Quarterly stress test of banks not enough

Published in The Australian Financial Review

In “Not enough stress in US bank test,” (June 24), Professor Lucian Bebchuk, Harvard Law School, says, “As long as banks are permitted to operate this way, the banks’ supervisors are betting on the banks’ ability to earn their way out.” Bedchuk is referring to the recent flawed stress testing of US banks. His message is that stress testing is essential but that it must be rigorous. As the author of a book on the finer details of stress testing after many years experience of building stress testing related technologies and using them to successfully manage billions of dollars of complex financial exposures, I agree.

A rigorous stress test measures bank exposure to wide ranging movements in all relevant economic variables. There are many ways to get a stress test wrong or be tricked. The value of a stress test depends critically on its frequency and transparency. The prudential regulator, APRA, requires banks to report quarterly and results are not published. Bank trading is a daily activity. A quarterly stress test leaves 99 per cent to trust.

I have repeatedly invited the authorities through my letters to publish rigorous bank stress tests daily in a website. Nothing could be more efficient or cost effective as a regulator of excessive bank risk.

Why not reduce risk and cost with an automated bank risk watch website? Minister Nick Sherry, answered in a letter to me dated 16 April 09, then as Minister for Superannuation and Corporate Law, “To require daily reporting as proposed in your email (to the Treasurer) would impose significant additional costs. These costs would ultimately be paid by the bank customers.” The Minister was poorly advised. Bank customers now know the much higher cost of weak risk management.

What is the cost of rigorous daily bank stress testing and reporting? Daily stress testing is already core risk management for a well managed bank — the entire process is electronic and automated. So the additional cost of daily electronic reporting to a central website is insignificant. There is no reason in the public interest to withhold risk transparency from taxpayers now underwriting bank deposits.

There is another cost however. Banks will lose the freedom to speculate in darkness. It will become apparent that even the current quarterly stress testing ignores the housing price risk — something US investment banks do too. And what about exposure to US sub-prime mortgages?

Governments and regulators have not understood where risk hides. Many senior bankers will fail a rigorous risk test. On the current course, the risk-free prediction is that more avoidable banking disasters will follow, in similar frequency to recent decades.

Published version - AFR- 1 Jul 2009

We need transparent stress testing

Published in The Australian Financial Review

In “Turnbull makes a few good points”,(18 May 2009), Alan Mitchell comments on the merit of a new indepedent institution to increase tranparency of economic management and notes the Business Council of Australia agrees.

Transparent stress testing is what we need; exposing the variation in outcomes to alternative market conditions. Treasury’s growth forecasts charting the budget course back to surplus will be wrong for every one of its five years and beyond. This is the one reliable economic forecast relevant to the budget papers. How much it matters is exposed by stress testing.

The value of the Treasury’s forecasts is transparent in its statement of risks in Budget Paper No. 1: Budget Strategy and Outlook 2009-10. It’s all a guess as it must be. The science of long term growth forecasting does not exist. A useful stress test shows how the government’s promises will change over a wide range of variations in the growth forecasts. Elastic promise are honest. Promises made on a fixed point guess are framed to be broken.

The BCA can endorse transparency by publishing its stress testing of the nation’s growth forecasts and superannunant returns to the alternative market conditions for selecting and paying CEOs — ranging from the entrenched closed opaque market to a transparent open and competitive market where CEO candidates compete for shareholder votes.

Another stress test for the BCA is the impact on the nation to changes in the shareholder voting system — ranging from the clumsy, inconvenient, expensive, opaque, auditless paper system in use to a secure, transparent, direct, greener and cheaper online vote.

The Australian Prudential Regulation Authority might follow and improve on the Obama administration’s lead by announcing robust  transparent stress testing of the Australian banking system. A bank stress test is out of date the next day. A regulator committed to bank transparency will publish daily stress tests. Why not? It’s not the cost. Daily stress testing is core business for banks.

Treasury’s guess work is as much affected by the unseen risk holes in the banking system and corporate governance as it is by the opaque capitalism of China.

Published version - AFR- 26 May 2009

Bank website to fix risk holes

Published in The Australian Financial Review

It’s refreshing to see a sensible argument in favour of short selling (“Short selling is the oxygen that markets need”, Opinion, January 28). In short, more realistic valuations mean less unwanted risk.

However, research fellow Sam Wylie’s argument for exempting financial firms from the same pricing rigour falls short. More leverage demands more pricing rigour, not less. The peril of mispricing bank risk is obvious now.

The downward spiral of GoldmanSachs and Morgan Stanley after a ban on short selling was lifted ir1 August is not an argument against short selling. The reputations of Wall Street investment banks have been crushed and for good reason. Why stop the market telling the truth?

