Leveraging Up on Bank Stress (II): improving the Bank of England’s Leverage Stress Test

This posting goes through the Bank of England’s leverage ratio stress test using an improved version of the leverage ratio to replace the one used by the Bank: it uses CET1 capital in the numerator instead of the looser and more gameable Tier 1 capital measure used by the Bank. Results show that the UK banking system performs extremely poorly by this stress test when assessed against the fully implemented leverage ratio requirements possible under Basel III, and even worse when assessed against minimum leverage ratio standards coming through in the United States and those recommended by experts.

In the previous posting, I examined the outcomes of stress tests that use the ratio of banks’ Tier 1 capital to leverage exposure as their capital adequacy metric. However, the use of Tier 1 capital in the numerator of the leverage ratio is problematic: Tier 1 capital is the sum of Core Equity Tier 1 (CET1) capital plus Additional Tier 1 (AT1) capital, and AT1 includes hybrid capital instruments such as Contingent Convertible (CoCo) instruments which are of unreliable usefulness in a crisis. Including these in our capital measure is undesirable because it might overstate the capital available to support a bank in a crisis and so undermine the principal purpose of any core capital measure.

We therefore need a more prudent capital measure and a natural choice is CET1 without any additional, softer, capital. Roughly speaking, CET1 approximates to Tangible Common Equity (TCE) plus retained earnings, accumulated other income and other disclosed reserves. [1] The ‘tangible’ in TCE means that it excludes intangible items such as goodwill and Deferred Tax Assets, and the ‘common’ means that it gives a measure of common share capital (i.e., shareholder capital stripped of more senior capital instruments such as preferred stock and other hybrid items). Of the measures available (and unfortunately, TCE is typically not available) CET1 is the best capital because its component elements are the most fire-resistant and hence most deployable in the heat of a crisis. To quote Tim Bush, CET1 is:

the plain old fashioned accounting shareholder interest. It's what bears the first loss, pays divs, and is what has to be recapitalised. It also excludes goodwill [and any other intangibles and] any expectant income and books all expected losses. [2]

Now define the CET1 leverage ratio as the ratio of CET1 capital to leverage exposure. If we take the outcomes of the Bank’s stress test applied to the CET1 leverage ratio and take the pass standard to be the potential maximum required minimum leverage ratio under fully implemented Basel III, then we obtain the outcomes shown in Chart 1:

Chart 1: Stress Test Outcomes Using the CET1 Leverage Ratio with the Potential Maximum Basel III Pass Standard

Notes to Chart 1:

(a) Author’s calculations based on information provided by the Bank of England’s ‘The Financial Policy Committee’s review of the leverage ratio” (October 2014) based on the assumption that the pass standard is the potential maximum required minimum leverage ratios under fully-implemented Basel III.

(b) The outcome is expressed in terms of the CET1 leverage ratio post the stress scenario and post any resulting management actions. These data are obtained from Annex 1 of the Bank's stress test report (Bank of England, December 2015).

It is fair to say that if the previous outcomes were disastrous, these are positively dire. The average outcome is 3.1%, the average pass standard is 4.2%, the average shortfall is over a hundred basis points and every single bank fails the test by a comfortable margin. By this test, the entire UK banking system is well and truly below water.

But it gets worse.

One problem is that reported CET1 values can be inflated by at least three different factors. Briefly:

• The reported CET1s are based on IFRS accounting standards, and a key component of CET1 is retained earnings, the reported values of which are likely to be inflated because IFRS allows banks to inflate the underlying asset values. [3]
• The regulatory definition of CET1 endorsed by Basel III involves an awkward ‘sin bucket’ compromise by which various items of softer capital (such as Deferred Tax Assets and Mortgage Servicing Rights) can be included in reported CET1 provided they account for no more than 15% of total reported CET1. [4]
• The CET1 values reported here are book values and market values will typically be less. Thus, ‘true’ CET1 values can be considerably lower than those reported in the Bank of England’s stress test report. 

The reported capital ratio is inflated further by a downward bias in the reported leverage exposure, which is the denominator in the leverage ratio. This downward bias is another long story. In theory, the leverage exposure is meant to take account of off-balance sheet items that would not show up in traditional exposure measures such as total assets. However, the regulatory leverage exposure measure is a highly compromised measure that is the result of a lot of behind the scenes lobbying by banks keen to keep their measured exposures down, not least in order to minimise their resulting capital requirements. Given (a) that off-balance-sheet items considerably exceed on-balance-sheet ones and (b) that accounting netting rules tend to hide a great deal of financial risk, if only because many supposedly hedged positions often fall apart in a crisis, and (c) that we know that banks are riddled with major data quality problems, then we would expect any half-decent exposure measure to be much greater than, say, reported total assets. However, they are not. In fact, when I looked into this matter, I was astonished to discover that the leverage exposures of UK banks are not only of the same order of magnitude as their balance sheet total assets, but are sometimes even lower. For example, the reported 2015Q3 leverage exposure for Lloyds was only 88% of its reported total assets. So once again, we have a downward bias in the leverage ratio numbers and no real way in which we can assess what the extent of that bias might be. However, whatever this bias might be, we can reasonably infer that it must be large.

We should also note that the pass standard assumed in the test reported in Chart 1 is by no means a high one and the Federal Reserve, for one, is already preparing to impose even higher minimum leverage ratios. In April 2014, the Fed finalized a set of ‘enhanced’ Supplementary Leverage Ratios (SLRs) on the 8 U.S. global systemically important banks (G-SIBs) and their insured depository institutions. These are supplementary requirements in addition to those required under Basel III. As part of this requirement, the U.S. G-SIBs will have to meet a 5% SLR at the holding company level and a 6% SLR at the bank level, and are due to come into effect on January 1, 2018.

Well, to spell out the obvious: if the UK banks perform badly against a pass standard equal to the maximum potential standard under fully implemented Basel III, then they would perform even worse when assessed against the Federal Reserve’s higher standards.

There is also the question of what the required minimum leverage ratio should be, i.e., as assessed from first principles. Curiously, this is one of the few subjects in economics and finance where there is a considerable degree of consensus among experts – and their view is that minimum standards should be much higher than they currently are. We are not talking here about a couple of percentage points, but a minimum that is potentially an order of magnitude greater than current minimum capital requirements anywhere in the world. There is of course no magic number but what we want is a minimum requirement that is high enough to remove the overwhelming part of the risk-taking moral hazard that currently infects our banking system. As John Cochrane put it: it should be high enough until it doesn’t matter – high enough so that we never, ever again hear the call that banks need to be recapitalized at public expense.

This consensus was reflected in an important letter to the Financial Times in 2010, in which no less than 20 renowned experts – Anat Admati, Franklin Allen, Richard Brealey, Michael Brennan, Arnout Boot, Markus Brunnermeier, John Cochrane, Peter DeMarzo, Eugene Fama, Michael Fishman, Charles Goodhart, Martin Hellwig, Hayne Leland, Stewart Myers, Paul Pfleiderer, Jean-Charles Rochet, Stephen Ross, William Sharpe, Chester Spatt and Anjan Thakor – recommended a minimum ratio of equity to total assets of at least 15%, and some of these wanted minimum requirements that are much higher still. Independently, John Allison, Martin Hutchinson and yours truly have also called for minimum capital to asset ratios of at least 15%, Allan Meltzer recommended a minimum of 20% for the largest banks, Admati and Hellwig recommended a minimum at least of the order of 20-30%, Eugene Fama and Simon Johnson recommended a minimum of the order of 40-50%, and John Cochrane and Thomas Mayer have suggested 100%.

By these minimum standards, the UK banking system is not so much underwater as stuck as the bottom of the ocean.

So what can we conclude from these stress test exercises?

Without a shadow of a doubt, the entire UK banking system is massively undercapitalised even under the relatively mild adverse ‘stress’ scenario considered by the Bank of England.

