Stress Test Thoughts

Too much has been written about the bank stress tests, so I hesitate to jump into the fray. Nevertheless, I thought an article in the today made two important points that are pretty obvious but haven’t seemed to get much play.

Here is what they had to say:

Because of this, bank risk managers (admittedly, not the most credible group these days) tend to view these tests as a public relations stunt that regulators will use to force their institutions to toe Uncle Sam’s line. That, in itself, is worrying. Regulators shouldn’t have to invent justifications for regulating properly. The right response by a bank when its overseer says jump is “how high?”

That regulators are wrangling with banks over the results of these tests shows that they are not confident in their ability to understand the institutions. That gives banks too much power. It would be better for watchdogs to demand that they reduce their complexity to comprehensible levels. Otherwise they’ll retain the upper hand – and no amount of testing will be sufficient to diagnose their problem.

I’m not sure I agree completely that banks need to slavishly comply with the regulators. There has to be some back and forth since neither party is in possession of complete knowledge but at the end of the day the regulators clearly are the top dog.

As to the comment about complexity, I’m of two minds. I’m pretty much in the camp that would like to see a make over of the financial system. I would prefer to see a system that results in banks that are pretty much limited to traditional finance and investment banks that deal with the more exotic instruments. The banks would be subject to fairly intense regulation and the investment banks treated much more lightly in exchange for no implicit or explicit government guarantees. In that sort of regime the banks should naturally become less complex and easier to regulate.

At the same time, there’s an argument to be made that the regulators need to up their knowledge level. I don’t want a system in which innovation and new products are squelched simply because they’re complex. We don’t dissuade Boeing from advancing the art of aircraft manufacturing simply because the new products are more complex. Those government agencies responsible for certifying the air worthiness of new planes are expected to master the nuances of the new technologies. I don’t see why finance should be any different.

We’ll see what actually develops.

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