By Mark Somers, Technical Director at 4Most Europe (www.4-most.co.uk)
Recent economic troubles in most major economies were made worse by the fact that major banks had not fully anticipated the scale of losses that were possible and therefore in many cases they were under-capitalised and under-prepared. The reason for this failure to understand the risks has many varied dimensions including inappropriate market incentives for banks, over-accommodating regulators, politicians with electoral incentives and geo-political transition changing the system in unexpected ways. Whatever the underlying reasons, what is key for banks and regulators, is to understand how to design a stress-testing regime that informs all stakeholders more effectively next time.
Banks are inherently good at managing risks they can quantify, for example interest rate hedging, daily market volatility or consumer credit cards. Where many fall short, is taking account of the risks that they know about but haven’t properly quantified, either because institutionally it falls into a gap or because they don’t understand the potential magnitude. Structures in the market that enabled banks to originate debt, package it and then move it off their balance sheets, often to other banks, were clearly broken. They had the legal trappings of risk transfer but across the economy leverage was increasing – and the ability to withstand shocks became wafer thin.
Time to ‘get serious’
Retail and commercial banks are clearly increasing their focus on stress-testing primarily in response to pressure from regulators. New regulations will require banks to disclose more information on the risks and capital consumption that they have quantified and this should enable investors and rating agencies to be able to come to a more informed decision for those elements.
However, the outputs still mainly inform the debates with regulators as opposed to linking effectively to risk appetite and ultimately business strategy. Stress-testing will have come of age when banks enter or leave lending to market segments and individual exposures within those segments based on insight as to what might happen in a downturn and how correlated this would be with the other exposures on the book.
Regulators are inevitably outgunned compared to the level of effort and insight the banks can put on the pitch regarding analysis of their own portfolios – as a result regulators can feel they are starting from a back foot. This leaves them in a difficult position – to concede ground and look for compromise with banks, typical of the regulatory approach in the run up to the crisis; or to stick to their guns, even though in some cases they may be wrong, and potentially be a constraint on the industry and ultimately the economy as a whole.
What is happening globally?
Internationally (including in the UK) banks are being asked to complete analysis to explain how their portfolios would react under defined regulatory scenarios and demonstrate the level of capital they would maintain in these stressed situations. These results are aggregated and anonymised by regulators and high level results have been published to instil confidence in the system overall.
Another exercise the banks are asked to complete is what is called a reverse stress test – essentially to answer the question: How bad would it have to get for the bank to fail? One enhancement I believe could be made is rather than defining a single failure, scenario banks should be asked to provide the risk contours of key stress indicators, GDP, interest rates, unemployment etc. that it would take for the bank to fail. The regulator could then compile the super-position of these across all major different banks operating in a market to understand the conditions under which there is a likelihood of systemic failure. These results should be published to enable economists and rating agencies to understand clearly how safe the banking sector really is.
Regulators make waves
Another interesting outcome that has been adopted internationally is for regulators to have their own private stress-testing tools for comparison. In fact, regulators are building their own stress-testing tools in the UK right now. The issue for banks is that they don’t want to be a position where it is the regulator arguing for their model vs the bank for its own. Instead banks need to understand the range of models that are possible and consistent with their historical data. Then the question: Is the regulators result consistent with this range? And if not, what effect has the regulator failed to capture to evidence that the banks internal models are more reliable?
This and the idea of publishing stress-testing results should provide both the carrot and the stick to incentivise banks to take stress-testing seriously and act on it appropriately, even when conditions have been benign for an extended period, as was the position at the start of 2007.
Improving stress-testing capabilities
With this motivation banks can look to improve their stress-testing capabilities in a number of ways:
- Recognise that there is no one, best stress-testing model (as opposed to forecasting). Model risk is a key and assessing multiple approaches and assumptions in a systematic way is an important component in estimating uncertainty in losses.
- Build a stronger link between current provision calculation and future loss forecasts. Banks increasingly need to demonstrate they are fully providing for their forecast losses.
- Unpick possible structural changes in the book from economic changes outside. What would the loss profile do if the bank closed to new business? This could be a potential stress-test scenario but one that few purely statistical models can answer clearly.
- Understand the benefits of exploring a wider variety of stressed scenarios. Typically banks are asked by regulators to investigate a handful of outcomes, in reality any one of these has a vanishingly small chance of happening – how can banks demonstrate they have all the bases covered without fully exploring the multitude of potential scenarios.
If these can be tackled critically and the outcomes are fully embedded in the way the business is monitored and the actions it takes today, then next time it should be very different.
About 4most Europe (www.4-most.co.uk)
4most Europe Ltd is a specialist credit risk analytics consultancy with offices in London and Edinburgh. The company provides a range of products and services across credit risk, fraud and pricing, working with blue chip clients predominantly in the retail banking and mobile sectors. The company offers a flexible, competitive model, either working with clients to manage regulatory change or delivering and implementing business critical solutions.
ECB stays put but warns about surge in infections
By Balazs Koranyi and Francesco Canepa
FRANKFURT (Reuters) – The European Central Bank warned on Thursday that a new surge in COVID-19 infections poses risks to the euro zone’s recovery and reaffirmed its pledge to keep borrowing costs low to help the economy through the pandemic.
Having extended stimulus well into next year with a massive support package in December, ECB policymakers kept policy unchanged on Thursday, keen to let governments take over the task of keeping the euro zone economy afloat until normal business activity can resume.
But they warned about a new rise in infections and the ensuing restrictions to economic activity, saying they were prepared to provide even more support to the economy if needed.
“The renewed surge in coronavirus (COVID-19) infections and the restrictive and prolonged containment measures imposed in many euro area countries are disrupting economic activity,” ECB President Christine Lagarde said in her opening statement.
