Stress Tests Must Go Beyond Banks to Systemic Risks
A recent paper by the Bank of England’s Executive Director for Financial Stability suggests that stress testing needs to go beyond individual banks to incorporate their impact on systemwide risk.
The B of E’s Andrew G Haldane presented the paper Why Banks Failed the Stress Test at a recent conference on the topic.
First, argues Haldane, a multi-factor risk scenario that is sufficiently extreme to constitute a tail event must be devised.
Second, regular evaluation of common stress scenarios is needed. “Having banks conduct regular evaluations of their positions relative to a set of common scenarios (provided by the authorities) would be an improvement on current practices in several respects.”
Third, an assessment of the second-round effects of stress should be added. “The results of these common stress evaluations should be the starting point, not the end point. These common stress tests need to be made dynamic, so that the second and subsequent round interactions, and their consequences for system-wide risk, can be evaluated”
“This calls for an iterative approach to stress-testing in which banks’ first-round results and management actions influence second round stresses facing firms – for example, the effects of asset sales and liquidity hoarding.”
In effect, what we would then have is a hybrid stress test-cum-war game.
Fourth, results should be translated into firms’ liquidity and capital planning. “The results from these exercises need to influence management outcomes if they are to be useful; the internal incentive problem needs to be overcome. So there should be a presumption that the results of these dynamic stress tests are taken, for example, to banks’ risk committees. And banks’ executives should periodically be asked how they intend to respond to these findings, including how effective their defensive responses are likely to be when the stress is system-wide and how the results affect liquidity and capital planning decisions.”
Fifth, transparency to regulators and financial markets is required. “The bank-specific results ought to inform regulatory decisions about firms’ capital and liquidity buffers. Indeed, there is a case for having these results set out regularly in firms’ public reports.”
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