Victor Cook

Stress Testing: What's Your Bank's AQ?

VP of Common Sense,

Now that you bring it up, I think it's likely a combination of bank transparency and investor perspicacity. The largest possible positive gap is created between share of market cap and share of bank revenues when investors are confident in their judgments and banks are forthcoming in their reports.

Good insight! Thank you.

~V

Stress Testing: What's Your Bank's AQ?

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Your comments highlight several relevant issues. I will try to address them one at a time.

“The distortion of value and the relatively small importance of market cap. as a representative of quality invalidate this type of comparison.”

By “the distortion of value” I assume you mean transforming the dollar value of capitalization into the market share of capitalization. If so, this does not “distort” value it just creates a linear transform of it. The correlation between a bank’s dollar value and share of value over the 32 quarters is exactly one. Also, market cap and bank revenue have equal importance in this representation of asset quality.

“It would seem that problems of scale would give the very large banks, (overall), a skewed result.”

Scale has no effect on a bank’s AQ score for two reasons. First, the unadjusted AQ score is calculated by subtracting share of revenue from share of market cap. This eliminates the scale effect: 25 minus 23 returns the same unadjusted AQ as does 5 minus 3. Second, these differences are normalized through division by the standard deviation of each bank’s 32 quarterly differentials. A bank's 32 quarter series of AQ scores averages zero with a standard deviation of one. So, there is no skew.

“Also, due to the illogical volatility in the banking industry in the last six months I doubt that this ranking will be accurate as to how the real banks read on the real ‘stress test’ list.”

Whether the recent volatility in the banking industry is illogical or not has nothing to do with a bank’s AQ score. The combination of transforming the dollar data to market shares and normalizing the differences has the effect of leveling the playing field. Whether the AQ will be more or less accurate then the real stress test is an interesting question. I share your doubt on this issue. But remember, these scores are based on real data for 92 real institutions over 32 quarters. Management has very little wiggle room on two of the three data inputs (number of shares outstanding and revenues) and no influence on the third (closing stock price).

One of my objectives in designing the AQ index is to “wash out” the effects of politics and manipulation. I don’t know if the AQ will succeed in this regard. But I do wish I had bet on that 50 to 1 long-shot in the derby!

Thank you for the opportunity of address these important issues.

~V

Stress Testing: What's Your Bank's AQ?

Allen,

In your comment you concluded:

“The model relies on ‘efficient market’ theory, which makes it hopelessly unreliable. You are assuming that investors, collectively, know the true value of these banks' assets. If that were true, we wouldn't have a problem to begin with.”

I would like to clarify these issues.

First, the AQ score couples the risk-adjusted effects of investor decisions (on a bank’s market share of capitalization) with those of management decisions (on market share of revenues) over the long term. No where in efficient market theory will you find mention of either company revenue or market share. It is precisely because markets are inefficient that I developed this round-about model of assessing a bank’s asset quality.

Second, please review the previous post in which I track the AQ index over the 36 quarters ending in 2008 for Goldman Sachs, Morgan Stanley and JP Morgan. The risky asset problems sleeping in the balance sheets of these three firms were reliably revealed by their AQ index years before they burst into the headlines. Investors clearly didn’t know about this problem.

By the way I did not include GS and MS in this analysis of 92 firms because they were not then included as bank holding companies in the American Banker's Q3-2008 list ... and my previous post focused on them anyway.

Thank you for the opportunity to clarify these issues.

~V

Stress Testing: What's Your Bank's AQ?

Jasper,

You said:

"If financial shares get drawn down by a general market downdraft, the banks measurements will decline, perhaps significantly, independent of any actual change in their operations."

Since the critical inputs to the AQ are a bank’s share of value and share of revenue, rather than dollar values, there will be a change in a bank’s AQ score as a result of market downdraft only under two conditions: either the bank’s price runs counter to the market or there is a significant change in the long-run volatility of the difference between its share of value and share of revenue.

Thank you for raising this important question. It’s one that may concern other readers.

~V