Who should stress test the stress-testers?

A James Alexander post

Kevin Dowd has recently published an expanded and provocative critique of central bank stress testing via the Adam Smith Institute. It is based on a 2014 piece for the Cato Institute.

Dowd makes many excellent points that highlight the terrifying challenge of adequately supervising systemically risky giant banks.

In the Cato version he writes:

One should also remember that much market instability arises from the erratic monetary policies of the Federal Reserve itself.  These policies  are  illustrated  in  Figure  1,  which  shows the Fed funds rate since the 1950s. By my count, there are 10 notable interest rate peaks.  All but one—that of the mid ’90s—were followed by sharp falls.  Among the highlights were the massive, necessary-but-painful  Volcker interest rate hike starting October 1979, which left much of the banking system insolvent in the early 1980s; the doubling of interest rates over 1994, which led to a wave of defaults (Orange County, etc.); Greenspan’s warnings of “irrational exuberance” in 1996 followed by monetary easing, which stoked the tech bubble that burst in 2001; and after interest  rates  peaked again, another major volte-face occured, in which interest rates became negative in real terms and stoked the subprime mortgage market. By 2007, interest rates had climbed again to just over 5 percent, but they were brought down to virtually zero in 2009 and have remained there since, well below inflation for nearly six years. If the past is anything to go by, these rates are stoking the mother of all booms and the mother of all busts as well. So, on the one hand, the Fed endorses—in fact, requires—the use of risk models, but on the other, it undermines them by its own erratic  monetary policies:  the  models  cannot  pick up the Fed’s sharp and unpredictable twists and turns. In fact, even the Fed itself can’t predict its own erratic twists and turns … it is the Fed that ultimately drives interest rates through its control of the money  press,  and  the  market  merely  reacts: the instability that everyone feared was created  by  the  Fed  itself.

While this is a somewhat populist précis of monetary policy over the last sixty years it does imply a critical question. How can the Fed be responsible for supervising the banks when its monetary policy is so often the cause of the problems of the banks?

And with the Market Monetarist interpretation of the Great Recession, or with a banking hat on, the Global Financial Crisis, this critique really is the key challenge to stress testing. The central banks turned a housing boom that was largely correcting itself into both a housing bust and a generalised economic crisis through not responding at all to the economic slowdown that the housing correction was engendering.

In fact, not only did they not respond they either steered the market to expect rises in interest rates or even raised rates (the ECB). They did this because of their fixation on headline inflation, based on their clinging on to an outdated Inflation Targeting regime.

The central bankers in the UK at least were also concerned about the moral hazard of lowering rates, or even providing emergency funding, “just to bail out the banks” from their liquidity challenges. Liquidity challenges that arose directly from tightening monetary policy increasing the demand for money and taking it away from funding banks’ housing loans. This insanely dangerous confusion of the role of monetary policy in promoting financial discipline led directly to the collapse of Northern Rock in September 2007, followed by numerous other UK domestic banks during 2008 and into 2009. Other central banks responded much more swiftly to these changes and avoided the catastrophe of bank runs.

Yes, the Basel 2 reforms had allowed and even encouraged much higher levels of bank leverage and a massively over-optimistic view of the reliability of financial modelling. But what the modelling could never really have included was the possibility of catastrophic monetary mismanagement. What reputable central banker would have signed off on bank models that included such ridiculous scenarios as central bank incompetence?

The Catch 22 issue is that banking regulation and monetary management are broadly in the hands of the same authority. And the monetary authorities cannot bring themselves to admit their own failures or the instability they cause and, hence, cannot bring it into the stress tests that they use on the banks.

A first step towards the adequate supervision of the banks has to be a recognition of the central banks’ responsibilty for the GFC. And then set the supervisors to build that narrative into their stress tests.

Note: To many, James Alexander will be known as “James in London”, a frequent commenter on a number of MM blogs.