Stress testing of banks is normally undertaken by the regulatory authorities when they are concerned about the health of the
banking system in the face of a probable future adverse macroeconomic
shock. Since the financial meltdown of 2008, the US had stress tested 19
largest banks, accounting for two-thirds of the total assets in the banking system,
and Europe had done such tests in 91 banks. Post the tests, while 10 of the US
banks needed assistance of some sort, the number for European region was 7. At
the time of writing this, the next in the line for stress testing is the banking sector
in Greece. The idea behind such stress tests is to assess to what extent
the large banks and financial institutions which have significant linkages with
the banking industry can withstand an adverse financial shocksay a
meltdown in asset prices. Banks are expected to be out of danger if the findings of the
stress tests confirm that banks under consideration will not have their networth
wiped out even in the face of large adverse developments in the financial
markets. Such stress tests often invite severe criticisms from academicians and
practitioners alike.
The criticisms of the US and European Union stress tests which had
been concluded in the recent past also confirm the same. The US bank
stress tests had been criticized from the point of view that the difficult scenarios
that the bank books have been subjected to is no worse than they actually
went through already, and hence doubtful in its ability to predict the outcome of
a worse scenario. In the European banks stress tests, only 7 out of 91
stress tested banks failed. These tests again have invited widespread criticisms
on the following lines. One, it has left out some of the crucial institutions
which are systemically important, but at the same time may not pass the tests
(KfW in Germany for instance). Two, tier one capital has been loosely defined to
include some hybrid debt instruments also. With a strict definition of tier
one capital to include only equity and free reserves, some of the
German Landesbanken would never have crossed the bridge. Third, a recent
paper by Adrian Blundell-Wignall and Patrick
Slovik1 shows that the stress tests ignored most sovereign debt
held on the banking books of banks, whereas it considered only their small
trading book exposures. This assumes added significance of late, especially in
the wake of huge interest rate spreads witnessed in the sovereign bonds of
Greece, Portugal and Spain in comparison with the German Bonds. |
