Did you know that the Hindenburg zeppelin had been rigorously stress tested? And that the design of the Maginot line was almost impregnable?
Everything that has ever sunk, exploded, tipped over, burst into flames, fallen down or simply not worked had been stress tested in its day. The problem is that stress tests are rarely left to the engineers, who as a breed just love to blow stuff up. Even their own stuff. Unfortunately testing is usually tightly controlled by the money men and the politicians. Whose over-riding concern is to make sure that nothing embarrassing or expensive is brought to light. And so the idea, for example, that someone might decide not to attack defences in the required manner but instead walk around the back, is not acceptable and therefore not within the scope of the test. And because it’s not, the defenses are tested against only the stresses they were designed for. And pass with flying colours. As, rather similarly, almost the entire European banking system passed their test.
The European Bank Stress test, I think, combines all the forms of testing failure into one spectacularly unwise package. Failure of imagination, of political will and of courage. Other than that it was great.
The essence of the European Bank test was that no sovereign default was allowed. To outside observers this made the whole thing risible and irrelevant. But while true it slightly misses the point of the test. The test, in my opinion was not really so much of the individual banks, but of the ECB and EU policy. Here is our policy – no country allowed to default – what will happen to the banks?
From a eurocrat point of view it makes sense. It shows the world what is going to happen under their policy. It sets out in more detail what to expect from the policy. What is not being tested is the policy itself. How can you test the Maginot line unless you test at against someone attacking it? From the point of view of apolitically limited imagination, it makes sense. From the same POV the bank test also makes sense.
In the real world however it has a few problems. Here are the main ones I see coming up to destroy the illusion of safety.
The problem with setting a ‘no sovereign defaults’ as the bed rock of European banking recovery is that it is a much more political than a financial undertaking. The ECB has essentially predicated its entire recovery policy on NOT ALLOWING a nation or its people to democratically decide to default and restructure their debts. What looks from one side to simply be a generous and strong financial promise to help at all costs, flip it over and it is actually a political decree that no restructuring is to be tolerated. In short the bank stress test was not a financial test it was a political declaration.
This is putting finance and its mandarins above democracy and its elected representatives. As such it is both dangerously dictatorial and quite possibly un-enforceable.
Take the situation in Greece. This week Greek lorry drivers were on strike. Their actions quickly began to paralyse the national infrastructure. The strikes were legal, largely peaceful and expressed the desire of the lorry drivers. The Greek government rushed into parliament a war-time law making strikes illegal with gaol time for those who persist. Which today they did – en masse – despite the use of riot police firing tear gas on their own people.
This is the reality of putting finance above the rule of democracy. Take away democratic control and people are left without any peaceful means of ruling themselves or expressing their sovereign will as free people. It is a dangerous road to go down.
Then look at Hungary. All its banks passed the stress test by an easy margin. Now I don’t think that makes them safe or solvent banks at all. But for those who set up the test it says just that. IF, that is, they follow the plan exactly as laid out. And there’s the rub. Remember this wasn’t a test it was a policy declaration with details attached. And the problem in Hungary is the government has made it clear they are servants of their people not the EU or IMF.
Hungary points out quite reasonably their finances aren’t the worst by a long way and their banks passed the test. So they feel they have some wiggle room and want to reduce the cuts a fraction and tax their banks to help with government finances. Neither of which are in the undemocratic financial uber-plan. SO what happens? Well both the EU and IMF make sure the markets know that unless Hungary set aside the wishes of the electorate and follows exactly what they are told, then the EIU and IMF will NOT help and the markets duly downgrade large sections of Hungary’s banks debt ratings.
Hungary thought the ECB/EU/IMF was there to help Hungary with its plan. Whereas they are there only to make sure Hungary complies with the IMF/ECB’s plan.
So Hungary is going to get squeezed into capitulation. The reality is Hungary could find a solution which would be workable for the markets and for its people BUT NOT one which the ECB approves of. Because such a plan drives neatly around the end of the stress test Maginot line of defence. Thus it cannot be allowed to happen.
These are some of the immediate political stupidities and dangers I see. Now to the financial ones.
The Stress test plan, because it maintains that NO sovereign default will be allowed – not even if a sovereign people want it, – simply declares that the amount and kind of financial stress it is going to bew concerned with and rule as admissable in polite converstaion, is significantly reduced.
