Stress Tests : Useful or Misleading?

Since the financial crisis and the collapse of the financial system authorities see stress testing from vital importance for financial institutions to shore up confidence in the financial system. Stress testing is an analysis conducted under unfavorable economic scenarios which is designed to determine whether a bank has enough capital to withstand the impact of adverse developments by examination of their balance sheets. Banks have to understand how robust their positions are to alternatives of macro events and other stresses, no matter how implausible they seem. Their existing risk structures and processes failed to account for the enormous liquidity crunch following the collapse of Lehman Brothers. Stress testing is pointed out as a very important tool to examine the structural challenges banks are facing today and to understand their risk exposures (market risk, credit risk, liquidity risk).

The financial crisis has highlighted the problems of over-reliance on quantitative models. The traditional performance measures (RoE and RoA) needs to be combined with more forward-looking risk tools and techniques. The European authorities, the EBA (European Banking Authority), ECB (European Central Bank) and European Systemic Risk Boards (ESRB) are strengthening bank stress testing procedures and their application. The exercises are used to evaluate bank’s plans to comply with the evolving capitalization requirements under EU’s latest Capital Requirement Directive CRD IV which is the implementation of the global agreed Basel III accords on banking capital and liquidity (8% core Tier 1 capital).

Incorporating banks’ reaction to shocks is a critical input into the design of informative stress tests, especially over long time horizons. This requires modeling solvency and liquidity shocks in a coherent manner because first, when banks react to financial stress, the source of the shock (solvency or liquidity) is not always clear and the measures that banks take in reaction to these shocks have both capital and liquidity aspects that are not easy to disentangle. It is clear that the stress tests scenarios need to encompass a much longer time horizon; incorporate structural shifts (e.g., ongoing deleveraging and changes of bank funding profiles) affecting the balance sheet and income; and emphasize more other metrics, such as profitability, and changes in RWA. Scenarios such as a benchmark scenario, a recession scenario or the impact of a sovereign debt shock to a recession are implemented during stress testing.

Are stress test possible to boost investors’ confidence? Can the added RQR safety measure save the euro zone and its financial institutions? The European Central bank is expected to release the results of its latest bank stress test in November, which involves reviewing the quality of bank assets and requiring those that fail to recapitalize. Not only conducting an in-depth asset quality review (AQR) but also a recapitalization quality review (RQR) will be necessary to supervise the euro zone’s largest banks. The AQR only reveals limited capital shortfalls, representing a fraction of the sector’s annual profits. An expanded RQR would address wider structural risks inherent in recapitalizing banks. It helps to highlight those banks where conventional recapitalization is impossible, and allow investors and national regulators to prepare for a potential bail-in.

In the stress test, any capital shortfall arising from either the baseline or the adverse scenario relative to agreed benchmarks will require a strengthening of capital buffers and/or other supervisory interventions, as will losses ascertained in the AQR. As the stress test results for the banks that are subject to the comprehensive assessment will incorporate capital requirements that may result from the AQR, the end result will be more demanding than in previous exercises conducted by the European authorities in 2011.

With respect to the selection of portfolios – AQR phase 1 – data for all 128 banks across the EU were submitted to the ECB on schedule in late December, followed by a data quality review undertaken in close cooperation with the NCAs. The collection of data focused on identifying the most risky portfolios for inclusion in the AQR and subject to the minimum criteria that selected portfolios must account for at least 50% of a bank’s risk-weighted assets in each country. Intensive work is currently under way to select, bank-by-bank, the portfolios to be reviewed. For banks operating in multiple countries, only the parent bank will be scrutinized. That process will end in mid-February. 

