Bank tests that put the stress on futility

Recent efforts to evaluate the ability of financial institutions to withstand unforeseen shocks are worthless and merely tell us what we already know.

Jefferson Best loosens a stack of one hundred dollar bills on a vibrating table before they are cut into singles at the Bureau of Engraving and Printing in Washington, D.C., U.S., on Wednesday, Oct. 14, 2009. Goldman Sachs Group Inc. said the dollar is likely to extend drops against the euro and commodity backed currencies over the coming six months, based on the greenback's correlation with cyclical assets and capital flows. Photographer: Andrew Harrer/Bloomberg *** Local Caption *** Jefferson Best

There are shiploads of utterly pointless things in this odd world of ours. Exhibit A is the Porsche car, which is ugly, impractical and extravagant. Exhibit B is Paris Hilton, no explanation needed. And the latest, or Exhibit C, is the popular fad of bank stress tests.

These are apparently undertaken to provide some idea of how close the banks are from committing hara-kiri and how much money would be needed to shore them up. Banks are always concerned about their capital (more specifically their Tier 1 capital) and that capital as a ratio of their total assets. They are also concerned about something similar called the capital adequacy ratio, which is total capital divided by risk-weighted assets.

If the Tier 1 or adequacy ratio drops below a certain number (12 per cent and 8 per cent respectively in the UAE) then the banks must scramble around for more capital. The idea is that a bank must always have some money set aside (capital) in case its assets - loans and investments - turn rotten. If this happens then a bank also has to make provisions. Provisions result in losses, which eat away the capital and thus the ratios take a beating. The minimum capital is also needed in case depositors get scared and line up in their thousands with outstretched hands.

So some wag had the cunning idea of running a few "scenarios" and then stepping back to see what happens to the banks' financials and the ratios. These scenarios were "what ifs": what if there was a double dip recession?; what if a few governments actually went bust? The Americans, as pioneers in everything including custom-made financial disasters, were the first off the mark, last year. They tested 19 banks of which 10 were found to be in need of a collective US$75 billion (Dh275.46bn) of capital injection. The Europeans, not be outdone, ran their own tests this year on 91 banks and claimed seven failed, requiring a combined ?3.5bn (Dh16.43bn) to meet EU standards. A large number of the tested banks were from the usual suspect nations: Portugal, Ireland, Italy, Greece and Spain.

On each occasion after stress-test results were announced the financial press erupted in joy, investors cheered, stock markets rallied, credit default swap spreads dipped and the talking heads solemnly declared that truly and verily, the worst had passed and banking salvation was just around the corner. Which I find very perplexing. I've got eight solid reasons why: 1. Running these tests after the biggest financial meltdown in 70 years reminds me of photos of squadrons of heavily armed F-16s vigorously circling the Washington skies 24/7 above a burning Pentagon after the September 11 attacks; a bit too late really. The tests should have been done when bank balance sheets were growing like no tomorrow.

2. We don't know precisely what exact assumptions underlie these scenarios. As every financial modeller knows, it's "garbage in, garbage out". So unless these tests were close to reality they were a colossal waste of time - and newsprint. I'm not a huge fan of Nicholas Taleb of The Black Swan fame but I bow to the man when he declares that most major shocks are simply unpredictable. So none of these tests can replicate what the future will hold because if they did then the future would be knowable and disaster would be avoidable, wouldn't it?

3.Another reason the tests were the joke of the year: the results were overly positive. The figure $75bn is a pittance compared with the $700bn-plus allocated under the US Troubled Asset Relief Programme in 2008. And ?3.5bn is paltry compared with the ?1 trillion bailout arranged by the European Central Bank a few months ago, after the Greek financial crisis. If this is the worst our pinstriped banking chums could dream of as "scenarios" then they should be lynched for lack of creativity as well.

4. The tests revealed very few surprises and merely restated the well known. The Spaniards and Greeks already knew about their weak banks and they were already working on solutions when the tests were ordered. 5.Even more bizarre was what came after the tests. OK, so EU banks need a few billion euros. But where is this coming from? Government handouts? Initial public offerings? A generous sovereign wealth fund? The Tooth Fairy? No answer. "Just go out and get the money," said the regulators to the banks. This was not dissimilar to Lord Blackadder ordering his sidekick Baldrick to "go forth into the streets" and solicit contributions to stave off immediate financial ruin. Running the tests was the easy part - but just try raising money in these tight times.

6. I also have an issue with ratios. Capital adequacy or lack of capital wasn't what brought titans such as LTCM, Bear Stearns and Lehman Brothers to their knees, it was simply lack of liquidity. At the first signs of trouble, counterparties ask for more cash collateral and these troubled firms were forced to rapidly deposit cash, sell-off assets or raise loans to post more collateral until they ran out of cash and assets to sell. Capital is simply an accounting number on the balance sheet - it does not represent cash assets held by the bank.

7. The financial crisis was triggered largely by the unregulated "shadow" banking system, not the regulated sector. It was companies such as Lehman and AIG that caused most havoc. So why isn't this sector being stress tested? Is anyone even looking at big hedge funds, those complex and opaque multibillion dollar behemoths that are "too big to fail"? 8. Why look at just the usual suspect nations? Isn't that where conventional wisdom says danger is lurking? And hence aren't those the very countries where it is least likely you'd find more nasty surprises? Has anyone, for example, looked at Russian or Japanese or Mexican banks? Remember how banks bankrupted a nation in Iceland?

So if stress tests are not the remedy, what is? Well, it's simple: get back to basics. Here are five pieces of advice for banks: 1. Put a lid on your borrowings. 2. Make sure not to borrow short and lend long. 3. Have enough liquid assets handy in the event Armageddon strikes. 4. Don't be greedy when shovelling out loans. 5. Oh, and do take a long golfing vacation every now and then - things may get better when you are away.

Binod Shankar is a CFA charterholder. He is a writer and consultant and runs Genesis, a financial training company