Simon Johnson calls for more transparent bank stress tests

In his NY Times column, Simon Johnson, former chief economist for the IMF, calls for more transparent bank stress tests to address the issue of solvency.  What caught my attention in the article was his observation about why national financial regulators on a global basis were actively blocking full disclosure of financial institution balance sheets.

Regular readers know that under the FDR Framework there are two primary reasons that stress tests are a fundamentally flawed undertaking.

• Governments are not suppose to be providing investment advice which is what publishing the results of a stress test is.  There is no upside particularly when subsequent events like the nationalization of Irish banks after they passed a stress test occur.

• Rather, governments are suppose to ensure that market participants have access to all the useful, relevant information in an appropriate, timely manner so they can run their own analysis.  This is particularly important since under the principal of caveat emptor market participants are responsible for any investment gain or loss.

As practiced, stress tests also suffer from a host of other well known problems including:

• They are focused on book capital.  Book capital is an easily manipulated accounting construct that has little to no relationship to the solvency of a financial institution (ex:  Lehman Brothers and Irish banks before nationalization).  

• Everyone knows the results before the tests are run as the tests are designed to minimize the number of banks that fail.  This is easily achieved by modeling financial institutions with a suspension of mark to market accounting (ex: level 3 securities include Greek debt for which there is no market and management gets to value) and ongoing extend and pretend regulatory forbearance (ex:  second mortgages).

So why does Professor Johnson call for more transparent stress tests?  Because he sees a solvency crisis and understands that raising more equity is an important component for ending a solvency crisis.

...The prevailing wisdom about Europe is that it faces primarily liquidity problems. In this view, a few of the larger countries have had trouble rolling over their debts, and some leading banks need help with short-term financing....

There are two problems with this ... The first is that sovereign debt problems can easily become solvency issues — that is, more about whether countries can afford to service their debts rather than whether they can raise enough cash at reasonable rates in any given week. 

.... The more immediate Achilles heel is banking....

The main immediate problem for Europe is that we still don’t know exactly the condition of its major financial institutions. 

Please re-read Professor Johnson's observation again.  Four years after the beginning of the global solvency crisis and we still do not know the answer to the question of which financial institutions are solvent and which are insolvent.

The Europeans have run bank stress tests twice recently, in mid-2010 and again earlier this year. But in both cases the tests were far too lenient and banks were not required to raise enough capital. 

They should have been compelled to increase their equity funding relative to their debt, in order to create a greater buffer against future losses. 

The 2009 banking stress tests in the United States can also be criticized for not including a scenario that was sufficiently negative. In recent weeks the market has expressed great skepticism about Bank of America, its inherited liabilities, future business model and, most of all, the adequacy of its capital.

This recitation of the history of bank stress tests confirms why they would not be done by governments for publication to all market participants.

... Yet the European stress tests to date must be rated a notch or three below even the [most recent US stress test] in terms of transparency and communication of information that allows market participants to make informed decisions. 

The latest round, conducted by the European Banking Authority through July 15, did not even examine what would happen if a sovereign borrower had to restructure its debts — exactly what Greece was working on during the same time frame. (To be precise, there was some “sovereign stress” in the tests but very little compared with what we have seen and could see.) 

This is worse than embarrassing. It creates exactly the wrong kind of uncertainty around European megabanks, including their operations in the United States and potential spillover effects. 

To the credit of the European Banking Authority, it made it a requirement of the stress test that financial institutions' make dramatically more disclosure about their exposures than had previously been done.

In part this happened because the European Banking Authority is new — it came into existence on Jan. 1 — and not sufficiently powerful relative to national bank supervisors, many of whom are stuck in an old mindset where transparency is bad and full disclosure of banks’ balance sheets is scary. 

Transparency and full disclosure require the regulators to give up their information monopoly and with it their ability to gamble with financial stability.

With transparency and full disclosure, financial institutions will for the first time be subject to market discipline.  Market participants will know who is solvent and who is insolvent.  Market participants will know the amount of risk that each financial institution is taking and will be able to adjust the price and amount of their exposure accordingly.

Transparency and full disclosure is scary because market participants are no longer dependent on the regulators.  Instead, market participants can Trust, but Verify what the financial regulators say and do.

...But partial facts and distorted information flow [from the financial regulators with their publication of the results of their stress tests] are exactly what creates fear and instability, not just in Europe but much more broadly. 

Please re-read this comment as Professor Johnson has articulated why financial institutions needs to provide full disclosure and why partial disclosure accompanying stress test results creates financial instability.