Banking

No Stress IV: The flaws in the Bank of England’s 2018 stress tests

A new paper by Kevin Dowd, Professor of Professor of Finance and Economics at Durham University and Senior Fellow at the ASI, explains the inadequacy of the Bank of England’s stress tests and argues that the UK’s banking system is still an accident waiting to happen:

  • The Bank of England has now undertaken five annual concurrent stress tests of the financial health of the UK banking system. Like their successors, the 2018 stress tests continue the Bank’s fine tradition of trying to persuade us that the UK banking system is strong when the evidence suggests otherwise. Their results are wholly lacking in credibility.

  • The stress tests are compromised by:

    • Conflicted objectives,

    • An inadequate number of stress scenarios,

    • Low pass standards,

    • Reliance on unreliable metrics, and

    • Questionable modelling.

  • Their key stressed capital ratios, projected impairment charges, and house price losses are too low to be believable.

  • The results from the stress tests are contradicted by the evidence from banks’ latest balance sheets and market prices, which show that banks are weak now, before any stress, rather than strong after a future stress that is supposedly more severe than the GFC.

  • The continuing weakness of UK banks after a long economic recovery is testimony to the failure of the Bank of England to perform its core function and rebuild the strength of the banking system after the trauma of the crisis.

The Magic Money Tree: The case against Modern Monetary Theory

A new paper by Professor Antony P. Mueller, a German professor of economics who currently teaches in Brazil, unpacks the logic behind Modern Monetary Theory:

  • Modern Monetary Theory (MMT) contends that government can spend without restraint and large deficits and debt don’t matter when the economy is not at full capacity. It asserts that the state, as the issuer of the nation’s currency, cannot go bankrupt because it can just keep creating and printing money; taxation exists not to obtain revenue but to oblige people to use a nation’s currency and control inflation; and that all public expenditure can be financed by debt or creating money.

  • MMT, whose theoretical foundations can be linked to the Marxist economic theories of Michal Kalecki, have come to prominence in recent months because of advocacy by the far-left of the Democratic Party in the United States and some left-wing commentators and campaigners in the United Kingdom.

  • MMT advocacy, particularly in the political sphere, is often driven by Utopian thinking by those who want massive unaffordable public spending programmes.

  • MMT is rejected by most economists. A recent survey by the University of Chicago found that no economic expert thinks that countries that borrow in their own currency need not worry about deficits because they can print money to finance debt. Similarly, none thought that it is possible to fund as much real government spending as you want by creating money.

  • There are a number of serious flaws in MMT:

    • MMT asserts, with limited evidence, that there is substantial unused economic capacity that government spending can activate. However, in practice, when government excessively expands the monetary supply (prints money) the impact is inflationary, if not hyperinflationary - as was the case in the Weimar Republic, Zimbabwe, and today in Venezuela.

    • MMT depends on governments knowing much more than they possibly could and acting more rationally than politics allows. It depends on government knowing precisely the natural rate of unemployment, and therefore when to spend, to stimulate activity, and when to tax, to drain the excessive inflationary impact of creating money. This ignores ignorance.

    • MMT is premised on substantial public employment policies to create economic activity for the unemployed. This policy underestimates the bureaucratic costs and the coordination problems that come with public employment policies. Only autocratic governments would have the means to enforce such policies.

Monetary Policy After The Crash: Lessons Learned

  • Conventional monetary policy has serious flaws and contributed to the 2008 Global Financial Crisis. Since then, emergency monetary policy has been relatively successful but lacks clarity. We should take the opportunity to reform policy such that the same rules apply in good times and bad.
     
  • The Bank of England’s Open Market Operations (OMO) should be reformed to reduce discretion and provide financial markets with greater certainty.
     
  • We should replace the Bank of England’s 2% CPI Inflation target with a nominal income (NGDP) target. Under current policy, the Monetary Policy Committee (MPC) must distinguish between demand shocks and supply shocks. Moving to an NGDP target resolves this problem as nominal income is aggregate demand, reducing the epistemic burden on the MPC.
     
  • Central bank intervention should be restricted purely to managing the money supply.
     
  • Open Market Operations should be as neutral as possible, focusing primarily on gilts. Financial markets should know in advance which margins the Bank of England intends to exploit. For example, if the Bank of England owns more than a certain percentage of gilts of a specified maturity, they then extend asset purchases to a pre-announced basket of investment-grade bonds.
     
  • Monetary policy can buy policymakers time, but it is unable to solve underlying problems of low productivity. The Bank of England cannot raise the Natural Rate of Interest in the long-term, but free market supply-side reforms should be a priority for government.
     
  • Stress tests, designed to measure the ability of banks to withstand market shocks, are complex. This makes them vulnerable to being gamed and it leads to risks that can be felt across the financial system. Prediction markets provide the best chance we have of avoiding future bailouts by boosting market competition and punishing excessive risk taking.

