There is a increased focus and hope on stress tests announced in recent US Financial Stability plan. The Stress tests will help seperate good banks from bad banks.
Andrew Haldane of Bank of England has written a fantastic paper on risk management and stress tests. Paper has good doses of humor with plenty of insight and history .
History of Stress Management:
To understand the recent failures in risk management, some history is instructive. Prior to the current financial crisis, the previous two low tide marks for the financial system and risk management were the stock market crash of October 1987 and the failure of the hedge fund LTCM in September 1998. Both prompted a sea-change inrisk management practices and technologies.
The October 1987 crash in many respects marked the birth of Value at Risk (VaR) as a key risk management tool in financial firms.
The date of birth of stress-testing is harder to trace. Early mention is made of it in a technical note by RiskMetrics in 1996. But it is clear that stress-testing was given considerable impetus by the failure of LTCM more than a decade after the October 1987 crash.
He says unlike VAR which was develoepd by JP Morgan (read the paper for insights), stress tests was developed mainly by IMF. Under its FSAP, IMF ran a lot of stress tests on financial systems of different economies. He also says how all this focus on risk management in times of Great Moderation (he calls it Golden Decade) was all an eyewash:
With hindsight, this Golden Decade and its aftermath has all the hallmarks of, in Charles Kindleberger’s words, Manias, Panics and Crashes. Enthusiasm about return gave way to hubris and a collective blind eye was turned to the resulting risk. This was a latter-day version of the Hans Christian Andersen fairy-tale, “The Emperor’s New Clothes”. In a classic collective delusion, the Emperor’s new clothes, you will recall, were admired by all. Conferences like this one became catwalks for banks and the authorities alike, parading their new garments through the streets in all their finery. Risk modelling became high fashion for the pointy-heads, haute-couture for the anoraks.
….The past two years have rather changed all that…. This year, stress-testing conferences like this one are more doghouse than catwalk.
He says there were 3 reasons for the failure of stress tests
disaster myopia – In a nutshell, disaster myopia refers to agents’ propensity to underestimate the probability of adverse outcomes, in particular small probability events from the distant past.
network externalities- Any asset portfolio is, in essence, a financial network. So the balance sheet of a large financial institution is a network, with nodes defined by the assets and links defined by the correlations among those assets. The financial system is similarly a network, with nodes defined by the financial institutions and links defined by the financial interconnections between these institutions.
misaligned incentives – Finally, and perhaps most contentiously, incentives and governance. Principal-agent problems crop up in all aspects of economics. But it is questionable whether there is any event in recent history where these agency problems have been exposed so frequently and extensively as during the current financial crisis.
He says a nice anecdote:
And the evidence? A few years ago, ahead of the present crisis, the Bank of England and the FSA commenced a series of seminars with financial firms, exploring their stress-testing practices. The first meeting of that group sticks in my mind. We had asked firms to tell us the sorts of stress which they routinely used for their stress-tests. A quick survey suggested these were very modest stresses. We asked why. Perhaps disaster myopia – disappointing, but perhaps unsurprising? Or network externalities –we understood how difficult these were to capture?
No. There was a much simpler explanation according to one of those present. There was absolutely no incentive for individuals or teams to run severe stress tests and show these to management. First, because if there were such a severe shock, they would very likely lose their bonus and possibly their jobs. Second, because in that event the authorities would have to step-in anyway to save a bank and others suffering a similar plight.
All you can do is on the simple explanation and curse as authorities should have seen this coming.
He then discusses someways to improve stress tests which I found too simplistic and repititive.
setting the stress scenario;
regular evaluation of common stress scenarios;
an assessment of the second-round effects of stress.
translation of results into firms’ liquidity and capital planning
transparency to regulators and financial markets.
The main lesson I could draw out is from the anecdote. Can we have risk managers cry foul when times are good? Most of the ivy league banks had “the risk management practices” but we still had things turn this horrible.
Does risk management really matter? Isn’t it better to instead divert the resources spent on risk management to take an insurance fund suggested by Rajan et al? Can a CEO really empower a risk manager to cry foul, be heard and the view supported? Can we expect a CEO not to encourage a business which leads to steady profits but has fat tail risks (like writing CDS etc)? These are the questions supervisors need to ask. Fancy stress tests will never help till we don’t fix problems of incentives.
Anyways, an excellent paper. Nice read.