Bank Stress Test Farce

There recently was a “bank stress test”. It was a nice piece of propaganda. That creates the illusion that someone is watching the banks and making sure they aren’t taking too big risks.

In a “stress test”, you assume a sharp market decline and see what banks are still solvent. There are a couple of big fallacies.

The first fallacy is “How big of a decline?” If you assume a severe decline, nobody will pass. If you assume a lenient decline, then everyone passes.

The second fallacy is “How do you value illiquid assets?” Suppose that bank A owns X and bank B owns Y. How do you know which will decline more, X or Y? Based on what assumptions you make, that affects which banks pass.

That’s the “advantage” of banks owning complicated illiquid assets. It’s practically impossible for someone to look at the positions, and decide if the bank is solvent or not. By hiding under complexity, banks can continue operating even if they’re insolvent. With negative interest rates, if you load on leverage, you’ll profit eventually, even if you’d be bankrupt if you were forced to liquidate immediately.

The third fallacy is “What if assets are already overpriced?” Suppose a bank has an asset on its books for $1B when it’s really worth $0.1B. If the stress test assumes a 50% decline from $1B, that still isn’t realistic.

The real problem is negative real interest rates and the central bank credit monopoly. The incentive is for banks to load up on leverage and take big risks.

The stress test is propaganda. It provides the illusion of responsibility. The results are meaningless. There’s a lot of discretion for the assumptions. If the calculation is strict, nobody passes. If the calculation is lenient, everybody passes.  If the calculation is biased, some banks will pass and not others.

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