
Don’t let a good crisis go to waste

In the aftermath of the financial crisis, regulators scratching their heads on how to prevent a repeat were in the early days of beefing up what would become a tough battery of annual stress-testing programmes – and a row broke out between one central bank and its prudential supervisory arm.
There was broad agreement that stress scenarios made sense as a means of getting banks to think about what would happen if an unlikely confluence of events led to another far-reaching, long-lasting crisis. The problem came when the question of how severe to make these scenarios arose, recalls one seasoned former regulator at the prudential watchdog – still the subject of endless rows between banks and regulators, and policy-makers themselves.
The central bank’s economists were pushing the regulator to make its stress scenarios countercyclical, recalls the veteran supervisor; the country was already mired in its deepest post-war recession, they argued, and surely things couldn’t get any worse – so why make the stress tests any more punitive for the country’s ailing banks than they needed to be?
Reluctant to call the bottom of the cycle, the regulator dug its heels in: “Sure enough, when we first came out with a really severe scenario, their economists were sceptical about how severe it was,” the supervisor – an economist by training – recalls. “The economic reality afterwards turned out to be even more severe.”
The episode cuts to the heart of a problem that has dogged administrators of stress tests – now established as the post-crisis barometer of the health of a nation’s banks – throughout the last decade: what does ‘severe but plausible’ look like?
Regulators’ worst-case scenarios, gradually watered down by intense lobbying from lenders and politicians, have not found their consensus on that point tested by real events – until now.
The economic devastation wrought by Covid-19 is already significant: the hits to employment, gross domestic product and other key macro factors regulators ask banks to test to has already surpassed supervisors’ severely adverse scenarios, and shows every sign of getting considerably worse before it gets better.
While the US is pressing ahead with its annual testing cycle, European regulators have already abandoned this year’s round altogether. The decision has raised eyebrows – not least since real-world loan-loss provisioning has already outstripped the Federal Reserve’s previous worst case. But, in fact, it’s more in tune with the shop-floor reality that banks are already pursuing in the wake of the crisis, where a clear trend is emerging. In the absence of credible inputs for standard models, banks are appraising the potential of methods borrowed from stress-testing to support everything from credit loss provisioning to real-time market risk management.
Conversations with scenario analysis experts at banks, buy-side firms and stress-testing vendors, as well as several former regulators, suggest a shift is under way: decades of established price theory underpinning stochastic modelling methods are being cast aside in terms of more fundamentally driven approaches: shocking loan books with prebuilt scenarios from vendors, running simulations using data from past crises and actively reappraising exposure to major creditors using expert judgement.
Once markets normalise, it seems unlikely firms will simply re-base their assumptions on the pandemic being the worst case for probability-of-default models, for instance, or gauges of interest rate volatility, and continue to model markets the way they always have. Even if models aren’t supplanted, they will rightly be subjected to challenge more routinely via alternative approaches.
A willingness by banks to cast aside the old and revisit the notion that the future can be predicted by selectively replaying the past should be embraced: it could unleash a period of immense creativity in risk management. As former Chicago mayor and investment banker Rahm Emanuel once observed, it’s a hell of shame to let a good crisis go to waste.
Only users who have a paid subscription or are part of a corporate subscription are able to print or copy content.
To access these options, along with all other subscription benefits, please contact info@risk.net or view our subscription options here: http://subscriptions.risk.net/subscribe
You are currently unable to print this content. Please contact info@risk.net to find out more.
You are currently unable to copy this content. Please contact info@risk.net to find out more.
Copyright Infopro Digital Limited. All rights reserved.
As outlined in our terms and conditions, https://www.infopro-digital.com/terms-and-conditions/subscriptions/ (point 2.4), printing is limited to a single copy.
If you would like to purchase additional rights please email info@risk.net
Copyright Infopro Digital Limited. All rights reserved.
You may share this content using our article tools. As outlined in our terms and conditions, https://www.infopro-digital.com/terms-and-conditions/subscriptions/ (clause 2.4), an Authorised User may only make one copy of the materials for their own personal use. You must also comply with the restrictions in clause 2.5.
If you would like to purchase additional rights please email info@risk.net
More on Risk management
JP Morgan, Eurex push for DLT-driven collateral management
The high-stakes project could be a litmus test for the use of blockchain technology in the capital markets
Start planning for post-quantum risks now
Next-gen quantum computers will require all financial firms to replace the cryptography that underpins cyber defences, writes fintech expert
US Treasury clearing mandate poses riddle for Asian markets
Participants unclear on how far the rules will reach, or the role of inter-affiliate exemptions
Looming US Basel endgame redraft sparks calls to save IRB
Experts say 20 years of data makes credit risk models more appropriate than standardised approach
Cool heads must guide financial regulation of climate risk
Supervisors can’t simply rely on ‘magical thinking’ of market discipline, says Sergio Scandizzo
Op risk data: Two Sigma pays the price for model mess
Also: KuCoin’s AML fail, Angola bribes bite Trafigura, and Trump’s green scepticism. Data by ORX News
‘More questions than answers’ in race to build repo plumbing
Complexity could slow development of matching and credit-checking tools for US Treasury trades
How Citi moved GenAI from firm-wide ban to internal roll-out
Bank adopted three specific inward-facing use cases with a unified framework behind them