End Notes

[1] For a more complete definition of CET1 capital, see Basel Committee on Banking Supervision (BCBS) “Basel III: A global regulatory framework for more resilient banks and banking systems” (Basel Committee, June 2011), p. 13.

[2] Personal correspondence.

[3] These and other problems with IFRS accounting standards are explained further by Tim Bush, “UK and Irish Banks Capital Losses – Post Mortem,” Local Authority Pension Fund Forum, 2011, and Gordon Kerr, “The Law of Opposites: Illusory Profits in the Financial Sector”, Adam Smith Institute, 2011.

[4] For more on this subject, see Basel Committee on Banking Supervision, “Basel III: A global regulatory framework for more resilient banks and banking systems," revised version June 2011, pp. 13, 21-26 and Annexe 2, and Thomas F. Huertas, Safe to Fail: How Resolution Will Revolutionise Banking, Palgrave, 2014, p. 23.

It's not obvious that the new Libor will be better than the old Libor

In a political sense it is obvious that the old way of calculating Libor had to change. But in the more economic, or even financial, sense it's not wholly obvious that this new method is going to be better. We've made this point before but there were actually two manipulations of that benchmark interest rate. One was varied traders trying to get their own bank to shade it one way or another in order to benefit their own trading books. This produced minor swings one way and another and the major losers were the trading books of other traders. Further, given that quite a lot of people were doing it the manipulations cancelled out to some extent (and if all had been doing it then there would have been no effect). The second was perhaps more serious although isn't what has been prosecuted. In the depths of the crash, when there wasn't in fact any interbank activity, Libor was still being reported as being reasonable. When, in fact, in the absence of there being any such lending, and no one would offer it even if someone asked (that being our entire problem, that the interbank market froze), the true Libor was somewhere up around infinity.

We're actually rather glad that second manipulation took place.

Still, politics being what it is the calculation method has to change:

Each day a group of banks publish the average cost at which they can borrow money from other banks. The measure was founded in the 1980s and grew in importance in the following decades.

But in 2012 it emerged that a series of banks’ traders had lied in their submissions, either to improve their own trading positions or to flatter the banks’ own financial position.

As a result the British Bankers’ Association surrendered its administration of the index, and the IBA took over.

The new system means the IBA’s computers are plugged directly into banks’ trading systems, and will record their transactions and so calculate Libor from actual market data.

The problem here is that not all of the banks on the reporting panel transact in all the Libor currencies and maturities on any particular day. They might well trade instruments, sure, but they don't all borrow across all those variants each day. There's thus something of a paucity of market information to be calculated. And if that interbank system freezes again, as it might well do in the next (yes, there will be another one someday) financial crisis then are we happier with the idea that reported rates will be soaring to infinity?

It's an interesting problem to which we have no ready answer. Is it better to rely upon the professional judgement of possibly corruptible experts or upon incomplete market information? If we had complete market information then it's obvious, but incomplete?

Leveraging Up on Bank Stress (I): the Bank of England’s Leverage Ratio Stress Test

(For the previous posting in this series, see here.) This posting goes through the Bank of England’s stress tests of UK banks’ leverage ratios – roughly speaking, their ratios of capital to leverage exposure. The banks perform poorly according to this test even under the very low 3% pass standard used by the Bank. Moreover, almost all banks fail the test under the higher minimum standards called for under Basel III when it is fully phased-in – and even those pass standards are much lower than they should be. These results confirm that the UK banking system is in very poor shape.

In an earlier posting, I suggested that the leverage ratio – the ratio of bank capital to its leverage exposure – is a better capital adequacy metric than capital ratios that use a denominator expressed in terms of Risk-Weighted Assets (RWAs). This is because the leverage exposure is a more reasonable and much less gameable measure than the RWA measure.

In this posting, I will go through the Bank of England’s second stress test – the test based on the Tier 1 leverage ratio, i.e., the ratio of banks’ Tier 1 capital to their leverage exposures. The definitions of these terms were explained here.

In this test, the Bank sets its minimum pass standard equal to 3%: a bank passes the test if its Tier 1 leverage ratio post the stress scenario is at least 3%, and it fails the stress test otherwise.

The outcomes for this stress test are given in Chart 1:

Chart 1: Stress Test Outcomes Using the Tier 1 Leverage Ratio with a 3% Pass Standard

charts ab

Notes:

(a) The pass standard is the bare minimum requirement (3%), expressed in terms of the Tier 1 leverage ratio - the ratio of Tier 1 capital to leverage exposure.

(b) The outcome is the Tier 1 leverage ratio post the stress scenario and post any resulting management actions. These data are obtained from Annex 1 of the Bank's stress test report (Bank of England, December 2015).

By this test, the UK banking system looks to be in pretty poor shape. The average outcome across the banks is 3.5%, making for an average surplus of 0.5%. The best performing institution (Nationwide) has a surplus (i.e., outcome minus pass standard) of only 1.1%, four (Barclays, HSBC, Lloyds and Santander) have surpluses of less than one hundred basis points, and the remaining two don’t have any surpluses.

You should also keep in mind that this 3% pass standard is itself a very low one. Despite its pretensions to impose tough new capital standards, Basel III still allows banks to fund up to 97% of their leverage exposure by borrowing and to have as little as 3% equity to absorb losses. Thus, if a bank has a leverage ratio of 3%, then it only takes only a loss equal to 3% of that leverage exposure to wipe out all its equity capital and render it insolvent.

Basel III’s minimum capital requirement is also way below the capital standards maintained by non-financial corporates, which only rarely have capital ratios below 30%.

In any case, the Basel 3% minimum requirement would not have helped had it been in place before the financial crisis: by 2007, UK banks’ average capital to asset ratios had fallen to just under 4% - still above the Basel III minimum, but not enough to prevent the collapse of the UK banking system.[1] There is, therefore, no reason to expect that such a minimum capital ratio would protect the system in the face of a recurrence of the recent crisis.

Going back to our stress test, you have an easy exam with a very low pass standard, and yet the UK banking system barely scrapes through, if even that.

It is also curious that the two weakest banks hit the pass standard right on the nose: had the stress been even a smidgeon more severe, they would have failed the test. It is almost ‘as if’ the stress test had been deliberately engineered to ensure that the adverse scenario was as adverse as it could possibly be without actually pushing any bank over the edge.

To be clear: I am not suggesting that the good folks at the Bank would even dream of fixing their stress test to produce such an outcome. But I am saying is that it is quite a coincidence to get not just one but two banks whose post-stress outcomes just happen to come out to be exactly equal to the pass standard.

Be all this as it may, the Bank’s assessment was much more upbeat than any Jeremiad of mine. Regarding the five best-performing banks (i.e., the ones that actually got a surplus) it reported that the PRA Board had judged that the “stress test did not reveal capital inadequacies” for these banks and saw no need to mention that their surpluses were rather on the small side – 0.3% for Barclays, 0.4% for Santander, 0.7% for HSBC, 0.9% for Lloyds, and only 1.1% for the star of the class, the Nationwide.

As for the two dunces that got surpluses of exactly zero in the leverage ratio test, the PRA Board carefully noted that their capital positions remain above the threshold CET1 ratio of 4.5% and meet the leverage ratio of 3%”. Nice choice of words.

Despite their capital inadequacies, these two then got off with of a slap on the wrist from the PRA and their capital plans were approved.

The Bank’s overall assessment was then this:

The stress-test results suggested that the banking system was capitalised to support the real economy in a global stress scenario which adversely impacts the United Kingdom, such as that incorporated in the 2015 stress scenario.[2]

Personally, I would have slightly re-edited this statement to read as follows:

The stress-test results suggested that the banking system only just managed not to fail the test under the 2015 stress scenario and obviously we cannot draw any conclusions about whether the banking system would have passed the stress test under any other stress scenarios that we did not consider.

