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Ten years after the crisis, experts question value of bank stress tests

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Ten years after the crisis, experts question value of bank stress tests

Since the financial crisis, regulators have introduced a battery of tests to ensure banks hold enough capital to cope with even the toughest scenarios. But a decade on, there is still a dispute over just how much capital is enough.

One of the most powerful voices raised against the present regime is that of Sir John Vickers, the former chief economist of the Bank of England, who chaired the U.K.’s Independent Commission on Banking. Regulators are seriously overestimating banks’ strength and that their accounting methods are flawed, Vickers said in a speech in Abu Dhabi, the United Arab Emirates, in November 2018.

Not far enough

He is not alone in questioning the suitability of the regulators’ stress tests, which were introduced to all major jurisdictions after the financial crisis. In 2018, as the world marked 10 years since the crisis, the outgoing chair of the European Banking Authority, Andrea Enria, called for "open and informed" discussion on ways to

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improve the EBA’s tests, highlighting the disconnection between the tests themselves and the potential supervisory actions of regulators. Meanwhile, Daniele Nouy, outgoing chair of the European Central Bank’s Single Supervisory Mechanism, said the tests told her nothing new.

Vickers’ contention is that the post-crisis reforms, which intended to make banks hold on to more capital, did not go anywhere near far enough. Under Basel III, a comprehensive set of reforms developed to strengthen regulations, banks are required to maintain a leverage ratio of at least 3%, and a common equity Tier 1 ratio of 4.5%, while systemically important banks must have a CET1 ratio of 7%.

When the International Monetary Fund’s Global Financial Stability report in October, 2018 asked if the world was safer, a decade after the global financial crisis, Vickers said the answer was "yes" a host of policy reforms overseen at international level by the Basel Committee and the Financial Stability Board mean the banking system is considerably safer.

Credit cycle

But Vickers said the IMF's question could have gone further.

"We are safer 10 years on, but not as safe as we could and should be," he said.

The EBA and the Bank of England's recent stress tests have shown that even in a global downturn, banks have sufficient core capital to avoid collapse. In December 2018, the EBA said that European banks’ CET1 ratios had improved to 14.3% at the end of the second quarter of 2018 compared with 14.0% in the same period last year.

For Vickers, the Bank of England’s approach to analyzing how much equity should underpin banks’ balance sheets is fatally flawed, since it calculates the optimum capital buffer at an average point in the credit cycle.

"Capital buffers are a safeguard for abnormal conditions, just as flood defenses are built for abnormal weather conditions," he said.

The Independent Banking Commission said it considered the Basel baseline CET1 ratio of 7% "clearly insufficient for systemically important banks" and said it seemed "very doubtful that any figure below 10% can be robustly supported by the available evidence and a case could quite easily be made for going higher."

Vickers quotes a group of economists who argued in a letter to the Financial Times that at least 15% of banks' total nonrisk-weighted assets should be funded by equity. He notes that the former governor of the Bank of England, Mervyn King, has said a 10% equity base "would be a good start."

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He is not alone in his view. Alex Brazier, the Bank of England’s director for financial stability strategy and risk has said: "It would have been easy in the aftermath of the crisis to swing the regulatory pendulum right the other way; to demand that banks fund themselves with huge amounts of shareholders’ equity."

"The system would certainly have been safer. There is a respectable academic case for very high levels of bank equity," Brazier said.

But regulators' new legal powers to recapitalize failing banks with shareholders’ funds, and their duty to keep regulation up to speed with the risks, do provide extra security, he said.

Value of bank assets

Vickers’ premise is that the real shock of 2008 was the fragility of the financial system itself and believes a key reason for that was inadequate equity capital.

"Banks’ capital adequacy is a cornerstone of our economic system," he said.

Vickers view is that Basel III is built on the premise that accounting methods measure the value of bank assets in an accurate and timely way, but bank assets are not easily tradeable and are therefore inherently difficult to value.

"Events 10 years ago made plain that reliance cannot be placed on accounting methods for accurate and timely valuation," he said.

Vickers said banks' strength looks very different if market valuations are used to calculate capital ratios, noting the IMF's view that in the eurozone, China, Japan and the U.K., the market value of equity is less than the price booked on banks' balance sheets.

Therefore, said Vickers, banks should not be considering big dividend payouts or share buybacks.

Royal Bank of Scotland Group PLC, for instance, has reported CET1 of £32.5 billion, and the bank said it "has a significant pile of excess capital" and is considering a "targeted share buyback" and an "additional special dividend."

Vickers said RBS has a price-to-book ratio of about 0.55x hardly excess capital as far as the public is concerned.