The FIG Idea: stress to impress

Regulators use their post-stress solvency assessments to determine what dividends banks can pay, and so, ultimately, stress tests help determine shareholder value. How a bank fares in the made-up scenario matters a lot for the real world investability of its securities.

But though the market pays attention — witness all the Royal Bank of Scotland headlines on Wednesday following its failure of the Bank of England’s test — stress tests are not always given the understanding they deserve. That’s partly because they get lumped in as just another add-on in an ever more complex capital calculation.

Capital adequacy used to be based on a fairly humdrum, static calculation.

In Basel I, this meant a Cooke ratio (early risk-based capital measure, named after Peter Cooke, former head of supervision at the Bank of England) comfortably above 8%; otherwise, a bank might have to raise capital.

In Basel II, things became a bit more complicated, but capital requirements were modelled on having positive equity during a pretty severe — once in 1,000 years, to be precise — shock episode.

In the recent financial crisis, though, this approach lost credibility. Banks failed and had to be bailed out to keep them operational, which taught the authorities a key lesson. What matters is that banks can be healthily solvent, even after a bad crisis and recession. Avoiding bankruptcy is not enough; staying viable is important, too. The show must go on.

Stress tests seem to offer the solution. They have become a “cornerstone of post-crisis prudential regulation”, in the words of US Federal Reserve governor Daniel Tarullo. They are meant to tell us how banks would fare under a severe, but plausible, hypothetical scenario — a “severe recession and associated market dislocation”. 

As the Bank of England said when publicising the results of its 2016 stress test, the goal is to help the authorities “identify, monitor and take action to remove or reduce systemic risks with a view to protecting and enhancing the resilience of the financial system”.

In practice, stress tests tell us little about banks’ true quality or resilience. The capital hit tends to be around 3%-4%, which becomes effectively a capital add-on. The outputs are totally driven by the input assumptions, and who can say which scenario is the one that should be tested?

One UK mortgage lender had a 1% hit in the 2015 stress test, featuring an emerging markets crisis, compared with an 8% hit the previous year, when the test assumed a domestic property crash. What do we learn from that? It’s hardly surprising or insightful.

But we do learn two things from single-scenario stress tests.

First, diversified banks tend to be more resilient to isolated stresses than highly focused banks.

Second, supervisors like the exercises, however hypothetical, because they give a robust reason for a bit of good old tyre-kicking.

In the words of the Fed, they like to get their hands dirty looking at “the assumptions and analyses underlying each firm’s capital plan, its controls and governance processes, and whether previously identified weaknesses in management and operations have been corrected”. Fail to impress, in these respects – as happened with three big banks in this year’s US stress test — and dividends can be blocked.

And this is the real point of the process. As well as an empirical exercise to flush out stragglers and gather good data — the only standardised, electronic disclosures in European banking have come from EBA stress tests — stress tests give a good stage for supervisory actions.

Beyond the public tests, banks are expected to conduct their own internal stress tests, using scenarios that they themselves have designed and chosen. Reverse stress tests, which look for the most likely scenario that will exhaust a bank’s equity, are also seen as a good idea, though we don’t hear much about them — perhaps because, by definition, they involve contemplating the bank failing.

More sophisticated banks have developed capabilities in “wargaming”, running through a series of what-ifs to see how they would react to sudden, unexpected events such as the appearance of an aggressive new entrant in the market, hacking of customer accounts, or the defection of key management to a competitor, for example. Weaknesses can be exposed the easy way, rather than the hard way.

Supervisors are learning a lot from stress testing about how banks function and are beginning to build a better understanding of how the banking system — rather than just individual banks — behaves under stress. Perhaps their improved wisdom will allow them to make regulatory capital requirements better reflective of the true economic risk.

However removed from reality they seem, stress tests form the bedrock of a vital discipline for the financial sector. To paraphrase former US president Dwight Eisenhower, “stress tests are nothing, stress testing is everything”.

The FIG Idea is written by a market participant with more than 20 years experience advising financial institutions.