Short selling will not destroy a good bank with transparent risk. Malicious rumours wither with
nothing to feed them.

The single, most important financial regulation missing in the world’s financial system right now is compulsory risk transparency. However, the security of risk transparency is threatened when the share price may not reflect the risk, as when one side of the market is shackled.

Security for the world’s economies is tied to bank risk transparency — immediately accessible to all, nothing less than a permanent bank watch website, a virtual place where all banks in the world must report daily their exposure to wide-ranging movements in all the economic variables to which they are exposed. And a share price that tracks risks like a wind sock.

The risk transparency idea will need strong political leadership. Yet it’s a difficult concept for most
lawmakers to embrace because their own house is opaque. Hansard is not transparency. Transparency must flow from the seat of power.

In a transparent parliament the opinions of all MPs on the big issues, including on bank transparency, are ranked live online for all to see. This will happen when politicians vote in their dome of conscience, launched in parliament in 2002.

Published version- AFR- 2 Feb 2009

Bank risk transparency wanted

Published in The Australian Fiancial Review

The November Group of 20 industrialised nations summit produced a communique that includes 47 action items aimed at improving early warning systems in the global banking system (“G20 backs new growth push”, November 17) Apparently not included is the single most effective, practical and inexspensive transparency measure possible. World leaders should demand nothing less than a permanent bank watch website where all banks in the world must report daily their exposure to wide-ranging movements in all the economic variables to which they are exposed.

This transparency measure will forever immunise  the global banking system against excessive risk taking in the most effective way possible. Such a website could easily produce and display net market risks across regions and banking sectors.

The first step involves agreement on a sensible standard for measuring the various risk components.

No astute risk engineer or scientist in the finance industry or academia will doubt the effectiveness of this transparency measure. True risk transparency will enable the market to self-regulate risk taking continuously. Excessive risk taking will be quarantined automatically.
preventing systemic failure.

It will be interesting to hear any objections. Which bank will admit it cannot produce this data? Is any bank now claiming the right to speculate in darkness? Has any regulator demonstrated it alone can be trusted to control bank risk?

Published version - AFR - 21 Nov 2008

PM could flag website to fix risk holes

Published in The Australian Financial Review

In “Bad risk mismanagement, not VaR” (Letter, October 23) Frank Ashe defends the banking industry risk measure standard VaR (Value at Risk) and blames the crisis on bad risk management. He then lists a comedy of risk management errors behind the UBS $US37 billion debacle. I doubt the same comedy of errors explains the silence of all bank boards, regulators and academics before the risk bomb exploded.

Published cartoon - AFR - 27 Oct 2008

Of course it was bad risk management. Risk management has three aspects, 1. risk measurement, 2. risk reshaping and 3. getting the first two right. Frank Ashe’s list of UBS errors fits nicely into point 3. Had the UBS risks been measured properly and transparent their massive risks would not have survived long enough to be mis-managed. At least one of the UBS board, its shareholders or its regulators would have moved like lightning to close the risk holes.

This is why I say the real root cause of the banking crisis was poor risk measurement, VaR. It’s the reason why bankers, regulators, investors, analysts and academics were caught out en masse and silent before the risk bomb exploded. The risks were not seen because the industry risk standard VaR hides catastrophic risks. Imagine cars built with speed meters that show variable measures for the same speed and never a speed over 60 KPH. The law on speed limit would be meaningless. VaR is the variable risk meter for banks. Two banks can report the same VaR – one may be safe, the other destined to crash.

I invite Prime Minister Kevin Rudd to take to the November 15 G-20 financial summit the idea from Australia that a website be established where all banks must report daily their exposure to wide ranging movements in all the economic variables to which they are exposed. The academics might like to show how such a website would have appeared over the last decade, including the VaR measures as a comparison. Add to this a permanent online global opinion market that harvests ideas from risk experts and ranks them live with democratic voting for all to see.

Published version – AFR – 27 Oct 2008

Value_At_Risk – Var Is a Dangerous Technique

Published in Euromoney’s Corporate Finance 1996 by Ralph McKay & T Erle Keefer

A means of representing risk as a single statistic is very appealing- and highly flawed, argue Ralph McKay and T Erle Keefer of consultancy Risk Technology. The value-at-risk method can conceal large risk holes, is insensitive to the possibility of catastrophic market events and ignores risk reshaping difficulties.

Value-at-risk and its new incarnations represent a form of risk appeasement. It ignores the real market risk problems. It is fashioned to impart a feeling of security to the people that it is supposed to give comfort to – central bankers, directors of banks and financial institutions, regulators and politicians. Objective scrutiny exposes this as unwarranted.

