Stress Tests

The next milestone in Ireland’s crisis resolution efforts will be the March 31st stress tests. In addition to revealing important information to financial markets, the results of the tests are likely to impact the political debate about the appropriate crisis resolution strategy, not least the contentious issue of default. At the moment, there appears to be a lot of confusion about what the stress tests are all about, which is important to clear up in advance to prevent the release being counterproductive in terms of the political debate. I offer some thoughts after the break, but I hope others will weigh in on the thread.

One confusion is already evident in the reporting on the macro scenarios released this week (see here). The scenarios include a “baseline case” and an “adverse case”. However, the latter is unhelpfully reported in the media as a “worst case”. There is of course a (joint) probability distribution over possible scenarios. The adverse case is simply a point on this distribution, presumably at the 95th percentile. It should be made clear what this percentile is in the official view of the distribution, allowing interested parties to form their own view on whether the presumed distribution is appropriate. To a significant extent, the precise point on the distribution is not important, as long as it is made clear what this point is.

The value of a stress test is it provides an estimate of the implications of the given scenarios for the size of the bank losses. To the extent that the scenario-based examination of the balance sheets is credible, the findings on hypothetical losses provide valuable information on the broader distribution of possible losses. The partial outsourcing of the stress testing is meant to increase this credibility. Given lingering doubts, however, it will be critical to give market participants as much information as possible on the composition of the balance sheets and the detailed assumptions used so that people can form their own judgements. This is especially important in light of Patrick Honohan’s emphasis in his ICMBS speech on the damage uncertainty is doing to Ireland’s creditworthiness.

It would seem we are being prepared for some quite bad news on the size of the needed capital injections. While we can expect that the markets will interpret this news properly, there is a danger that the numbers will be misinterpreted in the broader debate.

Simplifying just a bit, there are three components to the bank losses that will fall on the State given the guarantees: (i) losses beyond the capital of a guaranteed bank (notably the Anglo and INBS losses to date); (ii) losses on previous injections of State capital; and (iii) the losses on NAMA. A key focus will be the additional capital required for AIB and Bank of Ireland. It is reported that the capital target will be set so that core tier 1 ratio does not fall below 10.5 percent under the adverse scenario (SBP article here). While the stress tests are likely to reveal real additional expected losses, the bulk of the additional capital will be going to meet a very demanding capital standard, and should not be simply added to the calculation for aggregate bank losses.

It is valid to ask why the markets are demanding such high capital levels, which could reflect a very different estimation of the underlying losses than the official view to date. (On this alternative view, the current positive market valuation of one or both of main banks would largely be a reflection of option value due to limited liability given the high underlying uncertainty—a limit that does not benefit the State given the guarantees.) At least in part, however, the market requirement for capital reflects increased risk aversion (interacting with the high level of uncertainty about bank losses), doubts about the State’s willingness and ability to meet guarantees, and doubts about the ECB’s willingness to continue to act as lender of last resort.

19 thoughts on “Stress Tests”

  1. @John

    Can the baseline scenario be properly referred to as a Central Bank forecast of the most likely outcomes?

    The CBI says no – the baseline scenario “represent [s one of] two possible paths from a large range of future outcomes regarding property prices.”

    “the Central Bank is applying a scenario that both commercial and residential property prices continue to decline in the base and the stress case. It is important to note, that these are not forecasts of outcomes but represent two possible paths from a large range of future outcomes regarding property prices. In this regard, there is a significant degree of uncertainty surrounding the range of possible future outcomes for the domestic property market. These are related to borrower and bank behaviour, measurement problems determining the of extent of property price declines due to the lack of a significant amount of transactions, and the continued unavailability of national residential and commercial property price indices, and future demand for residential and commercial property.”

  2. @Jagdip

    I wondered about that too on reading the release. But you have to wonder what “baseline” means if its not the central forecast. It just adds unnecessary confusion. Perhaps vagueness is seen as giving some cover, but vagueness is not what we need.

  3. When is a forecast not a forecast?

    IMO the CB is attempting to be more transparent for the integrity of the process for the benefit of the public and in particular that subset of the public which is the markets.

    On the other hand they do not wish their criteria to be considered a forecast, as this might then result in `saying making it so`.

    On the whole I think transparency from here on the greater virtue.

  4. Wht not just make a summary spreadsheet available. They presumably have a load of assumed variables – already published – and given the cost of the exercise, an approximate, formulaic continuum of outcomes should be accessible.

    If I don’t believe the adverse CRE of -22% or whatever as a one-off, why can’t I change the input to something I think more redible and get an alternative figure for capital?

  5. @John,

    I too read the baseline scenario to be akin to the CEBS benchmark scenario last year and is a forecast of the likely outcomes. But given the authority of the central bank and the lack of transparency in property transactions, the CBI has the ability to move the market with its forecasts. Perhaps that is why it is being coy.

    Although it serves a slightly different purpose the UK’s FSA published its pre-stress test documentation on Thursday. Its detail is astounding compared to the Irish 3-page release – the macroeconomic scene setting extends to some 30 pages alone. http://www.fsa.gov.uk/pubs/other/pro.pdf

    We are reportedly spending €20m on these stress tests, they’re not cheap so I hope what is produced on 31st March is to a better standard than that produced this week. We need to start drawing a line beneath the banking crisis and if we produce another black box result like the CEBS tests last year, the markets simply won’t believe it and we will have flushed €20m away.

  6. John. Not to be rude but you come off as the last believer that it’s only a flesh wound. Newsflash, it’s not.
    You’ve done great work at being a sensible voice of “well, maybe the horse will sing” but the horse is mute.

  7. “It is valid to ask why the markets are demanding such high capital levels”
    Because John they, like many, believe the banks bust, that they can’t trade out of this, and by setting a level they’re unable to meet it might cause the state to come to it’s senses

  8. … it’s only a flesh wound.

    For me, it’s the Dead Parrot sketch, rather than the limbless knight, which keeps coming to mind.

  9. @ Brian Lucey

    Those that drag it out place themselves in the “idiotic reflexive ad hom can’t actually debate the issue at hand” camp.

  10. You cannot internationalize bank operationss and nationalize losses. Very simple – making a European citizen who just so happens to be living in Ireland liable for bank losses incurred at a systemic European level is discriminatory and contrary to the principles of European union

  11. @ John McHale
    Where is the danger of the results being misinterpreted In the broader debate?
    From what I am reading European stress tests are not well regarded with the FT calling it ” somewhere between a fudge and a joke”.
    The WSJ ran an article on this on Friday headed “EU stress tests under stress” pointing out that only 60% of the banks will be tested and describing the macroeconomic scenarios used to gauge banks’ resilience as relatively benign.
    Will the Irish tests get a better reception?

  12. Would be interesting to see the losses that NAMA could expect if the adverse scenario played out.

    I still think that 20% falls in commercial property values is too optimistic for the baseline scenario let alone the adverse scenario.

  13. @Eureka

    Surely you can if your democratically elected parliament chooses to vote in the legislation?

  14. The stress test /sensitivity analysis is a process of altering the variables of the four year plan agreed with the EU/IMF ,of which the dominant variable is the growth rate of the Irish economy in the medium term.

    If we cannot achieve economic growth, unemployment rises , tax receipts fall, demand for all types of Irish property falls, the bank deficiency rises and default becomes a certainity.

  15. I’m looking forward to these – especially for the Landesbanken in Germany – the French banques – and our Iberian cousins ……

    As for the Irish – they are not mine: non serviam. Default on them and let’s see who’ll be damned? Wont’ be the Irish serfs, dat’s fer sure.

Comments are closed.