Disclaimer: The viewpoints expressed by the author do not necessarily reflect the opinions, viewpoints, and official policies or positions of HSBC.
The Following the 2008 global financial crisis, central banks increasingly began to use stress tests to rebuild strength and confidence in the financial sector as a whole and monitor individual banks within the system. Although stress tests are a powerful tool that allows for a central bank to maintain a sound banking system, they should not be overused as there may be side effects that slow economic growth, restrict access to capital, and hurt financial innovation.
The Recent Financial Crisis
Central banks around the world have used stress tests to rebuild the financial sector and revive the ailing global economy. The U.S. and U.K. in particular have led the way. The U.S. implemented concurrent stress tests of major banks in 2009. The U.K. followed suit in 2014.
The Federal Reserve and the Bank of England have designed annual enterprise-wide, concurrent stress tests of major financial institutions within their economies to determine how much capital it might take to maintain the health of firms and the entire banking systems, keeping them resilient in troubled times. Banks are asked to quantify, in terms of capital impact, what could happen to their businesses and portfolios if the economy suffered a severe economic downturn. In response to the outcome, banks and their senior management must then take actions to ensure that they will remain healthy. Raising capital, restricting dividends and capital buybacks, cutting costs, and exiting businesses are all actions that might be taken to ensure that the requirements of the stress test are met.
The U.S. and U.K. central banking regulators especially have been firm in their determination in imposing stress tests. To date, they have been vindicated – stress tests have worked. The banks have significantly strengthened their capital positions but, just as important, the tests have reassured markets that the system is sound. The U.S. and U.K. financial systems, in trouble during the financial crisis that began in 2008, are once again strong and effective.
So stress tests are a powerful tool for supervisors and central banks. One commentator (Suskind, Ron. Confidence Men. New York: HarperCollins, 2011) noted that one of the most important decisions in the early months of the Obama presidency in 2009 was the decision by the U.S. Treasury to support running the Supervisory Capital Assessment Program stress test. More recently, on the morning of June 24, 2016, in the first few hours after the U.K. Brexit vote, Bank of England Governor Mark Carney assured the British public of the resilience of the financial system to weather volatility resulting from the vote, noting that the Bank of England had stress tested U.K. banks for much worse.
Unintended Consequences
Still, care and caution are needed. Stress tests are, in some respects, a macro-prudential capital allocation tool. Through the design and application of stress tests, central banks may determine the flow of bank credit to the economy and where that credit goes. This affects who gets money and who does not. With this power comes responsibility, and it’s vital that central banks are alert to the risks of five unintended consequences, all of which could lead to an uneven, and some might say inequitable, allocation of credit and capital across the economies and societies in which stress tests are being applied. This comes at a time when the “Global Risks Report 2017,” prepared for the World Economic Forum in Davos, Switzerland, notes that “rising income and wealth disparity and increasing polarization of societies” is one of the major risks faced in the global economy.
First, overly stringent stress tests would require the banks to hold too much capital, restricting credit and economic growth. If such tests had been the norm a decade ago, they might have helped central banks curb the runaway mortgage lending that inflated the housing bubble. But in today’s tough economic climate, this would hamper the global recovery. Potentially, stress tests can lead to capital buffers beyond what is reasonable and necessary for the underlying risks, where the marginal benefits in terms of stability are outweighed by the economic costs. Potentially, this could curtail U.S. and U.K. economic growth and diminish the economic benefits of the Federal Reserve Board and the Bank of England’s quantitative easing programs.
Second, stress tests could also serve to stifle financial innovation – for example, in areas such as risk management but also investment in innovations such as clean power and information technology that have improved our living standards today and created new jobs. By definition, new financial products (and the financing of new real products) have no track record, so the historical data needed for rigorous analysis is lacking. Central banks will likely be harder on new products that can’t be assessed quantitatively, even if such products mitigate risk or produce better real outcomes.