We have seen that these tests are based on scenarios in which banks in each country fail or pass. Are these scenarios and the required Core Tier 1 Capital ratio of 8% right? Can stress testing conducted by the European authorities cover up the whole weakness in the European Banking system? Is there enough following up, coordination and transparency? Are the results coming from accurate data? Liquidity risk was a kind of sleeping risk we didn’t took into account in the past. Are there other risks that needs to be measured? The U.K.’s Prudential Regulatory Authority has said it is likely that it will also test banks on completely other test metrics such as the leverage ratios as a measure of capital adequacy because banks are using the benchmark risk-adjusted metrics to overstate their financial strength.

 References :

1. European Banking Authority 2011 EU-Wide Stress Test Aggregate Report. European Banking Authority. 15 July 2011.
2. FRIEDMAND A., What Bank Stress Tests Are Missing. The Euro zone’s plan to clean up its troubled banks should cover recapitalization. Wall Street Journal. 25 February 2014.
3. SMITH G., EBA Outlines This Year’s Stress Test for EU’s Biggest Banks, Wall Street Journal. 31 January 2014.
4. Rebuilding Trust: Next steps for risk management in financial services. A report from the Economist Intelligence Unit. May 2010.
5. European Union: Publication of Financial Sector Assessment Program Documentation—Technical Note on Stress Testing of Banks. Monetary and Capital Markets Department. March 2013, IMF Country Report No. 13/68.

Is more financial stability possible?

The RoE (Return on Equity), an internal performance measure of shareholder value was a wrong financial performance measure. Since RoE is the most well-known performance indicator widely used by market participants and banks themselves in their disclosures (i.e. at the top line of bank reports), targeting RoE has exposed banks to higher unexpected risk levels and opened the door to a more shortterm- oriented approach to balance sheet management. This ratio was not adjusted for the risks that financial institutions are taking, i.e. leverage funding and liquidity profile.

Policies, including Basel I, have encouraged regulatory arbitrage. Reduced capital ratio minimums incentivized banks to increase leverage and a significant reduction in reserve requirements in the 1990s, precipitated lower liquidity and higher leverage. This created the conditions for a financial crisis we are facing today.

In the years 2002–06 before the crisis, profits were high but several large banks required bailouts. Banks increased profits through both balance sheet and off-balance-sheet growth and by taking on riskier asset/liability mismatches.

1. Return on Equity (RoE):

Return on Equity is the primary measure banks have pursued to evaluate their performance. RoE used to be very convenient for bankers. The bank board was given a target RoE which they could achieve in one or two ways: they could increase the returns or hold the equity low in the RoE measures. In the banking business they did both at the same time, high returns and equity low.

     RoE = net income / average total equity

Since mid-90’s the banking sector was underperforming the utility sector and was not serving the investors very well. It has bankers let to keep equity to a minimum and made them vulnerable as enterprises and has made the whole financial system very fragile.

What are proper ways to value the banks? What are the measures bank management and investors should be focusing on?

If bankers continue to pursue the target RoE they should wait for a longer period of years of time to measure if they have hit the target or not and to reward themselves. If they don’t wait this period for the consequences of the risks taking with the equity they are given. Than they need to adopt intra measures that are risk adjusted.

2. Return on Assets (RoA):

Return on Assets (RoA) is a basic measure of bank profitability that corrects for the size of the bank.

     RoA =   net income / average total assets

3. Return on Risk-Weighted Assets (RoRWA):

By introducing the measure Return on Risk-Weighted Assets (RoRWA) the boards and executive management needs to focus on the issue of risks. What risks are banks taking, what order of magnitude, what are the potential outcomes, in which area. These risk weights come out of Basel regulations, exposure against which they are measured are generated by the banks themselves. Since the crisis there are new Basel regulations, Basel III which is an improved version of Basel II/2.5. Now also capital and liquidity requirements, including the Tier I capital leverage ratio, liquidity coverage ratio, and the net stable funding ratio are primary measures of a bank.

