'Bank stress tests are inadequate' - author of ASI report "No Stress" writes letter to the Independent

Author of Adam Smith Institute report “No Stress: The flaws of the Bank of England’s stress testing programme” Professor Kevin Dowd has written a letter to the Independent:   

Bank stress tests are inadequate

James Moore’s article (18 June) on “No Stress”, my Adam Smith Institute Report on the Bank of England’s stress tests, dismisses its conclusions without any attempt to grasp its analysis.

Moore claims that the stress tests weren’t perfect, but the best the Bank of England could do; however, the analysis of the report shows that the BoE can, and should, be running safer tests. No one scenario can provide comfort that the system is sound.

Furthermore, the tests are based on an absurdly low safety standard, and if one stress-tests the tests against respectable standards all the banks would fail. They also lack credibility because the Bank can only allow the banking system to “pass”: anything else would imply that its own past policies have failed.

Moore might be satisfied with the results of the tests, but the rest of us should remain sceptical. Stress tests operate like a radar that is worse than useless because it cannot see the main hazards. We wouldn’t dream of sending out a ship or plane reliant on an unreliable radar. We shouldn’t do that with our banking system either.

Professor Kevin Dowd London SW1

Read the letter here.

ASI report, “No Stress: the flaws in the Bank of England’s stress testing programme”, examines the Bank of England’s stress testing programme and challenges the Bank’s conclusion that the UK banking system has sufficient capital to withstand a new downturn and suggests that the UK banking system is actually very weak.

The report argues that the stress tests are fatally flawed because they use a very low ‘pass’ standard, a 4.5 percent minimum ratio of capital to risk-weighted assets. This minimum is well below those coming through under Basel III. Had the Bank carried out a test using these latter minima, the banking system would have failed the test.

Sam Bowman discusses tax credits and Cameron's welfare reforms on Scotland Tonight

Deputy Director of the Adam Smith Institute Sam Bowman discusses tax credits and David Cameron's welfare proposals on STV's Scotland Tonight.

Sam Bowman discusses tax credits and Cameron's welfare reforms on Sky News

Deputy Director of the Adam Smith Institute Sam Bowman discusses tax credits and David Cameron's welfare proposals on Sky News.

Has Greek government been own worst enemy during negotiations? Sam Bowman argues NO in City AM

Deputy Director of the Adam Smith Institute Sam Bowman argues that Greece has been treated unfairly during debt negotiations in the City AM Debate Forum.

Greece has been badly mistreated by the rest of the EU. The structural reforms demanded by the Troika are desirable, though difficult in the current economic climate, but Greece has already cut state spending by 20 per cent and cut state employment by 30 per cent.

Greece has been running a primary surplus since 2013, and most of the €240bn in bailout money lent to the country was intended to service existing debt. Irresponsible borrowers, which Greece undoubtedly was, need irresponsible lenders too. At the onset of the crisis, European banks owned nearly $54bn of Greek government debt, and a Greek default would have damaged many of them. These were bailouts for Europe’s banks, not just for Greece.

The Eurozone’s refusal to restructure Greece’s debt, perhaps indexing it to nominal GDP as Greece’s finance minister has suggested, is therefore highly unreasonable. Greece has been at fault, but so have many other players in this sorry saga.

Read the full article here.

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ASI report “No Stress” features on BBC Radio 4's Today Programme

Adam Smith Institute report “No Stress: The flaws of the Bank of England’s stress testing programme” has featured in the Financial Times:

ASI report, “No Stress: the flaws in the Bank of England’s stress testing programme”, examines the Bank of England’s stress testing programme and challenges the Bank’s conclusion that the UK banking system has sufficient capital to withstand a new downturn and suggests that the UK banking system is actually very weak.

The report argues that the stress tests are fatally flawed because they use a very low ‘pass’ standard, a 4.5 percent minimum ratio of capital to risk-weighted assets. This minimum is well below those coming through under Basel III. Had the Bank carried out a test using these latter minima, the banking system would have failed the test.

ASI report "No Stress" features in the Financial Times

Adam Smith Institute report "No Stress: The flaws of the Bank of England's stress testing programme" has featured in the Financial Times:

The Bank of England’s stress tests of the banking sector have been attacked as “fatally flawed” for setting hurdles that are too easy to clear and giving false comfort about the safety of the financial system.

A report published on Thursday by the Adam Smith Institute, a free market think-tank, calls for the BoE annual stress tests to be scrapped, arguing they are “worse than useless” because they disguise weakness in the UK banking system.

The report has been written by Kevin Dowd, professor of finance and economics at Durham University, who is a vocal critic of the tests and criticised them at a Treasury select committee hearing in March.

Read the full article here.

ASI report, “No Stress: the flaws in the Bank of England’s stress testing programme”, examines the Bank of England’s stress testing programme and challenges the Bank’s conclusion that the UK banking system has sufficient capital to withstand a new downturn and suggests that the UK banking system is actually very weak.

The report argues that the stress tests are fatally flawed because they use a very low ‘pass’ standard, a 4.5 percent minimum ratio of capital to risk-weighted assets. This minimum is well below those coming through under Basel III. Had the Bank carried out a test using these latter minima, the banking system would have failed the test.

ASI report "No Stress" features in City AM

Adam Smith Institute report "No Stress: The flaws of the Bank of England's stress testing programme" has featured in City AM:

A THINK tank has called for an end to regulatory stress tests on banks, saying they are “sleep- walking” the sector into another financial crisis.

The Adam Smith Institute, a free market think tank, said the annual Bank of England tests – which are used to gauge the resilience of banks to volatile financials scenarios – gave false comfort to lenders because the rules were not rigorous enough.

It added the tests failed to apply a minimum ratio of capital to leverage for UK banks, which would have shown the banks to be weaker than when tested on risk weighted assets.

