In 2014, the Bank of England commenced a stress testing programme in an effort to test the capital adequacy of major UK-based banks. It concluded that its results demonstrated the resilience of the banking system. No Stress, a report from the Adam Smith Institute, suggests that we should be extremely sceptical of the Bank’s conclusions.
The report is by Kevin Dowd—Senior Fellow of the Adam Smith Institute, professor of finance and economics at Durham University, and author of three books, ten book chapters, and dozens of journal articles on risk modelling—who presents a powerful and rigorous indictment of the Bank’s stress testing programme.
Dowd makes the case that the stress tests are significantly methodologically flawed and worse than useless, giving policymakers unreliable information about the strength of the UK banking system, providing false risk comfort, and creating systemic instability by forcing banks to converge towards the Bank of England’s models.
The Bank of England (BoE) uses just one stress test scenario, which attempts to predict what would happen in the event of a major recession to the UK's major banks: Barclay's, the Co-op, HSBC, Lloyds, Nationwide, RBS, Standard Chartered and Santander. Using just one scenario is extremely limited – an economic downturn can take many forms, and a combination of unemployment, inflation and negative economic growth that was substantially different to the Bank's scenario could hit the banks in a completely different way. The BoE can say that the banks are safe under its scenario, but not that they are safe in general.
The BoE's use of risk-weightings, as opposed to leverage ratios favoured by many international authorities, to calculate banks' assets is extremely questionable. These risk-weightings are easy to game by banks, giving a rosier picture of their health than alternative measures would show. This also distorts the bank's investment strategy.
The BoE's approach forces a standardisation of banks' risk models, effectively putting all the British banks' eggs into one basket. By misleadingly reporting that the financial sector is safe, the BoE's stress test has provided false risk comfort to politicians and consumers.
For these reasons and more, Dowd concludes that we should end regulatory risk modelling and re-establish strong bank governance systems that make decision-makers personally liable for the risks they take. The report is available to download here.[gview file="http://www.old.adamsmith.org/wp-content/uploads/2015/06/No-Stress.pdf"]