Martien Lubberink argues New Zealand needs to play catch up in bank stress testing

By Martien Lubberink*

On Thursday 5 March the U.S. Federal Reserve will publish the results of the American bank stress tests.

At the same time, a handful of European banks are still recovering from last October’s European Central Bank asset quality review (AQR) and the European Banking Authority (EBA) stress test. UK banks felt the heat from the EBA and their national supervisor. Just before Christmas the Bank of England published detailed stress test results of British banks.

This column takes stock of recent developments in bank stress testing.

It shows that Europe, the United States, and the UK have significantly advanced their approach to bank stress testing. In particular the transparency of stress test results has improved significantly.

The transparency contributes to financial stability.

It is time for New Zealand to catch up.

A three-pronged approach to bank supervision

For many years, bank supervisors relied on a single measure to assess the financial health of banks. Before the Global Financial Crisis this was the BIS ratio. Today it is the CET1 ratio. Both are risk-based ratios: they divide bank capital by the total risk-weighted assets of the bank.

The risk-based ratios have serious limitations: they prompt banks to invest in safe assets, such as home mortgages and sovereign bonds. These assets have low risk weights, which exempt banks from holding much capital against them.

The risk-weighted ratios also make that banks avoid lending to riskier clients, such as, for example, small and medium sized enterprises. This is because loans to these enterprises generally have higher risk weights.

Bank supervisors noticed the weakness of the risk-based ratios. The ratios make banks choke off economies by making it hard for entrepreneurs to borrow, which is a serious problem in Europe.

In addition, they may support a housing bubble, which is an issue in New Zealand.

As a result, some bank supervisors have begun to rely on two additional instruments to assess the financial health of banks.

The first additional instrument is the leverage ratio.

This ratio weighs all assets, risky and safe, equally. Under new bank solvency rules, this ratio serves as a “backstop”, a safety measure that prevents banks from investing way too much money into safe (and therefore often unproductive) assets.

The second additional instrument is the stress test.

This test should identify risks that risk-based ratios and the leverage ratio fail to reveal. A distinctive feature of stress tests is that they are forward-looking, whereas the leverage ratio and the risk-based ratios rely on information from the past. The forward-looking nature allows supervisors to incorporate important economic developments into stress tests, which may make them more relevant than ratios that reflect a bank’s history.

Not a secret recipe anymore

The stress test has gained importance over the last five years. The EBA, for example, regards stress testing as “one of the primary supervisory tools”. Daniel Tarullo, member of the Board of Governors of the United States Federal Reserve Board, declared that supervisory stress testing has become “a cornerstone of a new approach to regulation and supervision of the nation's largest financial institutions”. The Bank of England decided that the stress test would sit alongside existing risk-weighted capital requirements and the leverage ratio framework.

An important development in stress testing is that supervisors have become much more forthcoming about their results.

This new openness was not deliberate, but the result of Goldman Sachs signalling to the markets that it would pass the 2009 stress test with flying colours before any stress tests results were made public. According to the New York Times “the [Obama] administration feared that details on healthier banks would inevitably leak out, leaving weaker banks exposed to speculation and damaging market rumours, possibly making any further bailouts more costly”. This is a key point in understanding stress testing: by keeping the results to himself, a supervisor makes it hard to restore trust in the financial system.

Since then, transparency has become the new black in stress testing.

For example, the EBA stress test website is remarkably accessible and comprehensive: it publishes details of its stress test scenarios and methodology as well as results. The EBA also discloses detailed data from individual banks in Excel-readable files that are only one mouse-click away. This enables anyone to form their own judgment about the financial health of European banks.

Only perfect practice makes perfect

Stress testing is more art than science. Supervisors learn from each stress test. Over time the quality of the tests improves.

A case in point is the EBA. Their first stress test, in 2009, hardly made a dent and it received scant attention.

EBA’s 2010 and 2011 stress tests went pear-shaped: they failed to spot weak Irish and Belgian banks that went belly up shortly after the results were published. However, subsequent tests, though often criticised for their sometimes awkward assumptions, did not suffer from teething problems anymore.

The EBA stress tests therefore show that it can take some years to acquire expertise in stress testing.

Bank stress tests in New Zealand

New Zealand lags about six years behind European and US stress test practices.

For example, last year the Reserve Bank conducted a joint stress test with APRA, the Australian prudential supervisor. The results – tucked away in November’s Financial Stability Report – show that New Zealand’s four large banks scraped through.

However, the reserve banks offers no information about individual banks. This is where the EBA was around 2009.

Despite lagging behind, it could be that the Reserve Bank is catching up. For example, last year, it deployed a strategic initiative that includes regular system-wide stress testing. It also intends to review the current practice for stress testing at New Zealand banks and to compare this to international best practice.

So far so, good.

However, on transparency, the Reserve Bank remains cautious. It wants to only publish aggregates.

This of course does not dovetail with the approach taken by leading supervisors, i.e. the EBA, the Federal Reserve, or the Bank of England.

It also misses an important point. A supervisor should publish detailed results as soon as it starts conducting system-wide stress tests. This prevents the general public from second-guessing the supervisor, and with it the health of the financial system.

It is never too late to catch up.

However, the longer the Reserve Bank waits, the longer it will take to build the expertise to run these tests smoothly, and the less prepared it will be for the next crises.

Time to play catch-up.

--------------------------------------------------------

*Dr Martien Lubberink is an Associate Professor in the School of Accounting and Commercial Law at Victoria University. He has worked the the central bank of the Netherlands where he contributed to the development of new regulatory capital standards and regulatory capital disclosure standards for banks worldwide and for banks in Europe (Basel III and CRD IV respectively).

--------------------------------------------------------

This article was first published in our email for paying subscribers. See here for more details and how to subscribe.