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

G20 MID-ATLANTIC RIDGE

[World with countries inflated or deflated according to size of GDP] The European Governments, especially EU led by President Nicholas Sarkozy of France, argued in Washington at the G20 summit (14-15 November) that since the 1980s, finance has become a quintessentially global phenomenon with money and credit flows washing (excessively) across borders. (Since 2000, for example, banks' international obligations grew from less than $12tn or 20% ratio to world GDP at end-2000 to more than $37tn or 60% ratio to world GDP by end-2007. This growth coincides with growth in world trade & trade payments imbalances and the rise in securitization of bank assets that caused the present credit crunch). Sarkozy said that financial entities are thus able to exploit the inability of nation states to tax or regulate them (international banks) effectively. Consequently, Europeans call for a new global financial architecture that starts with, and gives primacy to, new cross-border global financial regulatory authorities. These global institutions are currently established. The idea is to extend all of them to a wider membership, to be constructed, and will be a G20 core project for the immediate future including placing the IMF more centrally, which not all emerging economies may welcome? The Europeans note that existing international regulatory institutions, like the Basel Committee on Banking Supervision and the Financial Stability Forum, have very limited membership, cannot issue binding standards and rules, are heavily influenced by the financial lobby, and have proven to be totally inadequate both in predicting the financial crisis and in acting to stem it. All this made it into the final G20 statement that the European Commission is now busy working on, and this will include expanding G20 to work with G192 (the DOHA grouping of countries) and the UN.
The United States’ (last days of the Bush administration) posed a counter-argument that rested on the integrity unto itself of the nation state, locating the primacy of regulatory authority in national governments, and only adds new, cross-border forms of transnational collaboration and co-ordination. This reflects the stance of the US towards international bodies of the last 8 years, but can be expected to change dramatically under the new incoming Obama administration.
The USA's legacy position on global reform starts with existing national regulatory regimes, upgrading them considerably (USA is at least 1 year behind Europe in implementing Basel II prudential rules), and expanding them to encompass new financial instruments and institutions heretofore unregulated.
Both sides agree in the importance of more transparency that includes bringing credit trading into regulated exchanges or at least clearing houses and examining the role and qualities of credit ratings agencies. This ought to include the qualities of major stock exchanges. The North Americans (with UK support) argue that a national-based approach offers the best tools for the broadest possible political control because it is rooted in oversight by national governments, their executives and parliaments, which are themselves subject to popular (democratic) oversight, however imperfect. Behind these arguments, however, lie both ideology and the desire to protect the U.S.’s and UK’s financial sectors’ competitiveness as the dominant global financial industry centres. (Note that half of the EU's financial assets are managed and traded in the UK). The G20 Communiqué avoided direct reference to the national/ multinational debate and papers over any cracks between the U.S. and European positions. Several other Atlantic fault-lines emerged at G20, such as between a monetary and fiscal response, between reducing the market price of borrowing or more Government borrowing and spending. Europe wants to go faster, broader, and deeper with new regulations than the U.S. and wants more co-ordination of policy interventions, but does not translate this also into more global spending to recover faster out of recession. The risks of the G20 Communiqué are that some governments will pay more attention to the interests of their own financial lobbies than to the interests and urgent neglobally of their own citizens equitably with citizens worldwide, and that the emerging markets, developing economies, where over two thirds of the world's population live will see in this merely a power-grab by the club of rich nations seeking world dominance by financial means? The Communiqué refers to the "fight" against unccoperative states and tax havens (though these are usually places with tiny populations, but might in certain aspects apply to BRIC states - Brazil, Russia, India, China). A host of immediate measures have been agreed to in the G20 Communiqué to be done by the next G20 meeting in March 2009, and pushing into the long grass the Atlantic Trench divisions that some might see as between the Anglo-Saxon model of liberal finance and the European of social welfare responsibility? The irony of this is that the USA has actually been far more generous externally than the EU, not least by running historically massive trade deficits (c. $1tn) that have fed into BRIC countries' high growth rates. The new OBAMA administration has indicated it will be more inclusive globally, but it faces domestic protectionist lobbying. If its fiscal stimulis package (worth 8% ratio to GDP) and financial stability measures show signs of working during 2009, it will have the space to formulate new positions closer to that of the EU. The effectiveness of G20 lies in the detail and that still has to be worked out. Principles, broad guidelines and indicators as to specific criteria e.g. Basel II and whatever a new Bretton Woods will indicate are on the official agenda. There are four that can become minimum demands:
1. Total transparency – all financial instruments and all financial institutions to report fully on quality of markets and transaction data and this information made available to the public;
2. All banking assets & liabilities backed by capital reserves under Basel II, especially the economic capital calculation for buffer reserves to limit uninhibited leveraging;
3. All current and future financial instruments, and all systemically important financial service firms, market institutions, investment houses and financial information services brought under global standards of financial regulation;
4. New national and global regulatory systems to be subject to the widest and deepest democratic participation, including oversight, monitoring, and access to decision-making with participation of all G192.
The global financial meltdown is one of several converging world economic system crises caused largely by a free-for-all market fundamentalism over the need for civic responsibility globally, which is one way of seeing the matter, or it is more directly the result of severe trade and payments imbalances. This neo-liberalism has permeated especially OECD countries' governance systems at every level: local, national, regional, and global. Consequently, as global problems worsen to converge with financial crisis and recession cycles, so too may inequality within and across alll borders. The same recklessness that led to insolvency at the core of financial systems is also at risk of a pro-cyclical response that deepens inequality world-wide over the coming decades. The financial crisis (credit cycle) is doubling the downturn (depth and persistence) in economic cycles. The private financial institutions receiving taxpayer bailouts should be obliged to lend to the real economy in order to ease the transformation to recovery, and to an environmentally more robust world economy.