Stressing all the way to the starting line

The US Federal Reserve last week announced summary results of the latest round of bank stress tests, which show that the majority of the largest U.S. banks would continue to meet supervisory expectations for capital adequacy despite large projected losses in an extremely adverse hypothetical economic scenario. This is essentially a report card of how 19 of the largest US banks would fare under 'worst case' scenarios around unemployment, house price crashes, equity market drops and bank collapses, taking into account that institutions could (or need to ) pursue capital related actions such as issuance of capital, dividend payments, and share repurchases through stressed market conditions. For more details, see US Federal Reserve Stress Tests March 2012.

I will offer up a few observations here:

1. First, it provides interesting insights and food for throught into the business mix of these institutions, the quality of their assets and where the largest vulnerabilities lie - not merely for regulators, but also for equity investors, bondholders and business counterparties. For example, financial institutions with asset servicing, transaction banking and retail credit businesses are impacted less under these tests, compared to those that are heavily skewed towards SME and wholesale banking
2. Investment banks and broker/dealers with large trading positions would contribute >94% of all trading/counterparty losses in the system. These numbers are also a reflection of the size of fixed income and credit assets and derivative agreements in their portfolios. Most retail and commercial banks would incur minimal or no trading/CVA losses.
3. Some pundits in the industry are lauding these results, saying that the financial crisis that has swept through Wall street is "over"; and that these stress tests draw a line over the pain of the past few years. Whereas in actual fact, this is likely to be the first step into a new world - where the financial sector and broader global economy faces further challenges ahead, for instance in the Eurozone, as well as the stability of emerging market financial systems. Global financial linkages will impact developed market institutions and these will be the real check and balance to the resiliency of these regulatory "stress and health check" mechanisms.
4. Finally, in addressing risks, faith cannot, and must not, rest on the analytical tools and models, no matter how sophisticated they are, nor can it rest in the enforcement of financial regulation. The old adage of sound judgment and common sense, supported by data, analytics, and robust processes, still stands. For example, could the Fed’s assumption of a stress scenario in Europe be "too optimistic", not taking into account the possibility of multiple failures (rather than one)? This question brings up a point that in stress testing activities, it is an art in making judgement calls rather than science. Any stress testing calculation and/or process is only as credible as the quality of the assumptions and judgement behind them.

In an interim conclusion, I would state this: Although the news of encouraging stress test results promote the notion of safety and soundness in the banking system, competitive advantage at a firm level is based first of all, on this scarce commodity called trust, even before elements like optimizing of business mix, capital efficiency, product / service innovation and operational excellence are taken into account. The balance sheets of large institutions take time to rebuild, but a full measure of trust takes even longer to build (and sustain), notwithstanding stringent regulation and industry wide stress testing initiatives like this. Trust is a commodity in short supply nowadays. It takes a long time to build, yet can dissipate in a matter of minutes. And beyond this, it will take more than mere regulatory efforts to say that the banking system is fixed, but a global community of bankers, to restore trust. With these stress testing initiatives, I would say we are at least now at the starting line. There is a long marathon ahead.