Fresh lockdowns, a slow start to vaccinations across the 19 countries that use the euro, and the currency’s strength will increase headwinds for exporters, challenging the ECB’s forecasts of a robust recovery starting in the second quarter.
Lagarde saluted the start of vaccinations as “an important milestone” despite “some difficulty” and said the latest data was still in line with the ECB’s forecasts.
She conceded that the strong euro, which hit a 2-1/2 year high against the dollar earlier this month, was putting a dampener on inflation and reaffirmed that the ECB would continue to monitor the exchange rate.
The euro has dropped 1% on a trade-weighted basis since the start of the year, but is up nearly 7% over the last 12 months. Against the U.S. dollar, that number rises to over 10%.
Opening the door for more stimulus if needed, Lagarde confirmed the ECB would continue buying bonds until “it judges that the coronavirus crisis phase is over”.
Lagarde also kept a closely watched reference to “downside” risks facing the euro zone economy, which has been a reliable indicator that the ECB saw policy easing as more likely than tightening.
But she signalled those risks were less acute, in part thanks to the recent Brexit deal.
“The news about the prospects for the global economy, the agreement on future EU-UK relations and the start of vaccination campaigns is encouraging,” Lagarde said. “But the ongoing pandemic and its implications for economic and financial conditions continue to be sources of downside risk.”
Lagarde conceded that the immediate future was challenging but argued that should not impact the longer term.
“Once the impact of the pandemic fades, a recovery in demand, supported by accommodative fiscal and monetary policies, will put upward pressure on inflation over the medium term,” Lagarde said.
Benign market indicators support Lagarde’s argument. Stocks are rising, interest rates are steady and government borrowing costs are trending lower, despite some political drama in Italy.
There is also around 1 trillion euros of untapped funds in the Pandemic Emergency Purchase Programme (PEPP) to back up her pledge to keep borrowing costs at record lows.
The ECB has indicated it may not even need it to use it all.
“If favourable financing conditions can be maintained with asset purchase flows that do not exhaust the envelope over the net purchase horizon of the PEPP, the envelope need not be used in full,” Lagarde said.
Recent economic history also favours the ECB. When most of the economy reopened last summer, activity rebounded more quickly than expected, indicating that firms were more resilient than had been feared.
Uncomfortably low inflation is set to remain a thorn in the ECB’s side for years to come, however, even if surging oil demand helps put upward pressure on prices in 2021.
With Thursday’s decision, the ECB’s benchmark deposit rate remained at minus 0.5% while the overall quota for bond purchases under PEPP was maintained at 1.85 trillion euros.
(Editing by Catherine Evans)
Bank of Japan lifts next year’s growth forecast, saves ammunition as virus risks linger
By Leika Kihara and Tetsushi Kajimoto
TOKYO (Reuters) – The Bank of Japan kept monetary policy steady on Thursday and upgraded its economic forecast for next fiscal year, but warned of escalating risks to the outlook as new coronavirus emergency measures threatened to derail a fragile recovery.
BOJ Governor Haruhiko Kuroda said the board also discussed the bank’s review of its policy tools due in March, though dropped few hints on what the outcome could be.
“Our review won’t focus just on addressing the side-effects of our policy. We need to make it more effective and agile,” Kuroda told a news conference.
As widely expected, the BOJ maintained its targets under yield curve control (YCC) at -0.1% for short-term interest rates and around 0% for 10-year bond yields.
In fresh quarterly projections, the BOJ upgraded next fiscal year’s growth forecast to a 3.9% expansion from a 3.6% gain seen three months ago based on hopes the government’s huge spending package will soften the blow from the pandemic.
But it offered a bleaker view on consumption, warning that services spending will remain under “strong downward pressure” due to fresh state of emergency measures taken this month.
“Japan’s economy is picking up as a trend,” the BOJ said in the report, offering a slightly more nuanced view than last month when it said growth was “picking up.”
While Kuroda reiterated the BOJ’s readiness to ramp up stimulus further, he voiced hope robust exports and expected roll-outs of vaccines will brighten prospects for a recovery.
“I don’t think the risk of Japan sliding back into deflation is high,” he said, signalling the BOJ has offered sufficient stimulus for now to ease the blow from COVID-19.
NO EXIT EYED
Many analysts had expected the BOJ to hold fire ahead of a policy review in March, which aims to make its tools sustainable as Japan braces for a prolonged battle with COVID-19.
Sources have told Reuters the BOJ will discuss ways to scale back its massive purchases of exchange-traded funds (ETF) and loosen its grip on YCC to breathe life back into markets numbed by years of heavy-handed intervention.
Kuroda said the BOJ may look at such options at the review, but stressed a decision will depend on the findings of its scrutiny into the effects and costs of YCC.
He also made clear any steps the BOJ would take will not lead to a withdrawal of stimulus.
“It’s too early to exit from our massive monetary easing programme at this point,” Kuroda said. “Western economies have been deploying monetary easing steps for a decade, and none of them are mulling an exit now.”
(Reporting by Leika Kihara and Tetsushi Kajimoto; additional reporting by Kaori Kaneko; Editing by Simon Cameron-Moore & Shri Navaratnam)
World Bank, IMF agree to hold April meetings online due to COVID-19 risks
WASHINGTON (Reuters) – The International Monetary Fund and the World Bank have agreed to hold their spring meetings, planned for April 5-11, online instead of in person due to continued concerns about the coronavirus pandemic, they said in joint statement.
The meetings usually bring some 10,000 government officials, journalists, business people and civil society representatives from across the world to a tightly-packed two-block area of Washington that houses their headquarters.
This will be the third of the institutions’ semiannual meetings to be held virtually due to the pandemic.
(Reporting by Andrea Shalal; Editing by Chris Rees
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