It might also have pointed out that the banking system would have failed the stress test if the stress scenario had been more adverse or if the hurdle had been even a little higher.

There is another problem as well. The 3% pass standard assumed in this test took no account of the additional leverage ratio requirements that will be phased-in under Basel III: these are the additional leverage ratio requirements corresponding to the Counter-Cyclical Capital Buffer and Globally Systemically Important Institutions Buffer. If we include these to their maximum possible extent under fully phased-in Basel III, then we get the outcomes shown in Chart 2:

Chart 2: Stress Test Outcomes Using the Tier 1 Leverage Ratio with the Potential Maximum Basel III Pass Standard

Charts ab2

Notes:

(a) Author’s calculations based on information provided by the Bank of England’s ‘The Financial Policy Committee’s review of the leverage ratio” (October 2014) based on the assumption that the pass standard is the potential maximum required minimum leverage ratios under fully-implemented Basel III.

(b) The outcome is expressed in terms of the Tier 1 leverage ratio - the ratio of Tier 1 capital to leverage exposure - post the stress scenario and post any resulting management actions. These data are obtained from Annex 1 of the Bank's stress test report (Bank of England, December 2015).

If the earlier outcomes reported in Chart 1 were bad, these are disastrous: the overall average shortfall is 0.85%,[3] only one bank (Nationwide) scrapes through the test with a surplus of under 0.1% and the other six banks fail.

It gets worse, too: it turns out that even these outcomes are still overly optimistic.

More on this in the next posting.

Footnotes:

[1] See P. Alessandri and A. G. Haldane, “Banking on the state,” November 6, 2009, chart 2, p. 24.

[2] Quotes from Bank of England, “Stress testing the UK banking system: 2015 results,” pp. 9-10.

[3] And if we applied those other adjustments too, then we would get an even higher average shortfall, i.e., 0.85% + 3.5% – 1.89% = 2.46%. Ouch!

What Should Be the Absolute Minimum Pass Standard in the Bank of England’s Headline Stress Test?

[For the previous blog posting in this series, see here.] Consider the following question: according to the Bank of England’s own guidance documentation, what should be the absolute minimum pass standard in its headline stress test, the test based on the ratio of Common Equity Tier 1 (CET1) to Risk-Weighted Assets (RWAs)?

The Bank of England used a 4.5% pass standard in the test, but I assert that it should have used a pass standard of at least 7% instead.

Why does this matter? Well, if you use 4.5% as the pass standard, the UK banking system performs fairly well under the stress test, but if you use 7% as the pass standard, it doesn’t. [See End Note 1]

This is a big deal because it undermines the Bank of England’s narrative that all is well with the UK banking system.

So what do the Bank’s own guidelines indicate that it should use as the absolute minimum pass standard?

We can break this question down as follows.

First, what is the relevant Bank of England guidance document?

Answer: the guidance document is the Bank’s October 2013 Discussion Paper “A framework for stress testing the UK banking system”.

Then there are two further questions. According to this guidance document:

1. What is the connection between the pass standard in the stress test and the minimum capital requirement(s) imposed on banks?
2. What exactly is/are these minimum capital requirement(s)?

On 1:

Page 28 of the Bank’s October 2013 Discussion Paper contains the following statement:

Interpreting these [stress test] results, and reaching a judgement about bank capital adequacy, requires a view on the level of capital that regulators want banks to maintain in the stress scenario. This is often referred to as the ‘hurdle rate’.

This ‘hurdle rate’ is the same as my ‘pass standard’. To continue:

Ultimately, this is a policy decision by the FPC [Financial Policy Committee] and the PRA [Prudential Regulation Authority] Board. But there are a number of considerations the FPC and the PRA Board might take into account in considering the level of capital banks should maintain in a stress.

A key consideration will the minimum level of capital required by internationally agreed standards. Banks need to maintain sufficient capital resources to be able to absorb losses in the stress scenario and remain above these minimum requirements.

My interpretation: leaving aside the judgmental override caveat in the second paragraph, the pass standard should be at least as high as the minimum capital requirements.

This takes us to the second question: what is/are the minimum capital requirement(s)?

The Discussion Paper continues further:

Minimum capital standards have been set internationally by the Basel Committee on Banking Supervision and transposed into European legislation under the Capital Requirements Regulation and Directive (CRD IV).

For example, under the PRA’s proposed implementation of CRD IV, the minimum Pillar I common equity Tier 1 capital requirement will be set at 4.5% from 1 January 2015 onwards.

If you didn’t read any further, you might conclude that the pass standard should be 4.5% because the Bank’s Discussion Paper claims that the minimum Pillar 1 CET1 requirement [note the singular] is 4.5%.

But this is to presuppose that there are no other CET1 minimum capital requirements and this is not so.

In fact, the 4.5% minimum is only one component of a set of CET1 minimum capital requirements [See End Note 2] [note the plural] and the overall minimum capital requirement is the sum of each of the components in this set.

The second component of this overall minimum capital requirement is explained in footnote 2 on the same page:

Consistent with the Basel III Capital Accord, CRD IV [also] requires banks to have at least a 2.5 percentage point buffer of capital [the Capital Conservation Buffer or CCB] above the 4.5% minimum.

Thus, the CCB is an additional minimum requirement on top of the 4.5% minimum capital requirement.  

Therefore, the overall minimum capital requirement is the sum of these two minimum capital requirements and 4.5% + 2.5% = 7%.

And since the pass standard in the stress test must be at least as high as the sum of these minimum capital requirements, i.e., the overall minimum capital requirement, the pass standard should also be at least as high as 7%.

QED.

The Bank’s position seems to be that they can ignore the CCB in setting the pass standard because the CCB is a different type of minimum requirement and because the failure-to-comply sanctions associated with the two minimum requirements are different: failure to meet the bare minimum 4.5% requirement could lead to the bank being put into resolution, whereas failure to comply with the CCB minimum requirement would merely lead to the bank being required to file a capital plan with its supervisor who may limit payments of dividends and bonuses.

Such thinking would fail any logic test.

The Bank’s point about the CCB being a different type of requirement is correct but irrelevant; what matters is that the CCB is a requirement nonetheless.

Nice try, but the blind-them-with-an-irrelevant-difference-defence doesn’t work.

Conclusion: according to the Bank’s own guidance document, the absolute minimum pass standard for the CET1/RWA stress test should be 7%.

I also consulted a number of experts for independent opinions. Not a single one was willing to defend the Bank’s interpretation of its own rules.

Consider for example this response from my friend, the Canadian economist Basil Zafiriou:

I read the standard the same as you, Kevin. The CCB is a mandatory buffer, so it has to be added to the CET1 minimum for an overall capital requirement threshold. Suppose a fire safety code requires commercial establishments to have a front and back exit plus a sprinkler system: having a front and back exit meets the exits requirement, but an establishment would not meet the fire code standard unless it also had a sprinkler system.

Still, I doubt you can win this argument with the BoE. You’re relying on logic and they rely on argument by assertion. And since they make the rules, like Humpty Dumpty they can make any rule to mean “just what [they] choose it to mean.” [See End Note 3]

Basil’s analogy with a fire safety code is spot on, ditto the Humpty Dumpty – and we all know what happened to him. The Bank’s interpretation of its own document is like Humpty himself, scrambled.

To give another view on the matter, on p. 24 of his authoritative book on the Basel III system, Safe to Fail: How Resolution will Revolutionise Banking (Palgrave Macmillan, 2014) Thomas F. Huertas states that

Strictly speaking, the capital conservation buffer does not constitute a minimum capital requirement.

At first sight, this statement might seem to support the Bank’s position, if read alone and out of context. But now consider the sentence that follows:

Instead, it represents the level at which the bank has to conserve capital by limiting dividends and distributions and by liming bonus payments in cash to management and employees – ample reason in the eyes of many to regard 7 percent as the effective minimum requirement.

