published a paper that defines the culture problem. This has been widely reported under the heading, "Bonus and job fears led to soft stress tests at banks". As reported by Reuters, The Daily Telegraph and others, "THE people in charge of managing risk at the City’s biggest institutions were given no incentive to carry out the stress testing that might have prevented the financial crisis, the Bank of England’s new financial stability director has said. Bankers were instead more worried about losing their jobs, according to Andrew Haldane, the Bank’s executive director for financial stability.In comments which will spark questions about why the authorities did not encourage institutions to do more disaster-testing, Mr Haldane said he and the Financial Services Authority learnt some years ago that banks’ risk officers were simply not setting themselves tough enough stress tests. The only realistic ones are where a bank's capital is wiped out at least once. In fact in the present crises banks' reserve capital is being wiped out twice over. Most banks find it difficult to bring themselves to face up to stress tests that involve losing more than a quarter or maybe a half of their capital! They have problems facing reality! Certainly none of the risk experts would ever have dared to present their boards with a scenario of losing 90% of their share capital or quadrupling of funding costs or total drying up of wholesale finance or 50+% falls in securitised asset prices. The modellers would have been told to get real or get out! Haldane said that he and the FSA discovered some time before the crisis from a seminar of risk officers charged with assessing the threats facing their banks, that they were only testing for very modest stress in the financial system. Asked why, according to Mr Haldane, one executive said: “There was absolutely no incentive for individuals or teams to run severe stress tests and show these to management.“First, because if there was such a severe shock, they would very likely lose their bonus and possibly their jobs. Second, because in that event the authorities would have to step in anyway to save a bank and others suffering a similar plight.” As we have seen in many cases on both sides of the Atlantic in the credit crunch, many boards of directors, execs as also non-execs, seem to think that ignorance of the true state of their financial affairs is some kind of reasonable defence. It is not, and never should be! The warning comes only days after the HBOS whistleblower Paul Moore alleged that he was fired from the bank after warning of the risks associated with its lending policies. The House of Commons Treasury Select Committee is now going to investigate this and the many cases like it in detail. Mr Haldane, lead author of the Bank’s Financial Stability Report, said that before the crisis “stress-testing was not being meaningfully used to manage risk... it was being used to manage regulation.“Stress-testing was not so much regulatory arbitrage as regulatory camouflage.” He said that the banker who confessed the dilemma had been “spot on”. “When the big one came, his bonus went and the government duly rode to the rescue,” he said. Mr Haldane’s remarks, in a paper written for a conference on stress testing, underline a dangerous fault — those who are supposed to guard against possible crashes are not encouraged to raise the prospect of those risks with the board.
To read haldane's paper see: http://www.bankofengland.co.uk/publications/speeches/2009/speech374.pdf