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Weakest Link in Stress Testing

Posted by Karamjeet Paul on November 6, 2014
Posted in: Regulations, Sustainability Management. Tagged: , , , , , . 1 Comment

European bank-stress-test results were announced last week. The good news: only 13 out of 130 banks didn’t make passing grades. The bad news: this test says nothing about how well or badly these banks may do as going concerns in times of stress.

According to the New York Times, “the European Central Bank said its analysis was intended to strengthen banks’ balance sheets, improve transparency in reporting and persuade investors that these institutions are sound.”

This intent would have some credibility if before 2008 regulators had pointed out the banks that were not sound and then if some of them failed during the crisis. But there were no such judgments implying that no one could tell before the crisis which banks were sound and which were unsound.

Bank failures generally come as a surprise in crises. This is because today’s assessment of the soundness of banks is based upon so many subjective assumptions that it fails to prepare banks for the surprises extreme crises bring. The weakest link in the way current stress testing is done is the assigning of values to assets. In relation to the survival of banks in crises, it is a meaningless exercise. This is because no one knows what value these assets will have during crises. What compounds this problem is that such values-in-crisis are assigned during normal times when it is hard to envision a crisis environment.

In a conversation a couple of years ago, a senior risk manager at a large financial institution said that no one had foreseen before 2008 that the value of some the mortgage-related assets would be down by 10-15%. Everyone thought, he said, that a 5% loss would be the maximum deterioration. Actual loss turned out to be more than 20%.

So today’s stress testing is designed with the last crisis in mind. Actual results may turn out to be not as bad as assumed in such testing in some areas considered critical, but some other surprise that no one had thought of may doom institutions.

There is a better way to make stress testing useful to both regulators and institutions. (See “What Stress Testing is Not”)

Also, more on how can stress testing can a very useful indispensable tool in the next blog.

The Current Approach to Management of Risk Will Always Fall Short

Posted by Karamjeet Paul on October 22, 2014
Posted in: Extreme-Tail Risk, Regulations. Tagged: , , , , . 1 Comment

Yesterday’s Wall Street Journal carried a story: “Fed Tells Banks to Shape Up or Break Up.”. Even though the story does not specifically talk about the financial risk, it implies that banks are not doing enough to address regulators’ concerns. And addressing risk has been a significant concern since 2008. So if you combine it with their concerns that bank models almost always understate their capital requirements, it leads to a lack of trust and confidence, and may be even to mistrust.

Even if banks do all they can, there will always be a confidence gap because the current approach to managing risk can never cover the entire spectrum of risk. The problem arises because no one knows nor can define how much of the risk spectrum is not covered. And as long as there is an uncovered portion of the spectrum, banks are vulnerable. Such vulnerabilities will come to light only when the next crisis arises. Combined with the fact that risk models are too complex to follow and understand easily, there is no way to tell if the portion of the spectrum that is addressed has been done correctly or effectively. Thus banks are not only vulnerable but also no one knows how vulnerable, and whether this vulnerability is acceptable. This is the root cause of the confidence gap.

What is needed is a transparent approach that addresses the entire spectrum of risk that can be easily grasped. (See “What Stress Testing is Not”). Until this is addressed, the current approach to risk will always fall short and there will remain a confidence gap.

Financial Reform Has a Risky Blind Spot

Posted by Karamjeet Paul on October 7, 2014
Posted in: Capital, Extreme-Tail Risk, Regulations. Tagged: , , , , , , , , . 1 Comment

By Karamjeet Paul (Published by American Banker/BankThink September 25, 2014)

The financial services industry is often caught in a debate about whether it faces too much regulation or not nearly enough. This is a valid topic of discussion. But it distracts from another, even more critical matter: regulations in the aftermath of the most recent financial crisis have failed to effectively address the root problem that caused so many bank failures.

(Click here to read more …)

The Ugliness of Beautiful Models

Posted by Karamjeet Paul on September 25, 2014
Posted in: Capital, Extreme-Tail Risk. Tagged: , , , , , , , , . Leave a comment

A couple of weeks ago, during the New York Fashion Week, seeing glamorous models at the Lincoln Center Plaza brought to mind the beauty of models. Unfortunately, the conversation at a meeting soon after actually highlighted the ugliness of models.

At that meeting, frustrations were evident that regulators are always complaining that, despite the beauty of their sophistication, bank models underestimate the capital regulators believe is needed to support risk at financial institutions, and thus can lead to ugliness in times of financial crises similar to the crash of 2008.

(Click here to read more …)

Will New Liquidity Requirements Save Banks Next Time Around?

Posted by Karamjeet Paul on September 17, 2014
Posted in: Extreme-Tail Risk, Regulations, Sustainability Management. Tagged: , , , , , , , , , . Leave a comment

By Karamjeet Paul

For the first time in history, regulators are requiring financial institutions to have a specific amount of liquid assets on hand to withstand a 30-day run by creditors and depositors, should a sudden crisis strike again. This is a right step to keep the system from freezing as happened in 2008.

