October 7, 2013 / 12:37 PM / 4 years ago

COMMENT: Is the cure worse than the disease?

Oct 7 (IFR) - Regulator alert: You've only got until January 10 - that's fewer than 70 working days - to respond to the Bank of England's latest discussion paper, "A framework for stress testing the UK banking system".

But don't misconstrue the title; this goes way beyond UK banks.

The BoE quite clearly wants to cement the UK's already embedded and articulated notions of higher than internationally accepted capital standards. Such notions threaten the future of London as a global financial hub and muddle the competitive landscape for internationally active UK banks.

It seems to me that setting the bar so high that it acts as a disincentive to remain under the umbrella of UK regulation outplays the admittedly important benefit of better public confidence in the system. And crafting a facilitative regime for UK regulatory agencies to meet their statutory obligations is inward-looking and parochial and I think kind of misses the point of the exercise.

OK, so the stress tests are intended to offer UK regulators a forward-looking quantitative basis for monitoring the capital adequacy of individual UK banks, building societies and investment firms as well as the overall system. Fair enough. But the tests are being designed to be way more than quantitative. And they won't just apply to UK banks.

"SEVERE BUT PLAUSIBLE"

In a show of force and enjoining extraterritorial battle, the BoE will over time rope into the purview of its tests what it calls "significant" UK subsidiaries of foreign global systemically important banks. And it might also introduce a concurrent stress-testing regime for central counterparties.

The tests will be conducted against system-wide common scenarios as well as individual bespoke scenarios (the BoE expects the latter to result in higher losses). We're told the stresses that banks will have to be able to withstand will be "severe but plausible", which I must say sounds rather ominous. My question is: plausible for whom?

Remaining consistent with previous populist utterances from UK politicians, if the baseline is having banks that operate in the UK maintain enough capital to absorb losses and stay above internationally agreed minimum standards, the BoE has made clear that capital levels could be set above strict internationally agreed minimums.

And in a naked reference to previous efforts by the banks to game stress-test results by using self-serving internal models utilising unrealistic assumptions, the central bank is taking no chances and will also utilise its own models in order to dilute any incentives banks might have to fix the results - and, presumably, to promote a better sense of systemic comparability. Regulators will use synthesised model outputs but then apply their own judgements to define stressed profitability and capital adequacy results.

ABOVE AND BEYOND

Should the fact that regulatory judgement lies at the heart of the proposed exercise, as opposed to a simple pass-fail mechanism, worry bank management? I'd argue yes. The stress test "aims to deliver a more graduated policy framework, where the magnitude of remedial actions taken would be a function of policymakers' judgement around the adequacy of banks' capital plans," the discussion paper says.

Hmm  Put simply, regulators could still demand remedial actions even if banks are above internationally agreed minimums but still below the appropriate level of post-stress capital determined by the FPC and the PRA Board" [my italics].

"Banks could also be required to take remedial actions in light of identified inadequacies in their stress-testing and capital management capabilities, even if the PRA Board judged that they were adequately capitalised to withstand the range of scenarios explored as part of the stress test", the paper notes.

Sounds to me like that's going above and beyond  In fact, with this approach you have to wonder what the point is of a stress test per se, especially given the fact that remedial actions could go beyond straight capital cure into interfering in individual banks' business strategies and even bank management.

For bank managers, it's almost impossible to be certain about capital planning if your regulator makes you jump through hoops above and beyond those of international norms and which are not mechanical but based on the views of judgemental bureaucrats far removed from the demands of the arena of intense competition.

In fact, adding an overlay of bureaucratic judgement into the results at the same time as making the results of each bank stress test public and in the absence of a simple pass-fail, actually undermines system-wide comparability and injects a huge element of complexity and potential confusion in interpretation.

I've commented before on the "throwing the baby out with the bathwater" approach to financial regulation. It's worth noting that as well as undergoing UK stress tests in 2014, UK banks will also face parallel EU stress tests.

The Bank of England's latest paper is another example of intrusive, overbearing regulation. The Bank is hardly alone in what has become a sea of parallel and rival regulatory endeavour.

Sometimes, I wonder if the cure is worse than the disease.

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