Third, there is the risk that stress tests may evolve into financial protectionism and the misallocation of capital across borders. Most major banks run global operations, and their stress tests rightly consider global economic conditions. But a central bank may naturally be more concerned about conditions overseas, where it has less information and direct influence. So perhaps unconsciously, it may construct stress scenarios in which the global economy is hit by a severe downturn, disproportionately affecting overseas lending. With higher capital requirements against these loans, less foreign lending is a likely outcome, whether or not this is justified by the underlying risks. Indeed, some have said that there is often an inverse relationship between the severity of the stress test parameters and the geographical proximity to the central bank setting the parameters. Countries don’t need to build walls or impose punitive trade tariffs to shape the flow of capital across their borders. Parameters buried within a stress test scenario can have the same effect.
Fourth, banks may take less risk because of stress tests but that does not eliminate those risks. Instead, the risks may move to another, less visible part of the financial system where there are no stress tests and central banks have little influence. Moreover, it may well be the poorer and more vulnerable customers in the portfolios that stress tests tend to push, outside of the regulated financial sector, albeit indirectly through management reactions.
Fifth, while stress tests increase central banks’ authority, it doesn’t make them omniscient, even if a plethora of models and data creates this impression. The modeled approach, applied in a disciplined manner, has value but central bank stress test models may be perceived as being the ultimate black box. As Cathy O’Neil commented in her recent book, Weapons of Math Destruction, the danger is that models and big data can favor particular approaches that are embedded in algorithms, potentially increasing inequality and even threatening democracy. How do we know that such algorithm bias doesn’t exist in stress test processes?
Potential Policy Adjustments
Central bankers must, therefore, be sensitive that the effects that stress tests could have in creating a more uneven allocation of capital across and between economies. That suggests that more transparency about how the tests are conducted, how the results are considered, and how central bankers ensure that tests reflect the broader public interest and policy goals. Legislators may also seek to heighten their oversight of their central banks, probing them on the mechanics of the stress tests, with concerns of uneven outcomes and inequality as a key concern.
In particular, the following policy actions could be specifically considered:
- Stress tests might explicitly refer to micro-prudential outcomes and thresholds, the macro-prudential goals for the financial system and the broader policy goals of government, such as the impact of finance on issues of inequality and opportunity, which can have wider effects on stability.
- Stress test models could be specifically reviewed to establish whether there is a scenario or algorithm framework that represents an unwarranted domestic bias or effective financial protectionism, perhaps with the IMF providing relevant global comparisons to be incorporated into its ongoing Financial Sector Assessment Program.
- Central bank regulators should consider the potential management actions that are driven by stress tests, in particular, to ensure that portfolios of poorer and more vulnerable customers are not being driven outside of the regulated sector.
- In their research programs, central banks could encourage investigation into the role of their policy actions in affecting the allocation of capital to different sectors and actively encourage researchers to consider these issues in the context of stress tests.
- National independent oversight bodies such as the Government Accountability Office (GAO) in the U.S., or the National Audit Office or the Office of Budget Responsibility in the U.K., could extend their oversight programs to the review of stress test programs, looking to ensure that checks and balances are in place so that stress tests support a balanced allocation of credit and capital across the economy and society in the short and longer term. The GAO’s review of the Federal Reserve’s stress testing program in November 2016 provides a template for such a review.
Bank stress tests helped save the global economy from a depression. Central bankers must, however, be sensitive and ensure that, in the stable and resilient system they are seeking to create, there is the capacity to serve all parts of the economy equitably.
Disclaimer: The viewpoints expressed by the author do not necessarily reflect the opinions, viewpoints, and official policies or positions of HSBC.
About the Author:
Alan Smith is Global Head of Risk Strategy & Senior Executive Officer of Group Risk in the Global Risk function at HSBC. He is a member of HSBC’s Global Risk Management Board. He has joint oversight responsibility for Stress Testing globally at HSBC. He is a member of the Audit Committee of the Commonwealth Secretariat, the inter-governmental organization of 53 countries which promotes democracy, rule of law, human rights, good governance, and social and economic development.
