The case for market-based stress tests

a column by John Vickers for VOX: CEPR’s Policy Portal

The stability of the financial system depends on the capital of banks and other financial institutions. But the measurement of bank capital depends on regulatory accounting methods, which, as events a decade ago showed dramatically, do not always reflect economic realities in a timely fashion. This column argues that market-based measures should play a greater role in regulatory assessment than is current practice, in particular in stress tests.

The column opens as follows: I found this fascinating!

“I underwent a stress test of a personal kind at 8 o’clock one morning three years ago when I was about to be interviewed on BBC Radio’s Today programme by the formidable John Humphrys. The subject was bank capital requirements, on which I thought the Bank of England had adopted a softer than prudent policy stance.1 A few minutes before the interview, as the news was being read, John Humphrys came into the room where I was waiting and said something like this: “It’s a complicated topic. We need to make it intelligible to the listeners. So is it alright to talk about bank capital as like a pot of money that they keep on one side for a rainy day?”

“Given the terms in which bankers, commentators and, alas, regulators including central bankers often speak about banks “holding” capital and so on, it is entirely natural that John Humphrys would think that the pot-of-money metaphor was apt. But he wasn’t sure and he took the trouble to check. No, it’s not like that at all, I explained (off air, thank goodness). A pot of money is an asset, but equity capital is on the liability side of the balance sheet – part of banks’ funding structure. It is the difference between two big numbers – the estimated value of their assets and their liabilities (i.e. obligations to depositors, bond-holders, etc.). He got the point instantly and somehow managed to make the interview both intelligible and free of the pot-of-money fallacy.”

Continue reading

---