Economix Blog: Simon Johnson: More Transparent Bank Stress Tests Are Needed

Simon Johnson, the former chief economist at the International Monetary Fund, is the co-author of “13 Bankers.”

Europe and the United States both need to conduct another round of stress tests on their banks, with a model similar to what was done in the United States in 2009, but with a more negative downside scenario — in particular, assessing the effects of a major sovereign debt problem in the euro zone.

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The point of such a scenario is to determine how much equity financing banks need to have if the world economy turns ugly. If the big banks raise more capital in advance, we are less likely to see economic downturn again become financial catastrophe.

The prevailing wisdom about Europe is that it faces primarily liquidity problems. In this view, a few of the larger countries have had trouble rolling over their debts, and some leading banks need help with short-term financing. The European Central Bank can assist with both by buying government bonds and lending to banks and, in the most optimistic interpretation, the consequent political discussions will help strengthen European Union integration.

There are two problems with this positive spin on recent events. The first is that sovereign debt problems can easily become solvency issues — that is, more about whether countries can afford to service their debts rather than whether they can raise enough cash at reasonable rates in any given week. The key issue is growth — if Italy, Spain and others can show they will grow reasonably quickly, then debt relative to gross domestic product will decline, and rosy projections will be back in fashion.

But if signs of growth do not return soon, perhaps over three to six months, the next downward revision to forecasts will spread deeper debt pessimism. And any markdown for global growth prospects, including for reasons outside Europe’s control (such as overheating in China’s residential property market), would also not be helpful over the coming year. My Peterson Institute policy paper with Peter Boone in July suggested some potential escape routes, but the summer so far has produced only further attempts to muddle through.

The more immediate Achilles heel is banking. The virtues of big European banks were extolled by some Congressional representatives during the Dodd-Frank legislation in spring 2010. What a difference a year makes; not many members of Congress would today endorse anything about European banking, given all the problems that have emerged.

The main immediate problem for Europe is that we still don’t know exactly the condition of its major financial institutions. The Europeans have run bank stress tests twice recently, in mid-2010 and again earlier this year. But in both cases the tests were far too lenient and banks were not required to raise enough capital.

They should have been compelled to increase their equity funding relative to their debt, in order to create a greater buffer against future losses.

The 2009 banking stress tests in the United States can also be criticized for not including a scenario that was sufficiently negative. In recent weeks the market has expressed great skepticism about Bank of America, its inherited liabilities, future business model and, most of all, the adequacy of its capital.

Most likely, Bank of America needs to be broken up, with the continuing businesses funded with equity to a level that could withstand adverse legal outcomes and a deep recession. (For more background on how to think about bank equity, see the recent testimony of Paul Pfleiderer to the financial institutions subcommittee of the Senate Banking Committee; anyone working on banking policy in Europe or the United States should read this.)

Dodd-Frank created pre-emptive intervention powers, at the behest of Treasury and the Federal Reserve, with part of the rationale being that these could be used to prevent a megabank’s slow death spiral from becoming a market panic.

In “13 Bankers,” James Kwak and I expressed considerable skepticism that this could work — it just does not fit with the history and politics of regulation in the United States, within which even the Treasury secretary defers to what Bloomberg News calls the “Wall Street Aristocracy.”

The American 2009 Supervisory Capital Assessment Program, known as SCap (pronounced ESS-cap), was designed to reveal potential stressed capital levels and, as a result, the 19 companies covered by SCap have since increased their common equity by more than $300 billion.

Unfortunately, weakness at Bank of America generates systemic risk, undermines overall market confidence and magnifies the risk of another recession; this is exactly what SCap is supposed to have avoided — but failed to do because it was not sufficiently tough.

The Comprehensive Capital Analysis and Review stress tests, known as CCar (pronounced SEE-car), concluded in April 2011, were even less helpful. These were much less transparent, focused more on companies’ internal capital planning processes. The Fed did sensitivity analysis of the companies’ own stress tests; this is not exactly reassuring, given how badly the industry’s own models have failed in the recent past — including in the events that led up to the Fed’s $1.2 trillion of emergency loans in 2008.

Yet the European stress tests to date must be rated a notch or three below even the CCar in terms of transparency and communication of information that allows market participants to make informed decisions. The latest round, conducted by the European Banking Authority through July 15, did not even examine what would happen if a sovereign borrower had to restructure its debts — exactly what Greece was working on during the same time frame. (To be precise, there was some “sovereign stress” in the tests but very little compared with what we have seen and could see.)

This is worse than embarrassing. It creates exactly the wrong kind of uncertainty around European megabanks, including their operations in the United States and potential spillover effects.

In part this happened because the European Banking Authority is new — it came into existence on Jan. 1 — and not sufficiently powerful relative to national bank supervisors, many of whom are stuck in an old mindset where transparency is bad and full disclosure of banks’ balance sheets is scary. (The low capital levels of European banks was described more fully this week in a Bloomberg article.)

But partial facts and distorted information flow are exactly what creates fear and instability, not just in Europe but much more broadly.

If euro-zone leaders want to make any progress on governance reform, they should immediately strengthen the banking authority and call for a new round of stress tests. These tests should include a deep recession scenario in Europe, as well as disruptions to sovereign debt financing. At the same time, the Federal Reserve should acknowledge that the CCar was not enough; it’s time for a new round of tough stress tests here, as well.

The notion that bank equity is socially expensive and should be minimized is an idea whose time has passed — as Anat Admati, Peter DeMarzo, Martin Hellwig and Professor Pfleiderer have argued. It is time to find ways to strengthen the equity funding of major financial institutions around the world, quickly, fairly and effectively — a point that was made clear in the recent hearings held by Senator Sherrod Brown, Democrat of Ohio.

Any further delay risks worsening the global slowdown.

Article source: http://feeds.nytimes.com/click.phdo?i=002f16554526f35acb05e5ffd2601827