Put another way, his view seems to be that “strictly speaking”, the minimum is 4.5%, but “effectively” it is 7%.

Furthermore, after the end of his first sentence there is a flag to a footnote in which it becomes clear that he is not citing the Bank’s ‘framework’ document at all. Instead, he is citing the Basel Committee on Banking Supervision (BCBS) in its original Basel III framework document, “Basel III: A global regulatory framework for more resilient banks and banking systems.” This footnote refers to pp. 54-57 of the Basel III framework document and an example of what it says is the following, which appears on p. 55 of that document:

129. A capital conservation buffer of 2.5%, comprised of Common Equity Tier 1, is established above the regulatory minimum capital requirement.

This language and the use of the term “minimum capital requirement” in the singular suggest that the BCBS might have seen the CCB as something apart from the minimum capital requirement [sic]. This is a one reasonable interpretation of the BCBS document but the underlying ambiguity in that document (e.g., over whether there is one or more minimum capital requirement(s) etc.) is regrettable.

Be this as it may, Huertas’s statements cannot be cited in defence of the Bank of England’s ‘framework’ document as he was referring explicitly to the BCBS ‘framework’ document and he made no reference at all to the Bank of England’s ‘framework’ document. Nor can there be any ambiguity here: Dr. Huertas was crystal clear what he referred to.

So when is a minimum capital requirement not a minimum capital requirement?

The Bank’s answer: a minimum capital requirement is not a minimum capital requirement when the Bank doesn’t use it as the pass standard in its stress tests, even though it promised it would.

I am tempted to say that this is truly Clintonesque hair splitting, but it is not: it is simply wrong.

The credibility of the Bank’s stress tests should be out there unchallengeable and shining bright for all to see, not dependent on a misreading of its own guidance documentation – and a misreading that just happens to underpin the Bank’s preferred narrative that everything is fine with the UK banking system.

If the UK banking system is as strong as the Bank of England maintains, surely the Bank can build a stronger case that this?

Kevin Dowd

February 29 2016

End Notes

End Note 1:

To be precise, with a 7% pass standard, the average surplus over the pass standard is less than 100 basis points, 2 banks fail the test, 2 scrape through by very narrow margins over the pass standard, 2 banks get small margins over the pass standard, and only 1 performs well.

End Note 2:

To clarify, the other components are the Capital Conservation Buffer (CCB), the Counter-Cyclical Capital Buffer (CCyB) and the Globally Systemically Important Banks (G-SIB) Buffer. I believe that to be convincing, these should be set at the maximum plausible levels they might take under fully phased-in (‘fully loaded’) Basel III. (And I am ignoring the new Systemic Risk Buffer announced in December 2015.) However, for present purposes I focus on the CCB as I am only concerned here to make the point that the Bank should never have used 4.5% as the pass standard in its stress tests.  

End Note 3:

For those of you who forgot your Lewis Carroll, "When I use a word," Humpty Dumpty said, in rather a scornful tone, "it means just what I choose it to mean—neither more nor less."

The 2016 Financial Advice Market Review

The Financial Conduct Authority is due to publish their Financial Advice Market Review within two weeks. The FCA took charge of regulating independent financial advisers with a brief, broadly, to get more consumers to have better financial advice at more competitive rates. Unfortunately the FCA’s mindset is regulating large corporations, not sole traders as IFAs are. It is, or should be, a truly competitive market with quality and price determined by informed (and there’s the rub) consumers.

The result was a complicated set of rules. James Cartlidge MP described in the House of Commons (Hansard 1^st February 2016, p.738) his own IFA experience: “We had a famous document called MCOB—the mortgage conduct of business rules—which was the size of a doorstep, and none of which made sense to anybody. I think it is the assumption of the regulator that small practitioners have armies of compliance officers, just like the banks. Of course, nothing could be further from the truth.”

One of the worst new rules is the unbundling of advice from the financial products. Under this, the consumer pays the IFA up front for a lifetime’s advice and then receives the benefits in due course (or not of course). This may seem sensible at first blush but it is like paying Kelloggs for the lifetime value of their expertise to you and then buying cornflakes and Rice Krispies at cost thereafter. Consumers simply do not want to do that.

Cartlidge referred to the consequential claimed “loss of about 13,500 independent financial advisers” (15%). Senior industry figures reckon the use of IFAs has decreased by as much as 47.5% and, of course, the Treasury saw the figure as too low to start with.

Whatever the precise numbers it is clear that the FCA is failing in its mission to make the financial advice market more competitive. By increasing costs and complexity it is driving sole traders out and thereby reducing competition and value for consumers. The FCA cannot point to improvements in the quality of advice and consumers do not like the new charging arrangements. Most would rather muddle along on their own than take professional advice.

The FCA should see IFAs as potentially constructive partners in a joint effort to meet UK financial consumers’ needs, rather than wrong-doers needing to be policed. This would require a reversal of their current attitude. The 2016 FAMR is likely to add Pelion upon Ossa in terms of bureaucracy and cost, compounding the strategic problem.

I hope I am wrong.

It's not that you shouldn't ban cash it's that you can not ban cash

Allister Heath is quite right here, there's those who would ban cash and we shouldn't allow them to get away with it:

The problem is that this will embolden those officials who wish to abolish cash altogether, and switch entirely to electronic and digital money. If savers were forced to keep their money in the bank, the argument goes, then they would be forced to put up with even huge negative rates. They would have no choice - and central banks would be able to engage in monetary easing even in a world of zero or negative inflation. They would not be forced to resort to quantitative easing or “helicopter money”.

The various bansturbators are already greeting the idea with glee: how can people tax evade, save without being seen, conduct themselves as they wish if all money is electronic and recorded? And for the very obvious reasons of liberty and choice we should not allow them to get away with it.

However, that's not the half of it. It's not just that you shouldn't ban cash, it's that you cannot. And people today are making a mistake when they think that they can.

For yes, it is true that money today is fiat money, it's just something that government says is worth x and so we use it as if it is worth x. The assumption is that if the pieces of paper are taken away then we'll be without something worth x to exchange. But that is to believe that governments created money, rather than that we've found that government created money is convenient to us. And historically this simply has not been true, there have been all sorts of variations upon money. Private bank notes were privately created money, the stones of Yap were culturally created money and so on and so on. And if the government declines to issue tokens that can be used in exchange then we'll all come up with something else that we can use. We've even heard that expensive paintings are used in this manner in the illegal drugs trade these days. No one ever intends converting them into cash, they're simply a conveniently high value piece of collateral.

Yes, it's entirely true that fiat money is created by governments, they produce a certain value to it by insisting that we can pay taxes with it. But that's not the definition of money at all.

To approach the point using a subject we care deeply about: beer and pubs. In the US, generally, you go down to the corner bar to meet the guys and you buy your own beer. In Britain you toddle off to meet the chaps and you buy in rounds. In the Czech Republic you buy your own beer but order the shots in rounds. And there's no law, no tax collecting authority, insisting upon the tit for tat of rounds but there's a heck of an amount of social pressure keeping everyone in line. And that buying of the round for round is a financial transaction, it's just one that is not mediated by cash at all, it's mediated by that social pressure.

And we all take part in exactly those sorts of transactions all the time: a promise to do something is a transaction, we make those all the time. The absence of cash as paper would simply expand the areas of life where we use reputation as the currency.

Yes, government created fiat cash money is very useful: and we don't want them to try and ban it for that reason alone. But a ban wouldn't work anyway, as we humans have found the basic idea too useful and every society has come up with some method of keeping tabs on who owes what to whom. That's not going to go away whether we've got notes with a piccie of the Monarch on them or not.

The Bank of England’s Headline Stress Test: An Exercise in Really Weird Accounting

(For the previous blog in this series, see here.) This posting goes through the Bank of England’s headline stress test and explains that the reassuring conclusion that the Bank drew from them – that the UK banking system is in healthy shape – cannot be taken seriously because the Bank set the pass standard way too low. On the other hand, if we repeat the Bank’s stress tests but impose higher minimum capital standards in line with those called for under Basel III we find that the UK banking system is in very poor shape.