However, will focusing on liquidity prevent what can devastate institutions in crises as experienced by Bear Stearns, Lehman and Wachovia? No, it will not, because institutional liquidity problems in crises are caused by a more fundamental factor.

(Click here to read more …)

Plans to Address Extreme-tail Risk Are More Effective Than a Capital Surcharge

Posted by Karamjeet Paul on September 10, 2014
Posted in: Capital, Regulations. Tagged: , , , , , , , , . Leave a comment

The big news this week is that large banks will be required to have a higher level of capital in the form of a surcharge amount of capital.

The Wall Street Journal reported on September 9, 2014 (“Fed to Hit Bog Banks With Stiffer Surcharge”) that the new requirements are “aimed at reducing the risk …” and the required increase in capital would be “calibrated to the relative riskiness of the bank as measured by a series of factors.”

Large banks, or may be most banks, may very well need more capital. But this need for capital has not been tied directly to what causes the need for capital in the first place. Some of these “series of factors” aren’t necessarily a measure of what creates the capital requirement.

Capital is needed to cushion unexpected losses arising from extreme-tail risk, which carries the exposure that can result in devastations in extreme crisis. Therefore, the amount of the capital need should be driven by an explicit measure of extreme-tail risk. Unless an objective and transparent measure of extreme risk is used, proposals often lead to the use of factors that are not necessarily connected to extreme risk.

An example, as reported by the WSJ: “One new wrinkle in the Fed’s plan is to tie the size of the surcharge to a bank’s reliance on short-term financing …” The use of short-term financing creates liquidity risk, which matters in a crisis only if extreme-tail risk is perceived to be excessive. It doesn’t create extreme-tail risk. So a surcharge for this factor will have no bearing to the need for capital to deal with extreme risk in crises.

Unless, extreme-tail risk is addressed explicitly, a higher amount of capital will not accomplish what the Fed is trying to do. According to William Coen, Secretary General of the Basel Committee on Banking Supervision, “The answer isn’t simply to say you need another X basis points in capital. Maybe the better response is to require the bank to present a detailed plan on how it’s going to better manage these risks and to make sure the bank sticks to that plan.”

The debate about capital adequacy in the banking industry is not new. Those who have been in the industry long enough know that it has been around for at least 30-40 years. To date, the industry has resisted any change to the status quo, with a result that in the post-2008 world, regulators will define the needed change using subjective measures and opinions backed by the Dodd-Frank Act provisions. Such an approach will actually make banks more vulnerable than stronger in crises.

Lets face it. The status quo, as rationalized currently, is unacceptable. So either the capital requirement has to change or a new rationalization is needed. Rather than fighting or struggling to cope with the regulatory proposal, the industry must proactively come up with an objective approach to capital adequacy rationale that gets to the root of the problem.

I believe the use of an objective and simple measure like “Probable Maximum Loss,” along with an explicit focus on extreme-tail risk, can bring objectivity to this discussion and help make banks and the financial system stronger. As part of the suggestion by Mr. Coen, regulators should insist, and institutions on their own should develop effective plans for extreme-tail risk.

 

Surviving the Next Financial Crisis

Posted by Karamjeet Paul on August 26, 2014
Posted in: Extreme-Tail Risk. Tagged: , , , , , . Leave a comment

Book Review by Lawrence Baxter

Mr. Baxter is the William B. McGuire Professor of the Practice of Law at Duke University where he also directs the Global Financial Markets Center.

“Managing Extreme Financial Risk: Strategies & Tactics for Going Concerns” By Karamjeet Paul (Academic Press, 173 pages, $39.95)

About 30 years ago, many considered banking a mature industry. Revenue growth was sputtering, as the existing pie was being shared with new players such as GE Capital and Fidelity, and higher-credit-quality companies were turning to commercial paper. The era of bank “disintermediation” was moving into high gear.

Then came an unparalleled and fairly-sudden combination of 4 dynamics: (i) quants introduced the ability to model almost every element of financial risk, (ii) an unprecedented leap in the ability to manipulate huge amounts of data allowed quant models to create financial products manageable from desktops, (iii) securitization transformed almost any financial product into a tradable security, and (iv) the transformation wrought by the preceding 3 dynamics opened the way for a vast new world of “innovation,” in which the components of financial products could be stripped and recombined into a highly leveraged, ever more abstract world of structured securities and derivatives. Take away any one of these and the last 25 years would be very different.

This combination, akin to firing solid-rocket boosters from a craft losing altitude, enabled the industry to soar into unimagined new orbits. Capital markets, once competitors, became sources of new revenues. Instead of intermediating liquidity, financial institutions began intermediating risk between sources and users of liquidity, amassing on their books huge amounts of risk that would drive their revenue models.

With so much riding on risk, institutions invested gazillions into risk management. By 2008, risk management was the most sophisticated discipline the industry had ever had. So, why were banks so badly blind-sided?

(Click here to read more …)