10 December 2010

Thoughts about Stress Testing Guidelines

The Post-Lehman Era so far has been a clear demonstration of how fragile this powerful financial system may be. At the outset, this was surprising not only to the most of the outsiders, but also to the many of those working in financial industry, including those who are supposed to measure and control risks as part of their daily work. The conclusion was that the existing tools for identifying and monitoring risks simply were not enough. They not only did pay too little attention to the liquidity risk and capital quality, but they also did not enable to identify links between the different risk types, properly assess the possible contagion risks and systemic effects. One of the regulatory responses is that from now one, banks should implement comprehensive stress testing programmes, and include stress testing into their daily risk management. This is the background of the CEBS Revised Guideline on Stress Testing that was published in 26 August 2010, and is expected to be applied by EU members by 31 December 2010.

When reading this guideline, I first found myself thinking: “They [the regulators] are dealing with the consequences and not with the sources of the problems.” The cause of the crisis was not an insufficient stress testing framework, but fundamentally flawed financial instruments and –structures (like securitisation when conducted by the fractional reserve banks), and wrong intensives (such as the revolving door between bankers and regulators).

My second thought was: “If the banks themselves in their responses to the respective consultation paper argue that undertaking stress scenarios combining all risk drivers (credit, market, interest rate, liquidity) and all perimeters (including sophisticated products) is very difficult to be performed [which I very much agree and which is also acknowledged by CEBS], then perhaps this undue level of sophistication should be addressed first?” If the underlying business is not really understood, one cannot expect models to be more than just models because of models.

Next, I asked myself: “What aim are regulators keeping in mind when requiring the new stress testing framework to be implemented?” As stated in the introductory part of the abovementioned CEBS guideline, it is to facilitate the forward-looking perspective in risk management, strategic planning and capital planning of financial institutions. Sounds like a good intention. What is to be seen is where this improved understanding will lead to. Traditional banks requiring banning of structures and industry practices that cause negative externalities, i.e. systemic risks also to those not willing to participate in this apparently too risky business? Or everyone trying to grow bigger and more complex, because smaller and simpler ones are on a disadvantageous position, and proper stress testing and all the discussions around it enable them to see this. Alternatively, the intention of the guidelines may be to force too sophisticated institutions to acknowledge that they are too sophisticated and unable to assess their risks properly. Or, when introducing too-complex-to-fulfil instructions, the regulators are creating themselves an excuse or backdoor for the next financial crisis: financial institutions just failed to implement the guidelines properly.

Anyway, even if not a solution, improved understanding complemented with broader discussion of the issues is a step towards right direction.

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