In this posting, I will go through the Bank of England’s 2015 headline stress test – the test based on the CET1 ratio – the ratio of CET1 (Common Equity Tier 1) capital to RWAs (Risk-Weighted Assets). The definitions of these terms were explained here.

In this test, the Bank sets its minimum pass standard equal to 4.5%: roughly speaking, a bank passes the test if its capital ratio (as measured by the CET1 ratio) post the stress scenario is at least 4.5% and it fails the stress test otherwise.

The outcomes for the 7 banks involved – Barclays plc, HSBC Holdings plc, Lloyds Banking Group plc, the Nationwide Building Society, the Royal Bank of Scotland Group plc, Santander UK plc and Standard Chartered plc - are given in Chart 1:

Chart 1: Stress Test Outcomes for the CET1 Ratio with a 4.5% Pass Standard

Notes to Chart 1 at end

By this test, the UK banking system might look to be in reasonable shape. Every bank passes the test, although one (Standard Chartered) does so by a slim margin of under 100 basis points and another (RBS) does not perform much better. Nonetheless, according to this test, the UK banking system looks broadly healthy overall.

However, the choice of a 4.5% pass standard is odd, because the Bank itself requires that UK banks meet not only the 4.5% minimum but also meet an additional requirement – usually known as a Capital Conservation Buffer (CCB) – of a further 2.5%, making for a minimum of 7%.

If we apply the Bank’s stress test to a 7% pass standard, we then get the outcomes shown in Chart 2:

Chart 2: Stress Test Outcomes for the CET1 Ratio with a 7% Pass Standard

Notes to Chart 2 at end

We now get a rather different picture: two banks (Standard Chartered and RBS) fail the test and two more (Barclays and HSBC) barely pass with surpluses of less than 100 basis points. Only three (Lloyds, Santander and Nationwide) are above the pass standard with room to spare.

As I evaluate the results in Chart 2 using the Bank’s own criteria, I can see two banks that did not remain above international agreed minimum standards and two others that nearly didn’t – that’s 4 banks out of 7.

Furthermore, even the 7% pass standard is less than the minimum required CET1 ratio that will be implemented under Basel III by the end of the stress period, as it ignores two additional components of the total minimum capital requirement that will be in place by then – the Counter-Cyclical Capital Buffer and the Global Systemically Important Banks (G-SIBs) Buffer. The first of these is an additional buffer meant to counter cyclical factors and is set at the discretion of the Financial Policy Committee (FPC); it is current set at 0% but can be set as high as 2.5% under the Basel III rules. The second is an additional buffer applied to institutions that the FPC deems to be globally systemically important: the values of these buffers were announced in February 2015: 2% for Barclays, 2.5% for HSBC, 1.5% for RBS and 1% for Standard Chartered. These additional buffers will all be implemented as additional capital requirements by the start of 2019.

It would therefore be prudent to include these components in the pass standard as well, and in so doing, to set the Counter-Cyclical Capital Buffer to its maximum possible value of 2.5%.

Chart 3 shows the outcomes if we apply these more stringent capital requirements as the pass standard in the stress test:

Chart 3: Stress Test Outcomes for the CET1 Ratio with the Potential Maximum Basel III Pass Standard

Notes to Chart 3 at end

In this case, no less than four banks (Standard Chartered, RBS, Barclays and HSBC) are clear failures with outcomes well below the pass standard aka the maximum possible required CET1 ratio under fully-implemented Basel III. Lloyds is exactly equal on the pass standard, Santander is only a tiny bit over it and only Nationwide is comfortably above. Overall, the banking system clearly fails the stress test exam – and this despite the fact that the stress scenario was a mild one!

Pulling all these results together. The UK banking system passes the stress test exam if we take the Bank’s preferred (low) pass standard of 4.5%, which just happens to conveniently support its preferred narrative that the system is sound. However, the banking system performs far less well if we take a pass standard to be 7% (which was the minimum required CET1 ratio by end-2015), and it unmistakably fails the test if we take the pass standard to be the maximum requirements that could be in place under Basel III by the end of the stress period.

Put another way, even if we blindly accept all the major features of the Bank’s stress tests but the pass standard – if we accept the Bank’s chosen scenario, its use of the CET1 ratio as its capital-adequacy metric, the Bank’s own calculations etc. – and merely alter the pass standard to come into line with what the minimum capital requirement might plausibly be under Basel III by the end of the stress period, itself hardly a demanding standard – then we get a very different outcome to the one portrayed by the Bank: the UK banking system would then revealed to be massively capital-inadequate.

At the risk of belabouring the obvious, there are two further points about the Bank’s credibility that cry out from these results:

First, if the outcome of the stress test happens to depend critically on the choice of pass standard, then the outcome of the Bank’s stress test is not robust and therefore neither reliable nor credible – and this is especially so if the Bank’s preferred pass standard happens to coincide with its own self-interest which is to reassure us that the banking system is sound.

Second, the plausibility of the Bank’s view that the UK banking system is in good shape should not be contingent on such finer issues as whether the pass standard should be 4.5% (i.e., the pass standard implemented by the Bank) or higher (e.g., the pass standard promised by the Bank): if the UK banking system really were in good shape, this resilience should come through in all the tests, not just the least demanding test that happens to be the one that the Bank prefers. Moreover, for the test to be credible, the pass standard should be as high as is reasonably plausible. Conversely, for the Bank even to be suspected of applying the minimum pass standard they think they can get away with – when higher pass standards would give more negative outcomes – is to undermine the credibility of the whole exercise. The Bank’s stress tests need to be above suspicion if they are to be convincing.

If you don’t find this argument convincing, consider the medical analogy. A doctor is performing a medical check-up on a patient. He has a choice of tests to conduct: Test 1 has weak power to detect a particular problem, Test 2 has more power and Test 3 is more powerful still. By Test 1 there is no sign of any problem, by Test 2 there are hints that there could be a problem and hence a need to follow up, and by Test 3 the patient is clearly poorly. However, Test 1 is so weak that the doctor is not allowed to use it; instead, the weakest test he is allowed to use is Test 2, and the best practice advice among medical practitioners is to use Test 3 or something even stronger.

So what does the doctor do?

He tells the patient the results of test 1 and the patient thinks she is fine.

In the next blog, I will examine stress tests based on the more reliable leverage ratio as a capital adequacy metric.

Notes to Charts

Notes to Chart 1

(a) The pass standard is the bare minimum requirement (4.5%), expressed in terms of the CET1 ratio - the ratio of Common Equity Tier 1 capital to Risk-Weighted Assets.

(b) The outcome is expressed in terms of the CET1 ratio post the stress scenario and post any resulting management actions. The data are obtained from Annex 1 of the Bank's stress test report (Bank of England, December 2015).

Notes to Chart 2

(a) The pass standard is the sum of the bare minimum requirement (4.5%) and the Capital Conservation Buffer (2.5%), both expressed in terms of the CET1 ratio - the ratio of Common Equity Tier 1 capital to Risk-Weighted Assets.

(b) The outcome is expressed in terms of the CET1 ratio post the stress scenario and post any resulting management actions. The data are obtained from Annex 1 of the Bank's stress test report (Bank of England, December 2015).

Notes to Chart 3

(a) The pass standard is the sum of the bare minimum requirement (4.5%), the Capital Conservation Buffer (2.5%), the maximum Counter-Cyclical Capital Buffer (2.5%) and the Global Systemically Important Banks Buffer, which varies across the banks. These percentages are expressed in terms of the CET1 ratio - the ratio of Common Equity Tier 1 capital to Risk-Weighted Assets.

(b) The outcome is expressed in terms of the CET1 ratio post the stress scenario and post any resulting management actions. The data are obtained from Annex 1 of the Bank's stress test report (Bank of England, December 2015).

