‘Fatally flawed’ Bank of England stress tests peddle myth of financial security – report

Bank of England (BoE) Governor, Mark Carney. (Reuters / Matt Dunham / pool)
Bank of England (BoE) stress tests of Britain’s banking sector are “fatally flawed” and peddle the myth that the financial system is secure, a report by the Adam Smith Institute says.

The report, published Thursday, was authored by Professor of Finance and Economics at Durham University Kevin Dowd. It calls for the yearly tests to be scrapped and warns that they hide serious weaknesses in a vulnerable UK banking system.

In the aftermath of the 2008 financial crisis, stress tests have been used by the authorities as a way of gauging banks’ robustness. Following the global economic turmoil that followed the US subprime mortgage crisis, the methodology for conducting these tests was revised.

At present, it is deemed favorable to test financial organizations in groups. However, certain sectors of the financial industry such as asset management and central clearing houses remain exempt.

Dowd, who previously criticized the tests at a Treasury select committee hearing, told the Financial Times that the BoE have set the benchmark for minimal capital requirements too low. This practice leaves the BoE vulnerable to banks rigging their self-styled risk-analysis models, he said.

‘Credibility problem’

Capital requirements relate to the amount of capital a financial institution can hold. In Britain they are regulated by the BoE.

Dowd said the BoE is blighted by a “credibility problem” because its role of promoting financial stability dampens its regulatory rigor.

The Professor of Finance and Economics, who also works as a consultant advising governments on banking stability, said Britain’s 2014 stress tests were too easy on lenders.

He argued the BoE should have forced banks to meet a minimum leverage ratio, which weighs lenders' capital against their total assets. Such a move would make it more difficult for banks to manipulate their in-house risk-analysis models, he said.

RT asked the BoE to comment on Dowd’s findings, but a spokesperson for the Bank declined.

Unstable banking system

Move Your Money ethical finance researcher Joel Benjamin backed Dowd’s assessment that the BoE is blighted by a credibility issue.

“The major issue still facing the UK economy is that the financial sector is too large relative to the productive UK economy,” he said.

Benjamin said the BoE’s stress tests are “a carefully manicured smokescreen to rebuild tattered confidence in the sector.”

“Given the UK government still own Lloyds and RBS, there is a clear motive to fudge the figures and build investor confidence ahead of an RBS resale,” he said.

Benjamin argued that Britain’s largest accountancy firms “play an active role” in this process “by signing off on accounts, which allow banks to bring forward profits, and defer penalties and known impairments on their balance into future years.”

Benjamin said Britain’s banking system is plagued by a poor regulatory climate, and is ripe for white collar crime. UK media coverage of weaknesses in Britain’s banking sector is virtually non-existent, he warned.

“The$111 billion black holein HSBC’s balance sheet was reported by Forensic Asia and CNBC, but ignored by UK media outlets – most notably the BBC and Telegraph, whereHarry Wilson’s articleto this effect was skewered, leading to his resignation from the paper,” he said.

Adam Smith Institute (ASI) head of research Ben Southwood agreed that the UK banking sector is characterized by a number of weaknesses. He suggested “excessive uniformity” could be problematic.

However, in contrast to Benjamin, Southwood said regulators’ post-crisis response “may be harmonizing the banking system too much.”

Southwood echoed Dowd’s suggestion that stress tests should be scrapped. But he suggested moving towards a system where “key players”in the banking sectorself-regulatecould be problematic.

Southwood said such a strategy would be doomed to fail unless “authorities credibly commit to not intervening in a crisis” and “risks and crises are actually foreseeable.” He also expressed doubt over whether authorities would cease to intervene in the face of another crash.

The BoE says banks operating in Britain will be obliged to meet a 3 percent leverage ratio to pass its 2015 stress tests. If this benchmark was applied to the Bank’s 2014 stress tests, 50 percent of Britain’s banks would have failed. Among those who would have received a negative rating were the Cooperative Bank, Santander UK, Lloyds Banking Group and Royal Bank of Scotland.

If the BoE factored in all additional capital buffers banks must contend with into its tests, all of Britain’s eight top lenders would have failed these stress tests, Dowd's report found.

As the global financial crisis struck, Dowd noted these stress tests failed to uncover the impending crash of the Irish, Icelandic or Cypriot banking systems.

“Methodological flaws include the dependence on a single questionable stress scenario, inadequate data, poor metrics and unreliable models, especially risk models,” his report said.

Dowd suggested the BoE is not serious about stress testing. He said this service should be outsourced to the private sector.

‘Least resilient of all G7 economies’

New Economics Foundation (NEF) Senior Researcher for Monetary Policy Josh Ryan-Collins said NEF rates the UK’s banking system as the “least resilient” of all the advanced G7 economies.

Ryan-Collins said Professor Dowd is correct to highlight that stress tests failed to predict “three recent systemic banking collapses.”

But he argued these stress tests remain inadequate to this day because they fail to analyze the banking system as a whole.

“Our index of Financial Systems Resilience (FSR) takes the leverage measure preferred by Prof Dowd but adds six further resilience factors, including aggregate asset and liability composition, the level and nature of interconnectivity between banks and the diversity of ownership of types of banks,” Ryan-Collins said.

“On this broader measure of resilience the UK has the most vulnerable banking system of the G7 economies.”

Ryan-Collins said the UK banking sector’s large size makes it “uniquely vulnerable to financial shocks.” Other factors which render it unstable are its strong ties to the global financial system, particularly the shadow banking system, he added.

Ryan-Collins argued that the UK banking sector lacks diversity, and is effectively dominated by a group of large “privately owned, shareholder-driven banks.”

“UK banks assets’ are also more concentrated in the mortgage and financial sector than most other advanced economies banking systems, again making us more vulnerable to financial or house price shocks,” he said.

Ryan-Collins called upon the BoE to reform its stress tests and other regulatory mechanisms to include the resilience factors referenced in NEF’s recently published FSR report.

“Metrics on these factors – across the banking system as a whole – should be developed and measured regularly,” he said.

Ryan-Collins insisted a range of structural reforms are paramount – particularly the separation of retail and investment banking.

He predicted the Conservative government’s planned sell-off of RBS will negatively impact on an already vulnerable banking sector.

“Selling off the Royal Bank of Scotland will create yet another very large, privately owned shareholder owned bank focused on short-term returns and mortgage lending – the last thing the British banking system needs,” he said.

The New Economics Foundation “proposes splitting RBS into 130 regional and local banks that are owned by local public trusts,” Ryan-Collins said.

“The new citizens’ bank would focus on business and consumer lending in defined local areas, replicating the highly successful approach of the German Sparkassen system and the older UK Trustee Savings banks.”