The main way it does this is by only allowing a smaller part of the banks over all exposure to debt, to be stressed or tested. The larger part, not included or stressed, happens to include the bulk of bank holdings of sovereign debt. To explain – Because the tests presumed no nation would default, then all the holdings of that debt could be assumed to be held by the banks safely to maturity.(No default – no need to sell). The banks would NOT suddenly have to sell those holdings to raise cash, thus triggering a massive collapse in the value of those same holdings at all the other banks in all the other nations and there would therefore NOT be no sudden liquidity bottleneck.
What this meant was that nearly ALL the banks involved transferred large amounts of their worst performing debts from their trading book (the tested bit) to their bank book (which was not tested). The debts if they had been left on the Trading book would have been subject to a 23% cut. Transferred to the bank book to hold until maturity they suffered no cut at all. And that is how you pass the test! Simples as a rodent once said. Two German banks DG and WGZ did exactly this. WGZ said it moved almost all its €35 billion in debt exposure in this way.
Of course you can’t really avoid a loss by simply carrying a piece of paper from one room to another. Even in banks this won’t work in the real world. You can’t take your phone bill into the shed and suddenly find that in there you don’t have to pay. So what has really happened is by ‘holding to maturity’ the ECB is actually saying there will be no losses because we will be there to make up any cash short fall. Which makes zero sense as a test, but perfect sense as a policy declaration.
The Stress test was also predicated on banks being able to raise more money/sell more debt going forward AND at affordable rates. Once again assuming away what the naive had thought they were testing.
But will they? This is where it becomes circular. The ECB’s plan is that the stress-test/policy declaration is itself what will ensure the banks will be able to borrow. Because if the market will see this plan, know the ECB is NOT going to allow a little matter of democracy get in the way in Greece or Hungary or anywhere else it starts to grow AND that in return for this suspension of democracy the ECB is there to pay all the accruing debt payments of all the banks as they arise – THEN the markets should be happy to lend. “Only the ECB can do dis” (Think Heineken ads circa 70’s)
But what if people don’t comply? Well thankfully that was not allowed in their test/policy. So we don’t have to think about it. No one will walk around our defences! It’s just not allowed.
However already signs are not hopeful. Take Spain’s second largest bank, Banco Bilbao Vizcaya Argentaria (BBVA). Last week they sold €2 billion in new debt. Good you might say. And the headlines did. What they didn’t linger on was that the debt was sold as covered bonds AND even so had to pay a record interest rate. The rise in rates isn’t great. Obviously. But its the covered bond which is the worry.
Covered bonds are bonds which stay on the seller’s books. Which means that unlike other bonds which are backed only by the assets underlying them, the covered bonds are also covered (hence the name) by all the worth and assets of the bank. This in turn means that in the case of default or insolvency these covered bonds take precedence over ALL other debts and obligations. They would get paid before the ECB, the IMF or God if he had been so foolish as to invest.
No one wants to issue covered bonds. Its the bank equivalent of saying you will cut off an arm if you default. Its a mafia kind of deal. AND EVEN SO they still had to pay record interest. It doesn’t get much clearer, that the markets are not impressed by the ECB plan/put/promise.
BBVA had revealed that its losses and non-performing loans had jumped up massively again. These are the truths and consequences the ECB policy cannot paper over.
And the funding needs of the EUropean banks over this year and next is a HUGE problem. The problem going forward is not only whether the rate of losses and the rate of growth to off-set them are both a benign and rosily optimistic as the ECB supposes, but how much debt the banks have to raise ANYWAY not including any losses. The amount is – painful.
This is from the Wall Street Journal,
The International Monetary Fund has estimated that €877 billion of euro-zone bank debt was due to mature this year; €771 billion comes due next year and €714 billion in 2012. In the U.K., the major banks need to refinance or replace as much as €800 billion of funding by the end of 2012, according to the Bank of England. That amounts to more than €25 billion a month—double the rate at which banks recently have been raising funds, the bank said.
Bear in mind this is happening at the same time as the ECB, the BoE and the FED will all be trying to sell Trillions on debt. It is both the sheer amounts but also the fact that more and more debt is ONLY being bought for short duration meaning its back on the market to be re-financed before the ink has had time to dry. Is this sustainable? Is it stable?Luckily, again, not part of the test. So don’t worry!
Good this isn’t it. Maybe Ostriches have had it right all along.
These are just a few points about the Stress Test and its undemocratic and illusionary nature I wanted to make. Next I want to get into a more fundamental look at whether we have fixed the system as a whole. But first I need a cup of tea.
covered bonds wiki
Something in the FT the other day made me look up covered bonds as had no idea what they were ! They do have a long history, and are often used outside USUK, but I suppose all depends on whether the issuer is into fraudulent accounting, or not …
One of the better descriptions of the stress test I heard was 'firing an arrow and drawing a target around wherever it lands'.