An Introduction to the Bank of England’s Stress Tests

This posting provides an introduction to the Bank of England’s recent stress tests on the UK banking system. It suggests that a stress test can be compared to a school exam: there is the exam paper or stress scenario and there is the performance of the candidate against a pass standard to determine whether the candidate passes or fails. More precisely, with a mild stress scenario, a highly gameable capital-adequacy metric to assess performance and a very low pass standard, the Bank’s stress tests can be compared to an exam that is extremely easy to pass. This bias towards a ‘pass’ result undermines the credibility of the entire exercise. (For the previous blog in this series, see here.)

The purpose of central bank stress testing is to assess the banking system’s capital adequacy, i.e., the ability of banks to withstand financial stress. A stress test has three key components:

• An assumed adverse stress scenario – essentially a guess scenario generated by modellers at the central bank.
• A metric to gauge the strength of each bank. This metric is the bank’s capital ratio – the ratio of ‘core’ capital to some measure of the total amount ‘at risk’ - the intuition being that core capital provides a buffer to absorb potential losses and keep the bank solvent in a crisis.
• A pass standard by which we determine whether the post-stress value of the capital ratio is (or is not) high enough to merit a pass mark in the test.

There is a natural analogy here with a school exam, the purpose of which is to assess a student’s academic strength. It too has three key components:

• There is an exam paper based on a set of questions, and underlying this, the issue of how easy or tough the exam paper might be. The easiness/toughness of an exam paper is comparable to the severity (or otherwise) of a central bank’s stress scenario.
• There is the performance of the candidate in the exam, i.e., the mark they receive.
• There is the pass standard, i.e., the minimum mark that a student must achieve in order to pass the exam.

We then draw our conclusions. For example, if we had an easy set of questions and a low pass standard and the student achieved a low mark, then we shouldn’t conclude that the student is academically strong.

Similarly, if we had a stress test with a mild stress scenario, a low pass standard and generally low post-stress capital ratios – all of which are in fact the case with the Bank’s stress tests – then we shouldn’t conclude that the banks are financially strong.

Yet this is exactly the conclusion that the Bank draws from its stress tests.

We should also say a little more on the capital-adequacy metrics and the pass standard.

To evaluate a bank’s capital adequacy, we need estimates of both the numerator (core capital) and the denominator (the total amount ‘at risk’).

By core capital, we mean the capital available to support the bank in the heat of a crisis. However, there are a number of different core capital measures available and some are more reliable than others. Their reliability is in inverse proportion to their broadness: the broader the capital measure, the more ‘soft’ capital it includes and the less reliable it is. The narrowest and best is Common Equity Tier 1 (CET1), which approximates to tangible common equity (TCE) capital plus retained earnings. In this context, the ‘tangible’ in TCE means that it excludes ‘soft’ items such as goodwill and other intangibles that cannot be deployed to help it weather a crisis, and ‘common’ means that it excludes more senior capital items like preferred shares and hybrid capital. However, in its stress tests, the Bank also uses a broader definition of capital known as Tier 1 capital; this is equal to CET1 plus some additional and therefore softer hybrid items.

As with any exam, a major concern is cheating – or ‘gaming’ to use the more polite language used in this area. In the case of the capital measure, the concern is with banks’ ability to exploit loopholes (e.g., by stuffing softer and less expensive-to-issue capital items into the core capital measures approved by regulators) and, of course, with their lobbying to create such loopholes in the first place.

Then there is the denominator, the total amount ‘at risk’. Traditionally, this was taken to be the total assets of the bank. However, for many years now the on-balance-sheet amounts at risk have been dwarfed by the amounts at risk off the balance sheet in securitizations, contingent liabilities, derivatives etc. These off-balance-sheet risks have long since made the total assets measure highly inadequate.

To make matters worse, the exposure measure long favoured by the Basel system is not total assets, which would be bad enough, but so-called ‘Risk Weighted Assets’. We can think of RWAs as a game to lower the ‘at risk’ numbers in order to get lower capital requirements. In this particular game, every asset is given a fixed arbitrary ‘risk weight’ of between 0% and 100%. So, example, the debt of OECD governments would be given a zero risk weight on the presumption that it is riskless – that’s right, Greek debt is considered riskless! - whereas commercial debt would be given the full risk weight of 100%.

The result is to create artificially low ‘Risk Weighted Asset’ measures that are much lower than total assets. To give an idea, latest available data for the UK banks that participated in the stress test show that their average ratio of RWA to total assets was a mere 33%, which means that on average across the system, two thirds of bank assets are deemed by this measure to have no risk at all! And one institution – the Nationwide - had a RWA to total assets ratio of just under 18%, meaning that no less than 82% of its assets were deemed to be entirely risk-free. So either these banks have indeed taken very low risks or they are just very good at playing the risk-weighting game. The evidence suggests the latter.

Going further, this RWA system is tailor-made for gaming: you load up on zero-weighted assets and you are rewarded with a lower capital requirement because you are deemed to have low risk. In limit, you could load up entirely on zero-weighted assets: you would then be deemed to have zero risk and incur a zero capital requirement. If we look at the data, we see that average risk weights across the big banks have trended down from about 70% in 1993 to a little below 40% by 2011. If this trend continues, then the average risk weight should hit zero by 2034 and every single risk in the banking system would be invisible to the risk-weighted measurement system.

There is also abundant evidence – most notably that provided in a widely cited paper published by the Bank of England itself [1] – to suggest that the RWA measure is so poor that it actually gives a contrarian indicator of risk, i.e., that a fall in RWAs indicates rising risk!

Part of the explanation is that banks were loading up on assets with low RWAs to reduce their capital requirements.

Even more worrying is that banks were also engaging in vast derivative and securitization transactions to move assets from high to low weight classifications to reduce their capital requirements even further. Indeed, this game even had a name – Risk-Weight ‘Optimisation’ (RWO) – and RWO really means risk-weight minimisation.

And this RWO that almost no-one has ever heard of was the main driving force behind the enormous growth in derivatives trading and securitization in the years running up to the Global Financial Crisis (GFC) – and in so far as it led to (much) greater risk taking and (enormous) capital depletion it was also a major contributing factor to the GFC as well. [2]

Thus, a low RWA does not indicate low risk; instead, it indicates RWO: it suggests that the banks concerned are taking more risks, but are better at hiding them from the risk measurement system.

To help deal with these problems, the Basel III international bank capital adequacy regime introduces a new measure of the amount at risk known as the ‘leverage exposure’. This measure makes a half-hearted attempt to incorporate some of the off-balance-sheet risks that do not appear in the total assets measure. However, the adoption of this new measure was subject to the usual bank lobbying and one must have serious doubts about it. Nonetheless, if we rule out the RWA measure, then we are stuck with a choice between total assets and the Basel III-based Bank of England version of leverage exposure as the only exposure measures available to work with.

With both the capital and exposure measures, we should also be concerned with the mischief that arises from highly gameable accounting rules. Examples include the abuse of hedge accounting rules to hide risks, and the abuse of International Financial Reporting Standards (IFRS) accounting rules to create illusory capital, which makes banks appear more capitalised than they really are, and to create fake profits, which can then be siphoned off as bonuses to the bankers who created them and in the process decapitalise the banking system. [3]

Returning to our main theme, the Bank uses two different capital-adequacy ratios in its stress tests:

• The first is the ratio of CET1 capital to RWA – the so-called ‘CET1 ratio’ – and it is the tests based on this ratio that the Bank always highlights in its headline commentary on the stress tests.
• The second is a supplementary capital ratio (the so-called ‘leverage ratio’), the ratio of Tier 1 capital to leverage exposure.

