Stressful times

This morning’s financial pages are full of coverage of the European bank stress tests, which were released yesterday evening. The good news is that with two exceptions, the regulators were broadly satisfied that the 51 European banks under scrutiny would be able to withstand severely adverse market conditions, in the sense that they would be able to hold their common equity tier one (CET1) ratios above the absolute minimum of 4.5%. In plain terms, this means that banks should be able to maintain a sufficiently large capital cushion in order to continue operating during times of market stress and thereby remain solvent.

In the wake of the problems resulting from the Lehman’s bankruptcy in 2008, it makes sense for the authorities to pay greater attention to the risks posed by the banking sector. Indeed, the lack of regulatory oversight magnified the extent of the post-Lehman’s distress so it is a positive step that problems are being addressed. But previous efforts to stress test the European banking sector were criticised for not being stringent enough, and the same familiar refrains are being heard again this morning. It is true that the risks appear to have intensified in the wake of the Brexit referendum and it is also true that different countries face different degrees of macro risk, which makes it difficult to compare the impacts of the adverse scenarios across countries. 

But these criticisms are to miss the point. We can never know exactly what kinds of shock will materialise and the best that we can do is give a hypothetical benchmark against which to judge a range of possible outcomes. Like any forecast, they will probably prove to be wrong but if we get the broad direction of travel right, we can be satisfied (though we can only hope that we never have to find out).

In any case, as the European Banking Authority pointed out, banks are far better capitalised today than they were five years ago. The CET1 ratio at the end of 2015 across the panel of 51 banks was 13.2 % versus 8.9% at the end of 2010 (albeit on a slightly different definition). The rules have been tightened up and banks have done their best to comply with regulators’ demands for a broader capital base. There is little doubt that banks were under-capitalised pre-Lehmans and it is only right that they should be forced to build a better stable door, even though this has forced them to pull out of capital intensive businesses which has had a notable impact on profitability. 

However, this does not excuse the fact that regulators were far too complacent about the risks which banks were running prior to 2008. Public calls to send bank chiefs to jail were never matched by calls to jail regulators for neglect! Indeed, whilst disgraced RBS chairman Fred Goodwin was stripped of his knighthood, former BoE Governor Mervyn King was ennobled and, it was noted this morning in the FT, “has quietly taken up a role as a senior adviser to Citigroup.” Lest the irony of that should escape anyone, Lord King argued in his recent book that the structure of the financial system in flawed and that “without reform of the financial system, another crisis is certain.” 

Back in 2011, former Barclays chairman Bob Diamond argued that it was time to end the criticism of banks over their role in creating the recession of 2008-09. He was ahead of his time: There were many problems with the banking system in 2011 which needed to be resolved, and there is still a lot to do today. But banking recovery is not being helped by the fact that interest rates are at all-time lows, making it harder for banks to generate profits and rebuild their capital base. With the Bank of England widely tipped to cut interest rates deeper into all-time low territory in the course of next week, that is an issue to which I will return,