BoE stability chief calls for stress war games

Banks could be forced to carry out joint stress tests to model the knock-on effects of a single disturbance on the entire financial system, according to the Bank of England's head of financial market stability, Andrew Haldane.

Speaking at a London conference last week, Haldane said existing risk tests underestimated the "network externalities" of financial problems - the degree of damage that could be done at second or third hand by the collapse of a single counterparty, such as Lehman Brothers. But the complexity of the modern financial system means predicting such effects would be "unrealistic even for the authorities, much less an individual firm".

The solution, Haldane said, could be "an iterative approach", which would take account of other firms' responses to the initial stress -responses that could include the evaporation of market liquidity or sudden drops in asset prices due to forced sales.

He also highlighted two other reasons for the general failure of stress testing: myopia and perverse incentives. Noting systemic financial crises tend to happen at intervals of roughly a decade - the 1987 crash was followed by the 1998 long-term capital management crisis and then by the 2007 credit crisis - he speculated that bank risk managers and the models they use generally tend to forget about anything that happened more than 10 years ago, and base their risk analysis on a sample of recent data that is in fact unusually positive. "The credit crunch of the past 18 months is but the latest in a long line of myopia-induced disasters," he commented.

The policies of banks and governments had also given risk managers incentives to use unrealistically mild stresses - in the knowledge that a severe stress would lead to a government bail-out, Haldane said. He also accused banks of performing stress tests only grudgingly, when required to do so. "Stress testing was not being meaningfully used to manage risk. Rather, it was being used to manage regulation. Stress testing was not so much regulatory arbitrage as regulatory camouflage," he remarked.

Regulators around the world have blamed inadequate stress testing as a factor in the credit crisis: last month the Basel Committee on Banking Supervision said banks had used unrealistically mild stress scenarios and often ignored the tests' results.

See also: Basel releases stress-testing guidance
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