But are these Basel-driven risk weightings right? Does a bank board need to judge these weightings themselves? Which other measures do we need to take into account to let banks better perform than in the past? The RoE was the primary measure of many banks which they pursued in terms of the profitability objective, the capacity to generate sustainable profitability. We have seen that it has not contributed to long-term shareholder value. Instead it has contributed to volatility of returns, excessive leverage, risk-taking which has made our financial system very unstable. This has encouraged the banks to keep the equity small as possible and the leverage as large as possible and has made the financial system fragile. Today, it is very important to promote financial stability. We have to create well regulated banks that are more prudent. It means more equity in the mix and having the right targets to encourage them.

We are investigating how the RoE changed before, during and after the crisis. What are the main drivers explaining the RoE changes over the crisis? What are appropriate performance measures after the financial crisis? Are the Basel regulations good policies or do need banks themselves consider other measures. Are stress testing programs imposed by Basel a good tool to supplement other risk management approaches and measures?

References :

1. The determinants of bank capital structure. Working Paper Series. No 1096 / September 2009. European Central Bank.
2. Beyond RoE - How to measure bank performance. September 2010. European Central Bank.

Life after a Catastrophe

By definition, in a fractional reserve banking system, banks use high leverages. Nevertheless criticism about the capital structure of banking sector and its risks expressed after every major financial crisis and bank run; and 2008 global financial crisis was not an exception. We all hear the call to deleveraging and the frightening stories about how excessive use of leverage in banking industry lead to not just an unstable financial system, but also a fragile economy as a whole. 

In this blog we will examine these claims and look at the effects of 2008 global financial crisis to the balance sheets of banking sector. We will mainly focus on the European countries. Since the debt crisis in Europe is still an issue, we believe that a deeper investigation would be beneficial for everybody with an interest about the situation of European financial system. 

One of the main mistakes that we see in both the layman’s and most of the financial press’ perception of Europe is the tendency to look at these countries as consisting of two very different groups. Namely: the rich north and the poor south. They then expect an alignment in every issue according to this binary paradigm.  

In the case of usage of leverage in banking sector among different European countries, this story of bi-polarity is simply refuted and we see that the reality is a lot more complicated. The chart below shows how leverage ratios vary among countries. It also shows that deleveraging after the financial crisis is not ubiquitous and there is a significant variation among countries.  

Moreover we’re observing a significant change in the lending behavior of banks after the financial crisis. The chart below shows that banks lend increasingly more to governments instead of households or private firms. There are various reasons for this situation, which I will not investigate further in this article, but I believe that simply by looking at these figures we can talk about a crowding out effect.

We're not just observing a change in the balance sheets of the banks but also their activities itself. Today, Banks are not the traditional banks that we know of. Deposit & lending is just a fraction of their business. Shadow banking and capital markets have been increasingly substituting their role as lenders. 

An op-ed article at the Wall Street Journal by AXEL WEBER and SERGIO ERMOTTI also point at this matter and criticizes the naive focus on leverage ratios:

“There are two ways banks can increase capital ratios: either by increasing capital or by reducing risk-weighted assets (RWAs). A recent paper by the European Banking Authority shows that the Core Tier 1 ratio for 64 EU banks rose to 11.7% in June 2013 from 10% in December 2011. This improvement has come fairly evenly from banks both increasing capital and reducing RWAs.

Within that reduction of risk-weighted assets, there has been an implicit incentive for banks to shift away from capital-intensive corporate lending to less capital-intensive activities, such as lending to governments. 

Weak bank lending has been somewhat offset by capital-market activity. The problem is that bank lending still makes up 80% of corporates' total funding mix. Moreover, although debt issuance is an option for large listed companies with reasonable credit ratings, it is not a viable form of financing for smaller companies—let alone individuals.”

As they also point out, because of the riskiness difference among assets, the importance of leverage ratio becomes questionable. With the Basel 3 standards we will see some interesting developments about this issue.

There is a lot to say and we will try to investigate these issues further in our future posts.  

References :

1. The Wilder View - The European Debt Crisis In 3 Charts 
2. The 'Silent Austerity' in Banking by AXEL WEBER and SERGIO ERMOTTI