In our mechanism, when the CDS price rises above a critical value (indicating that the institution has reached an unacceptable threshold of weakness), the regulator would force the LFI (large financial institution) to issue equity until the CDS price and risk of failure came back down. If the LFI fails to do this within a predetermined period of time, the regulator will take over.
We have been given Quantitative Easing 2 ((QE2)) by the Federal Reserve System in the United States and now we are facing Stress Tests II ((ST2)) to be imposed on banking institutions in the European Union. Will we eventually be facing Financial Reform Act II ((FR2)) that will incorporate the next round of regulatory reforms of the financial system of the United States?
I put this new round of stress tests for banks in the same place I put QE2 and the initial Financial Reform Act of 2010 and Basel III (B3): In the dust bin. For my comments on QE2 see here; for my comments on the Financial Reform Act see here; and for my comments on B3 see here.
Regulators and reformers ((R&R)) just never seem to get it right!
One reason is that they are always fighting the last war. The current popular belief amongst the R&R is that the initial stress tests in Europe did not include tests on liquidity, and this element of the banking structure needs to be examined to get a real view of how much “stress” the banks can take. The R&R intend to correct this omission in the next round of stress tests.
Just two points on this. First, liquidity is a market condition and not something that exists on balance sheets. One cannot look at a balance sheet and determine how liquid markets will be. Duh!
Second, if a bank cannot raise funds in financial markets because it has bad assets, this is a solvency problem and not a liquidity problem. In addition, such banks cannot retain funds from market-savvy customers
Hugo Dixon wrote in the New York Times on Tuesday that the Irish banks, Allied Irish Banks (AIB) and the Bank of Ireland (NYSE:IRE), were “excessively dependent on wholesale money from other banks and big investors.” These monies are very interest rate-sensitive and very sensitive to credit risk. Even though these banks passed the earlier stress tests, when the smell of problems arose, the wholesale money “started to flee.”
However, the problem faced by these banks was not a liquidity problem. The problem arose because the wholesale depositors were concerned over the health of the banks -- and this is a solvency problem.
The situation here is that the R&R can only work with historical data and, consequently, are always behind the times. Their analysis is always static. The movement of the “wholesale money” is current market information and provides a forward looking assessment of the condition of a bank or banks .
What would be desirable would be current information that was “forward looking” and more accessible to the investing public. What would be desirable would be some kind of “forward looking” market information that reflected the viewpoint of market participants that were “betting” their own money.
In a recent post I included a chart that presented market information and was very current. This chart shows information on Credit Default Swap (CDS) spreads on European banks as well as on Spanish banks. One can see that the price of these CDS's began rising in late 2009 in anticipation of the sovereign-debt crisis of 2010, and began rising even more dramatically before the current crisis that Europe is now facing. It seems as if some market indicator like these CDS’s could be used as an early warning signal that trouble is brewing in the financial sector of an economy or in specific banks, setting off further analysis of the institution(s) involved that would be conducted by the regulatory agencies.
Just such a suggestion has been made by Oliver Hart (the Andrew E. Furer Professor of Economics at Harvard University) and Luigi Zingales (the Robert C. McCormack Professor of Entrepreneurship and Finance at the University of Chicago, Booth School of Business). Quoting their article "To Regulate the Finance, Try the Market":
In another article, the authors argue: “The financial crisis of 2008 resulted from a series of misguided policies, failures of regulation, and missed signals. Unfortunately, much of the conversation about regulatory reform since has revolved around ideas that would only extend and exacerbate all three.”
The problem with implementing a plan like this is it that it causes the R&R to feel like they are losing some of their control, their power. Furthermore, many people within the R&R have little confidence in financial markets; it does not fit within their worldview. This is why I ended up a recent post with this comment: “Many politicians and certain economists don’t like the market system. Market performance often contradicts the world views held by these politicians and economists. And that makes them angry.”
In conclusion, I have very little confidence in a new round of stress tests and believe that ST2 will lead to ST3 … and then ST4 … and eventually ST(n), where n is any number you want to give it. To me the sign that an approach is not appropriate and will not be successful over time is that people continue to use the same system and attempt to make the system tougher and tougher. Their system never works because their worldview needs to be changed.