Neither of these ratios is entirely satisfactory: the first because it uses the worse than useless Really Weird Assets measure, and the second because it uses a softer capital measure (i.e., Tier 1 instead of CET1). However, notwithstanding this latter weakness and one’s doubts about the leverage exposure measure in its denominator, the leverage ratio provides a much better metric of capital adequacy than the ratio of CET1 capital to RWAs, precisely because it is not dependent on the fatal flaws in the latter.

It was therefore unfortunate that the Bank of England chose to focus on stress test results using the CET1/RWA ratio rather than the leverage ratio.

Then there is the question of choosing a suitable pass standard.

One approach is to choose a pass standard that reflects the minimum regulatory capital standards imposed on banks – most obviously, the standards imposed under Basel III. Indeed, the Bank itself suggested pass standards of at least Basel III quality. As it explained in the October 2013 Discussion Paper setting out the stress testing framework:

A key consideration [in setting the pass standard] will be the minimum level of capital required by internationally agreed standards. Banks need to maintain sufficient capital resources to be able to absorb losses in the stress scenario and remain above these minimum requirements.

The document then notes that under the Prudential Regulation Authority’s proposed implementation of CRD IV, the EU Directive on capital regulation, there is a minimum CET1 [to RWA] requirement of 4.5%, and it observes a little later that “CRD IV [also] requires banks to have at least a 2.5 percentage point buffer of capital above the 4.5% minimum.” [4] Note the word “required” here.

In short, the Bank suggests that the hurdle rate/pass standard should be at least as high as internationally agreed minimum required capital standards [read: Basel III] and it acknowledges that this minimum required standard is at least as high as 7%.

But for reasons best known to itself, the Bank then chose a pass standard that fell below these minimum standards: it set the pass standard at 4.5%.

A cynic might suggest that the Bank chose a mild ‘stress’ scenario, focused on a very ‘soft’ and highly gameable capital adequacy metric (the CET1/RWA ratio) and chose a very low pass standard to engineer an undeserved ‘pass’ result for the UK banking system.

I am not suggesting that the Bank actually did this, but the Bank’s stress tests could be construed that way.

And this is a big shame, because it undermines the credibility of the whole exercise – the Bank of England failed its own stress test.

In the next posting, I will start to examine the stress tests in more detail.

References

[1] See A. G. Haldane, “Constraining discretion in bank regulation,” April 9, 2013, p. 15, chart 2.

[2] See G. Kerr, “How to destroy the British banking system – regulatory arbitrage via ‘pig on pork’ derivatives,” The Cobden Centre, January 21, 2010.

[3] For more on these problems with IFRS accounting standards see T. Bush “UK and Irish Banks Capital Losses – Post Mortem,” Local Authority Pension Fund Forum, 2011, and G. Kerr, “The Law of Opposites: Illusory Profits in the Financial Sector”, Adam Smith Institute, 2011.

[4] Bank of England, “A framework for stress testing the UK banking system,” (October 2013), p. 28.

New paper: Sound Money: an Austrian proposal for free banking, NGDP targets, and OMO reforms

Our new paper on nominal GDP targeting is out now. Below is part of the press release we sent to the media; for the full press release, click here. To read the whole paper, click here. The Bank of England should abolish the Monetary Policy Committee, use Quantitative Easing instead of interest rates to conduct normal monetary policy, and switch from an inflation target to targeting the total amount of nominal spending in the economy, also known as nominal GDP, argues a new paper from the Adam Smith Institute released today.

The Bank should prefer a rules-based system like this to the discretionary system it currently uses but, the paper argues, it should ultimately look toward ending monetary intervention altogether. The UK’s monetary regime should eventually aim towards the ‘free banking’ systems that brought financial stability to 18th and 19th century Scotland and elsewhere.

The paper, Sound Money: an Austrian proposal for free banking, NGDP targets, and OMO reforms, is a comprehensive critique of the flaws in the way the Bank of England currently does monetary policy and offers a superior means of achieving their goals of macroeconomic stability.

Quantitative easing should be extended to the market generally rather than being an interaction with a few preferred dealers, so as to minimise distortions caused by buying from select financial institutions, it says. It should be made open-ended, with the purpose of stabilising the growth path of nominal GDP—the total amount of spending in the economy—letting the market determine how much of that nominal GDP is real output and how much is inflation.

Author of the report, Prof Anthony J Evans, concludes that, after a century of failure, it may even be time to strip central banks of their powers over monetary policy entirely entirely, and let private banks issue their own notes.

The paper takes inspiration from the free banking systems of the 19th century, especially those in Switzerland and Scotland, but also from the monetary economics of Nobel Prizewinners Milton Friedman and Friedrich Hayek, who both argued that central bank discretion tends to push the economy away from rather than towards stabilisation.

Friedman showed how the central bank’s unwillingness to accommodate massive spikes in money demand in the late 1920s and early 1930s led to the US Great Depression—and how industrial production rocketed at the fastest pace in history when Franklin Delano Roosevelt raised the money supply to meet market demand by going off gold in 1933. This has played out again in the recent financial crisis, where a free banking system would have seen less fanning of the pre-crisis flames and more water afterwards—tighter policy in the run up and easier policy during and following the crash.

Stress Testing without the Stress – the Bank of England’s Stress Tests

This is the first of a series of postings on the Bank of England’s 2015 stress tests of the financial strength of the UK banking system, which concluded that the banking system is able to withstand a severe stress scenario and still function well. It turns out that the stress scenario – often described in the press as a ‘doomsday’ scenario – is surprisingly mild. And because of this, we cannot conclude that the UK banking system is strong enough to withstand a severe stress scenario. To make matters worse, the much vaunted rebuilding of the UK banks’ balance sheets didn’t happen either and UK banks may be as vulnerable now as they were in 2007.

On December 1 last year, the Bank of England released the results of its second round of annual stress tests of the capital adequacy or financial strength of the UK banking system. This exercise is supposed to be a financial health check for the major UK banks – it tests their ability to withstand a severe adverse shock and still come out in good financial shape.

The stress tests covered six major banks and one building society – Barclays, HSBC, Lloyds Banking Group, the Nationwide Building Society, The Royal Bank of Scotland Group, Santander UK and Standard Chartered. Between them these institutions account for over 80% of lending to the UK economy.

The stress tests were billed as severe and the press would commonly label the stress scenario as a ‘doomsday’ one. Here are some of the headlines:

“Bank of England stress tests to include feared global crash”

“Bank of England puts global recession at heart of doomsday scenario”

“Stress tests: the Bank of England’s doomsday scenario”

“Banks brace for new doomsday tests”

All this is pretty scary, but fortunately there was a happy ending: there are one or two small problems but on the whole, the banks come out smelling of roses:

“UK banks pass stress tests as Britain's "post-crisis period" ends”

“Bank of England signals end of the financial crisis era”

“Bank shares rise after Bank of England stress tests”

“Bank of England’s Carney says UK banks’ job almost done on capital”

Phew! The Bank of England put the UK banks through a daunting stress test but the banks came out in good shape and we can sleep safely in our beds.

Going further, at the press conference announcing the stress test results Bank of England Governor Mark Carney couldn’t have been more reassuring:

UK banks are now significantly more resilient than before the global financial crisis.

This year’s test complements last year’s effort. It is focused on an emerging market stress that prompts reassessments of global prospects and asset prices; considers the implications of deflation not inflation; and places greater emphasis on exposures to corporates rather than households. It also includes an unrelated but important stress of costs for known misconduct risks.

The stress test results, taken together with banks’ capital plans, indicate that the UK banking system would have the capacity to continue to lend to the real economy even under such a severe scenario.

They testify to the value of the reforms that have rebuilt capital and confidence in the UK banking system.[1]

The key point to take is that this [UK banking] system has built capital steadily since the crisis. It's within sight of [its] resting point, of what the judgement of the FPC is, how much capital the system needs. And that resting point - we're on a transition path to 2019, and we would really like to underscore the point that a lot has been done, this is a resilient system, you see it through the stress tests.[2]

The message was that there would be no more major increases in capital requirements and we were now at the end of the post-financial crisis era.

