When the Bank of England announced the results of the annual stress tests for the British banking sector this month, officials were surprised that they could not bring the press corps into their inner chambers in Threadneedle Street due to Covid-19 restrictions.
But the drama of the annual announcement has already waned in the seven years since the central bank began annually testing testers’ ability to resist Armageddon.
Gone are the days when investors anxiously waited to discover which bank would be asked to raise extra capital or limit dividends to align their balance sheets. The last failure in a BoE stress test was in 2016, when the nationalized Royal Bank of Scotland was ordered to revises its capital plan.
The more high-octane days of stress testing are even further back. In the 2010-11 Irish exercises, the whole country held its breath to discover the size of the hole in its banks’ balance sheets, only to find out it was so gaping that Ireland would have to take an EU-IMF lifeline to to stop it. . Banks in some parts of mainland Europe watched the European Central Bank’s first stress tests in late 2014 with similar tremor.
Now we are well into the new normal. Banks almost never fail, leaving the stress testers with a mystery.
“I was bothered by the question, ‘what are these things for when everyone succeeds?’,” Recalls one official involved in the post-crisis stress tests. With each passing year the banks all pass, he questioned how much information the tests actually give central bankers and regulators.
One thing about which world regulators would have welcomed information in the recent past is how banks would fare in a perennial disruptive event such as a pandemic. Stress tests were silent at that point, because a crisis like Covid’s was never among the imagined apocalyptic scenarios against which banks were tested.
Yet an analyst who has been covering these things since their inception says stress tests are still helpful to his clients, though their importance has declined rapidly since the crisis.
The US tests, which directly determine the maximum dividend levels, are the most impactful. The EU version, now overseen by the European Banking Authority, has the least practical reading because the focus is on assessing resilience rather than forcing actions. But the exercise provides valuable standardized data on banks.
In defense of stress tests, officials argue that banks are well-capitalized, in part because they are put off by their steps every year. Banks want to keep their capital at a level that minimizes the chances of a humiliating failure.
Strict stress testing also improves risk management, they add. The Americans have the strongest claim here because the U.S. stress tests include a qualitative element, where the Federal Reserve examines banks’ internal checks and balances, and requires improvements as needed.
The broader global argument is that the hard numbers part of the stress tests provides useful insights into the risks banks are taking, which could lead to better choices. If it had been in place in the early 2000s, banks would have known how much risk they were running in their subprime books.
Bank insiders agree to that point with that logic. One industry veteran says stress tests are “super helpful” in understanding risks and “a very good tool to have a mature conversation for people who are not quantum nerds”.
But he argues that the complexity of regulatory stress testing can be detrimental to risk management by requiring large resources. This veteran is concerned that his bank’s risk department missed a recent major issue with an upset client because it “has turned into a regulatory and compliance organization, with all of our resources going into regulatory stress tests”.
A stress test practitioner at another bank describes submissions from 1,400 to 1,500 pages. “Stress tests are important. . . but if we are going to do it, let’s do it rationally, ”he said, arguing that the complexity of the process was not beneficial.
In the US, banking scenarios form part of the Fed’s annual review. Risk managers say the Fed, bruised after being blinded by the pandemic, is pushing banks to create more extreme scenarios. The endgame is usually an asteroid, at which point the more slippery risk managers point out that if a large rock did fall from the sky, the world would have much bigger problems.
The official involved in creating the early stress tests says the asteroid scenario is nonetheless worth considering. “Then you have to say [to politicians], they can not survive this scenario, do you think they should be able to? ” he said. “The question is how resilient do you actually want the banks to be?”