Given the notorious billion-dollar derivatives losses and absence of senior supervision, the clamour for a simplified risk measure such as value-at-risk is understandable. And the arrival of value-at-risk has served positively to focus attention on the need for risk measurement.

What is wrong with value-at-risk? Popular, broadly accepted definitions eschew too much essential information. They represent market risks as a single statistic. This single statistic is appealing and easy to explain. Unfortunately, it is even easier to use it to hide large risk holes. Managers consequently oblivious to the actual risk can increase systemic risk of derivatives bungles.

The manager presented with a value-at-risk number is like a fruit and vegetable trader who has a basket of fruit to sell but knows only the weight of the basket. He, along with the rest of the market-place, does not know from this single parameter whether the basket contains potatoes, mangoes, a mixed bag or bad apples. Thus he cannot determine what price to ask – he cannot assess the risk. To the fruit and veg trader, weight is not a market risk measure. Similarly, on a detailed analysis conventional values-at-risk are barely worthy of being treated as a measure of market risk.

Beware Tunguska Events

Even as a simple measure of risk, value-at-risk is highly exposed to criticism. Values-at-risk assume well-behaved markets but ignore the impact of real worry, the financial markets’ Tunguska events , such as the stock market crash of October 1987.

Derivative markets are very young. There is little data from which to predict the frequency of market crashes – that is the size and frequency of so-called outliers. But the limited data that exists is alarming and the only prudent approach is to assume that the big crashes have not happened yet. A prudent risk measurement must highlight exposure to the totally unexpected – because, in truth, it should be expected.
The value-at-risk concept of measuring risk in terms of a 99% probability of market movements is dangerous and misleading. For example, portfolios with deep out-of-the-money short option positions frequently show little sensitivity to the 99% movement. However, for even larger movements they may incur accelerating losses. Values-at-risk can be blind to this form of market jump risk.

Value-at-risk relies heavily on past statistics as a guide to the future. Another example of this is the actual or implied use of correlations between different markets and risk diversification. Negative correlations produce cancelling risks in the value-at—risk. Most of the time, diversification helps to minimize losses. However, when the security of diversification distracts attention from absolute protection risk management practice – as value-at-risk appears to be doing now its effect can be destructive in the medium to long term. This is because correlation and diversification assumptions can prove inadequate when the risk Tunguskas hit.

An absolute risk measure seeks to protect wealth in a defined manner regardless of the probability of adverse market movement. For example, the maximum wealth loss may be limited to an acceptable level. Compared with the value-at-risk 99% probability-type protection, outcomes between OK and destruction may be different when a Tunguska hits.

Risk reshaping

Quality risk management is only half the story; risk reshaping is its complement. For example, two portfolios may have identical value-at-risk numbers. However, the risk may be eliminated easily in one of the portfolios, whereas the other may be difficult to modify because of the bumps-to-the-risk-carpet problem. That is, attempts to control one aspect of the market risk may worsen other aspects.

The value-at-risk statistic ignores these risk-reshaping difficulties. Frequently, such complexities of risk reshaping may be the real risk problem, even though value-at-risk numbers may appear benign. Value-at-risk hides all information required to assess reshaping risk. Using the value-at-risk, it is impossible to determine which transactions are required to reshape market risks.

A single risk number ignores market asymmetry. A portfolio may be more exposed to loss than profit, but this cannot be known from the value-at-risk number. Its limitations extend to overall trading philosophy.

Value-at-risk tends to give validity to the popular notion that financial institutions make money by incurring market risks. The more risk, the higher the potential returns. This is a myth. The target value—at-risk number should be zero. All risks should be fully hedged — particularly in zero-sum markets. The objective should be to eliminate market risk, leaving only counterparty and operational risks to worry about.

This is the case when a bank sees itself as a manufacturer of financial instruments. Such a manufacturer may not be able to achieve the ideal zero-risk position at all times, but how many senior bankers hold the misguided belief that a zero value-at-risk means zero profit?

The underlying reality is that market risk management is a complex problem. It is dangerous to oversimplify the issues. An effective set of risk numbers should indicate the present value change in the portfolio in response to all economic parameters affecting the portfolio, whether correlated on not, and indicate exposure to both small and and very large moves. If the portfolio is properly hedged, the exposure to a very large market jump may be the same as the exposure to smaller moves — zero.■

The ‘Tunguska event was a large mysterious aerial explosion in Siberia at 7.40am on June 30 1908. It devastated 500,000 acres. It is thought to have been caused by a comet. June 30 remains the financial day of reckoning for many companies.

Published version – Euromoney’s Corporate Finance – 1996