Well, it’s a great story Mark, but it just ain’t so.

Let’s go back to the stress scenario. This single scenario envisages a hypothetical global downturn emanating from China: economic growth there falls from just under 7.5% to 1.7%, and trigger a Chinese/Hong Kong house price crash. Financial markets freeze up, some trading counterparties fail, emerging currencies slide against the dollar, the UK and the Eurozone go into recession and the oil price tumbles. Plus various other bits and pieces including the misconduct issues that Governor Carney mentioned in his remarks at the press conference.

But how severely would this scenario impact the UK?

The answer is surprising.

Consider the main variables hitting the UK banking system as the scenario takes its course:

• Bank Rate is projected to fall from 0.5% at the end of 2014 to 0% in 2015Q3 and then stay there. CPI inflation is projected to fall from 0.1% at the end of 2014 to bottom out at -0.9% in 2015Q1 and then recover to 0.5% by end-2019.
• Annualised real GDP growth rate falls from 0.6% at the end of 2014 to bottom out at -1% in 205Q4 and recover to 0.9% by end-2019.
• Unemployment falls from 5.7% at the end of 2014 to peak at 9.2% in mid-2017 and then fall back to 7.2% by end-2019. UK residential and commercial property prices fall by 20% and 35% respectively.
• Bank lending expands by 9%: this looks odd for an adverse scenario, especially given the long contraction in bank lending post-2007.
• Impairments on lending to UK businesses remain modest.
• Bank pre-tax losses of £37 billion: this compares to UK bank losses of at least £98.4 billion over 2007-2010, and which wiped out at least 185% of banks’ capital.[3]
• The Vix financial market volatility index – often called the ‘fear index’ – is projected to rise from just over 20% at the end of 2014 to peak at 46% in 2015 before falling back. This compares to its 2008 peak of just short of 70%.[4] Annualised world GDP growth dips to -0.7% before recovering, compared to its fall to -2% in the Global Financial Crisis.

The rise in the unemployment rate and the falls in UK property prices are on the moderately severely side but are still lower than what we have witnessed in other countries in the EU since the onset of the Global Financial Crisis. For their part, the other projections in the Bank’s adverse scenario range from mildly adverse to highly optimistic. Not exactly doomsday.

The banks’ projected reaction to this scenario is also on the mild side. The capital ratio that the Bank prefers to cite when discussing the stress tests, CET1 capital divided by Risk-Weighted Assets, falls on average by 3.6 percentage points from 11.2% at end-2014 to 7.6% by end-2016; its secondary stress test capital ratio, roughly speaking, the ratio of capital to total assets, falls on average from 4.4% to 3.5% over the same period; and the CET1 capital measure falls by £55.5 billion from £298.1 billion to £242.6 billion.

In short, the Bank’s stress scenario is not particularly stressful.

But if this is so, then how do we know that the UK banking system is strong enough to withstand a severe stress test?

We don’t.

The Bank’s confidence that the banking system is sufficiently “capitalised to support the real economy in a global stress scenario which adversely impacts the United Kingdom” may be a touch premature.

The banking system might be able to withstand a mildly adverse scenario, but we cannot extrapolate from any such conclusion to infer with any confidence that the banking system can withstand a more adverse scenario.

If the stress tests can’t be relied upon, let’s turn to a different test that we can rely upon – the inter-ocular trauma test more popularly known as a reality check: just look at the data and see what they say

Well, there is the good news and the bad news.

The good news is that by the capital-adequacy measure that the Bank cites most - the ratio of Tier 1 capital to RWAs – the banks are getting stronger. By end-September 2015, the average value of this ratio across the UK banking system had risen to 13%.[5] An alternative capital ratio, the ratio of Common Equity Tier 1 capital to RWAs, had risen to 12% by the same date.[6] Back in 2007, the average ratio of Tier 1 capital to RWAs across the big UK banks was little more than 6%.[7] By this comparison, the Bank of England is entitled to claim that the UK banking system has undergone a major recapitalization.

Moreover, given its view that the optimal Tier 1/RWA ratio is about 13.5% - and about 11% if certain risk measurement improvements are made - then the Bank could also rightly say that the job of recapitalizing the banking system is nearly done: only another 50 basis points to go.

But before getting the champagne out, we should pause to note that there are several rather big ‘ifs’ in there.

One relates to the Bank’s confidence that the optimal Tier 1/RWA ratio is about 11% post the risk measurement improvements they have called for. A few years ago the experts – the Basel Committee (including Bank of Canada Governor Mark Carney) and the Vickers Committee – were telling us that the optimal ratio was 18%. Now the experts – including Bank of England Governor Mark Carney – are telling us that the optimal ratio has gone all the way down to 11%. So one wonders whether they were right then or right now. Personally, I don’t believe they were right then or right now: I don’t believe any of it, and this is in large part because I have no confidence whatever in the RWA measure on which these recommendations are based.

Why the Bank relies on this measure I don’t know: a brilliant analysis by its own (now) chief economist in 2013 elegantly destroyed whatever credibility the RWA measure might once have had. Comparing the average leverage and average RWAs of the big global banks in the run-up to the crisis, Andy Haldane sardonically observed that as the crisis approached,“ the risk traffic lights were flashing bright red for leverage [whilst] for risk weights they were signaling ever deeper green.” Thus, RWA really means Really Weird Assets and the inescapable implication is that RWA-based capital ratios should not be touched with a barge pole.

So the bad news is that the capital ratios based on an RWA denominator tell us nothing useful about the banks’ real capital strength – except, perhaps, to signal that a higher ratio of capital to RWAs might perversely indicate a weaker bank.

A basic principle of good scientific methodology is that measures of the things we measure should actually measure the things that we think they measure.

We therefore need to reject RWA-based measures as nonsense and go back to old-fashioned ratios of true capital to un-risk-weighted assets. According to data from the Bank itself:

• The UK banks’ average leverage ratio (as judged by the ratio of equity to total assets) in 2007 was about 4.3%.[8]
• By end-September 2015, the average leverage ratio was 4.6% if we go by the ratio of Tier 1 capital to leverage exposure, and 4.2% if we go by the more reliable ratio of CET1 capital to leverage exposure.[9]

To pull all this together, the Bank’s stress tests have no real stress in them and the recapitalisation of the UK banking system didn’t happen.

The core metrics indicate that UK banks may be just as weak now as they were in 2007 – and maybe more so.

In the following postings, I will further explore the Bank’s stress tests and suggest additional reasons why the Bank’s confidence in them might be premature.

Sneak preview: even if we accept every single feature of the Bank’s stress tests – and we shouldn’t – the banking system only just passes the tests. Adversely stress the slightest feature and one or more or all of the banks fail the test. This has got to make you wonder…

References:

[1] Financial Stability Report Press Conference, 1st December 2015, ”Opening remarks by the Governor,” p. 1

[2]  Bank of England Financial Stability Report Q&A, 1st December 2015, p. 11.

[3] Local Authority Pension Fund Forum, “UK and Irish banks capital losses – post mortem,” September 2011, p. 3.

[4]  https://uk.finance.yahoo.com/q/bc?s=%5EVIX&t=my. Accessed December 20 2015.

[5]  Bank of England, “Financial Stability Report,” December 2015, Issue No. 38, p. 9.

[6]  Bank of England, “Financial Stability Report,” December 2015, Issue No. 38, chart B.1.

[7]  Bank of England, “Financial Stability Report,” December 2015, Issue No. 38, chart B.1.

[8] Bank of England Financial Stability Report June 2010, p. 44, chart 4.1. This chart shows that in 2007 banks’ average ratios of assets to equity was about 23. This makes for a leverage of 1/23 or approximately 4.3%.

[9] Data assembled from Annex 1 of the Bank of England’s 2015 stress test report.