Peter,
I like that one.
Saw this at the FT this morning and am broadcasting !
It is old news, but a reminder of where we could all be going … unless …
comment on IDS welfare reform editorial at Gdn
I wonder what IDS would say about this article ?
When I asked what the American Dream means to them, Mark looked despondent. “It’s not a dream,” he said. “I would hate to sound like one of those Tea Party people but I really do want my country back. I just don’t feel like that is going to happen.” His words reminded me of a famous quip by George Carlin, the late, great American comedian – “It’s called the American Dream because you have to be asleep to believe it.”
There is free registration to read a few articles at the FT …
Jobs just aren't going to fall from the sky in a magic re-run of all previous Recessions, so we need radical policies such as the Basic Income refered to by neilwilson just above. A New Deal for safeguarding the mass of people in a changing world. And yes, the quality of life could even be better !
So is IDS blindly tinkering with good intentions, or fully conscious of where we are going and just concerned with personally staying at the top of the pile ?
Seeya !
http://www.nytimes.com/2010/07/28/business/economy/28bailout.html?_r=1&scp=1&sq=Blinder%20&st=cse
From the New York Times. Just so you will know what kind of opposition we're up against. The heavyweight professors of elite universities say you're wrong and they support the financial classes "scientifically proved" solution; that everybody else pays must their debt or else…
Excellent article frog2, but I couldn't help thinking about how lucky those American families were compared with most of the rest of the world. Nevertheless, the article does act as a warning to all those who have grown comfortably numb in a consumer-fuelled capitalistic society.
How on Earth do we move from a heavily leveraged population to one that can survive with Basic Income? The Financial Class would gobble it all up and then lobby for the Basic Income to be increased.
Clearly, as Great Grand Dad has been saying for years, we need to change our ways; but the Financial Class does not want this. Their survival depends on us being perpetually insolvent. Unless their power diminishes we will forever be trapped in Golem's Toxic Debt Wasteland.
Time for another deliciously naive, cunning plan methinks:
Step-1: Set up banks that are free of debt and are not allowed to partake in high-risk investment activities.
Step-2: Wait sufficient time for people to transfer their accounts to the new banks.
Step-3: Allow all banks to continue without bail-outs.
Step-4: Bring in Basic Income for people reaching 18 years old.
Step-5: Bring in Basic Income for people emerging from bankruptcy procedures.
Step-6: Replace state pensions with Basic Income.
Step-7: Buy-to-let houses can only be sold for half the current market value.
Step-8: Re-assess everybody's collective credit card limits. The credit limit should take in to account how many cards a person has. People with balances above their newly calculated credit limit should pay a lower interest rate on the excess.
Step-9: Eliminate all people who create annoyingly silly plans like this one.
Yes, yes, I'm going out the door now …
Lars Eirik link
RichGB — a lot of us were lucky … 🙂
… wait a moment.
Step-7 is not explained properly. It's intention is to bring property prices down, providing an avenue for people moving from highly priced to lower priced homes. The landlord would be forced to rent out the house to meet costs and make a tidy profit before it re-enters the market.
In reality, this will only work with new properties, but the building industry won't complain.
Oops! Is that a superfluous apostrophe?
Interesting, but like I've mentioned before, I reckon these issues with stress tests are a symptom not a cause.
Comparisons with proper engineering stress tests are a bit misleading because the results of the tests change the system, (i.e. imagine the political consequences if lots of banks HAD failed the tests) although the Maginot Line is a fairer analogy. Similarly, the markets would've got uppity if they'd decided not to do the stress tests at all. This fudge looks like the best of a fairly bad bunch of options to me.
Stress tests are a good idea; the main problem is that they weren't implemented rigorously enough during the boom years. I'm not sure what changing the rules for them would achieve at this point.
Also, (and I accept this is nitpicking but it's a new fact I've just learnt so I want to show off…) : Ostrichs DON'T bury their heads in the sand according to this
They don't!? Tam, part of my childhood world just crumbled.
Hi RichGB,
I guess your list was partly tongue in cheek, but I think that gradually shifting tax off labour and onto land value would be a simpler way to achieve similar aims. We should aim to make employing people as cheap and as easy for a company as possible. The aim should be ti keep house prices roughly where they are now for a few decades by gradually increasing land taxes and shifting tax off labour. The banks will hate this, which is probably why it wont happen!
Rob