Read the full article here.

ASI report, “No Stress: the flaws in the Bank of England’s stress testing programme”, examines the Bank of England’s stress testing programme and challenges the Bank’s conclusion that the UK banking system has sufficient capital to withstand a new downturn and suggests that the UK banking system is actually very weak.

The report argues that the stress tests are fatally flawed because they use a very low ‘pass’ standard, a 4.5 percent minimum ratio of capital to risk-weighted assets. This minimum is well below those coming through under Basel III. Had the Bank carried out a test using these latter minima, the banking system would have failed the test.

ASI report "No Stress" features in the Yorkshire Post

Adam Smith Institute report "No Stress: The flaws of the Bank of England's stress testing programme" has featured in the Yorkshire Post:

The Bank of England’s banking stress tests are highly unreliable and could be “worse than useless”, a report has warned.

Libertarian think-tank the Adam Smith Institute said the Bank’s assessment of how well funded institutions should be could provide “false comfort”.

Regular stress testing - checking banks and building societies have enough cash to weather market shocks - was introduced in 2014 as a way to assess the strength of the sector.

These tests are “fatally flawed” because they use a single scenario test with a low pass rate, the think-tank claimed.

Read the full article here.

ASI report, “No Stress: the flaws in the Bank of England’s stress testing programme”, examines the Bank of England’s stress testing programme and challenges the Bank’s conclusion that the UK banking system has sufficient capital to withstand a new downturn and suggests that the UK banking system is actually very weak.

The report argues that the stress tests are fatally flawed because they use a very low ‘pass’ standard, a 4.5 percent minimum ratio of capital to risk-weighted assets. This minimum is well below those coming through under Basel III. Had the Bank carried out a test using these latter minima, the banking system would have failed the test.

Press Release: Bank of England's stress tests deeply flawed, 'worse than useless' says new report

For further comments or to arrange an interview, contact Head of Communications Kate Andrews: kate@adamsmith.org | 07584 778207

• The Bank of England’s banking stress tests are highly unreliable; methodological flaws may provide false risk comfort that make them worse than useless.

• The stress tests build systemic instability into the UK banking system, pressuring banks to converge to the same models and risk management practices, and making them all blind to the same risks.

• These flaws include their dependence on a single scenario and their use of ‘risk-weighted’ asset measures, which are unreliable because of their dependence on gameable risk models, and the use of a very low ‘pass’ standard, a 4.5% minimum ratio of capital to risk-weighted assets.

• Even accepting the Bank’s own scenario, alternative tests using a higher capital standard or the superior leverage ratio would indicate that the UK banking system is actually very vulnerable.

The Bank of England’s banking stress tests are deeply flawed and may prove to be worse than useless if they give false risk comfort to financial markets, according to a new report from one of the UK’s top stress testing experts, released today by the Adam Smith Institute.

The report, “No Stress: the flaws in the Bank of England’s stress testing programme”, examines the Bank of England’s stress testing programme and challenges the Bank’s conclusion that the UK banking system has sufficient capital to withstand a new downturn and suggests that the UK banking system is actually very weak.

The report argues that the stress tests are fatally flawed because they use a very low ‘pass’ standard, a 4.5 percent minimum ratio of capital to risk-weighted assets. This minimum is well below those coming through under Basel III. Had the Bank carried out a test using these latter minima, the banking system would have failed the test.

If the Bank used the standards set out in Basel III, depending on the level at which the Counter Cyclical Buffer was set, at best just two (of eight) banks would pass; if the CCB had been set to its potential maximum (2.5%) to produce a more rigorous and more credible test, then every single bank would have easily failed.

The Bank also failed to carry out any tests based on a minimum ratio of capital to leverage – which is much less dependent on unreliable risk models. Even the most undemanding of such tests – one based on a minimum leverage ratio of only 3% - would have revealed that the banking system was very weak. The Bank’s failure to apply this latter test is puzzling because the Bank expects UK banks to meet this minimum standard.

Overseas experience also indicates that stress tests are useless as indicators of bank vulnerability and can go catastrophically awry. Recent stress tests failed to notice the impending collapse, not just of one but of three national banking systems: Iceland in 2008, Ireland in 2010 and Cyprus in 2013, all of which collapsed shortly after being signed off as safe by regulatory stress tests.

The BoE asks us to believe that there are no icebergs out in the banking sector, though the report argues this is merely because the Bank’s own radar fails to detect them – essentially the same radar that completely missed the last iceberg that sank the banking system in 2007-2009.

The report calls for Bank’s stress testing programme to be aborted forthwith, and calls for reformers to focus on the restoration of sound accountancy standards. It also calls for an end to regulatory risk modelling and the re-establishment of strong bank governance systems that make decision-makers personally liable for the risks they take.

The author of the report is Kevin Dowd, professor of finance and economics at Durham University and a partner in Cobden Partners based in London. He said:

The Bank's party line is that the UK banking system is safe. However, it is simply impossible to assess the health of the banking system using a stress test based on a single scenario, which is all that the Bank considers. How do we know that the banking system will be safe under all the other scenarios that the Bank of England didn't consider? Well, we don't.

On the other hand, had the Bank carried out a meaningful stress test, then all sorts of awkward questions would have arisen - such as why the banking system is still in a mess despite the vast amounts of public money that have been thrown at it since the onset of the financial crisis. But no-one - especially not the Bank - wants to face up to the point that Bank's policy towards the banking system has been a very costly failure and continues to leave the banking system vulnerable.

Notes to editors:

To access the full report “No Stress: the flaws in the Bank of England’s stress testing programme”, click here.

The Adam Smith Institute is a free market, libertarian think tank based in London. It advocates classically liberal public policies to create a richer, freer world.