Read the whole paper

No Stress III: The flaws in the bank of England's 2016 stress tests

  • The Bank of England uses its stress tests to reassure the public that the UK banking system is safe. However, the Bank’s reassurances lack credibility and are contradicted by the evidence.

  • Rightly interpreted, the stress tests demonstrate the opposite of what the Bank claims they do: they demonstrate that UK banks are still financially weak and far from resilient. The UK banking system is an accident waiting to happen.

  • The conclusion that UK banks are weak is confirmed by an analysis of their capital positions and is further confirmed by banks’ market values being less than their book values. Low market values indicate problems with the banks that the stress tests did not pick up.

  • The Bank made a number of mistakes in its stress tests. Among these: it relied on book values instead of market values, relied on unreliable metrics such as risk-weighted assets and Tier 1 capital, relief on a single stress scenario and used insufficiently demanding pass standards. The Bank’s stress model also produced implausibly low projected losses and so failed a basic reality check.

  • More generally, the stress tests are based on a series of imprudent judgments that led the Bank to miss obvious problems with UK banks.

  • Regulatory stress testing is a highly imperfect tool with a track record of repeated failure in other countries, is compromised by conflicting objectives and by the Bank’s poor forecasting record. It is also compromised by basic Public Choice economics, i.e., that public agencies act in accordance with their own interest.

  • It also creates invisible systemic risks by pressuring banks to standardise their risk management practices to conform to the Bank’s view of the risks they face.

  • Far from providing a credible assurance that the banking system is safe, the stress tests are worse than useless because they provide false comfort, suggesting that the UK banking system is safe when it is clearly not. In this sense, the stress tests are like a ship’s radar system that cannot detect an iceberg in plain view.

  • The stress test programme is therefore dangerous and should be scrapped.

Read the full paper here.

Killing the cash cow: why Andy Haldane is wrong about demonetisation

In this polemical essay, Prof. Kevin Dowd lays into Bank of England chief economist Andy Haldane's views on demonetisation—abolishing cash.

One of the most significant developments in economic policy in recent years has been a gradually escalating government war against cash. At first sight, one might think that there is nothing too much to worry about: we are merely talking about technocratic issues related to payments technologies and the implementation of monetary policy, and cashless payments systems are already both commonplace and spreading. The reality is rather different: the issues at stake are of profound importance. The abolition of cash threatens to destroy what is left of our privacy and our freedom: we wouldn’t be able to buy a stick of gum without the government knowing about it and giving its approval. The cash abolitionists want total control over your money and what you can do with it. Besides making us all entirely dependent on the whim of the state, banning cash also threatens to cause widespread economic damage and have a devastating impact on the most vulnerable in our society. Quite simply, the government’s war against cash is the state’s war against us.

Read the whole paper here.

No Stress II: the flaws in the Bank of England’s stress testing programme

“No Stress II: the flaws in the Bank of England’s stress testing programme”, challenges the stress tests carried out by the Bank of England to assess the financial resilience of UK banks, and refutes their claim that major UK banks could withstand another big shock.
 
The report's release comes as Europe faces a renewed banking crisis. There is already a major crisis in Italy and mounting concerns about Deutsche Bank, the biggest bank in Europe and recently described by the International Monetary Fund as the most systemically dangerous bank in the world.

Read the paper online here

Sound Money: An Austrian proposal for free banking, NGDP targets, and OMO reforms

Anthony J Evans lays out the first, second and third best policies for monetary reform. He outlines reforms to quantitative easing policy that would reduce the distortions it causes; argues that inflation targeting and the Monetary Policy Committee should be replaced by an automatic nominal GDP target; and ultimately says the Bank of England should be scrapped altogether, replaced with privately-run ‘free banking’.

Read the report.

No Stress: The flaws in the Bank of England’s stress testing programme

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 sees 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, present 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.

For these reasons and more, he 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.

Read the paper.

The Real Problem Was Nominal: The Crash of 2008

Prof. Scott Sumner, who inspired the US programme of QE3 and was dubbed ‘the blogger who saved the US economy’ by The Atlantic, explains how central banks—not bankers—caused the 2007-8 crash. He goes on further, showing how the European Central Bank is repeating the mistakes the Fed and the Bank of England made in the dark days. And he argues that they can solve the slump and prevent future crises with a market-based, rule-based, stability-focused monetary policy of targeting the level of nominal GDP.

Read the report.

Quids In: How sterlingization and free banking could help Scotland flourish

An independent Scotland using the pound outside of a currency union would have a more stable financial system and economy than it has now or than a currency union could provide, argues Sam Bowman. ‘Adaptive sterlingization’ – a combined policy of unilateral use of GBP without a formal currency union and reform of Scottish banking regulations – would reduce risk-taking and increase competition in banking, significantly reducing the prospect of large-scale bank panics and financial crises. The ‘dollarized’ economies of Latin America – Panama, Ecuador and El Salvador – provide strong modern-day evidence that banking systems do better without central lenders of last resort.

Read the report.