Five years ago, the financial regulators of the United States — and more broadly the world — didn't see the storm coming. Would they if a new one were brewing now? The answer to that is far from clear. The regulators have more information now, and they have applied the tools they have to measure risk with more vigour.
But a new assessment from a little-known agency created by the Dodd-Frank law argues that the models used by regulators to assess risk need to be fundamentally changed, and that until they are they are likely to be useful during normal times, but not when they matter the most.
"A crisis comes from the unleashing of a dynamic that is not reflected in the day-to-day variations of pre-crisis time," wrote Richard Bookstaber, a research principal at the agency, the Office of Financial Research, in a working paper. "The effect of a shock on a vulnerability in the financial system — such as excessive leverage, funding fragility or limited liquidity — creates a radical shift in the markets."
Bookstaber argues that conventional ways to measure risk — known as "value at risk" and stress models — fail to take into account interactions and feedback effects that can magnify a crisis and turn it into something that has effects far beyond the original development.
"What happens now when people do stress tests," he said in an interview, "is they look at each bank and say, 'Tell me what will happen to your capital if interest rates go up by one percentage point.' The bank says that will mean a loss of $1 billion.
That is static. That is it." But, he added, "What you want to know is what happens next." Perhaps the banks
will reduce loans to hedge funds, which might start selling some assets, causing prices to drop and perhaps having additional negative effects on capital. "So the first shock leads to a second shock, and you also get the contagion." The working paper explains why the Office of Financial Research, which is part of the Treasury Department, has begun research into what is called "agent-based modelling," which tries to analyse what each agent — in this case each bank or hedge fund — will do as a situation develops and worsens. That effort is being run by Bookstaber, a former hedge fund manager and Wall Street risk manager and the author of an influential 2007 book, "A Demon of Our Own Design," that warned of the problems being created on Wall Street.
He said the first work was being done with the help of MITRE, a research organisation that came out of the Massachusetts Institute of Technology, on the interactions between banks and leveraged asset managers, with particular attention on how so-called fire sales develop as asset values plunge. Additional work is being done by central banks in Europe, including the Bank of England.
"Agent-based modelling" has been used in a variety of nonfinancial areas, including traffic congestion and crowd dynamics (it turns out that putting a post in front of an emergency exit can actually improve the flow of people fleeing an emergency and thus save lives). But the modelling has received little attention from economists.
Richard Berner, the director of the Office of Financial Research, said in an interview that his agency was trying to gather information in many areas, understanding that "all three of those things — the origination, the transmission and the amplification of a threat — are important." The agency is supposed to provide information that regulators can use.
Bookstaber said that he hoped that information from such models, coupled with the additional detailed data the government is now collecting on markets and trading positions, could help regulators spot potential trouble before it happens, as leverage builds up in a particular part of the markets. Perhaps regulators could then take steps to raise the cost of borrowing in that particular area, rather than use the blunt tool of raising rates throughout the market. Any benefits from such research is at least a few years away, however, and for now bank regulators are placing renewed emphasis on stress tests, which under the Dodd-Frank law must be conducted annually on the largest banks in the country. This year's version, due out in March, will release more information than those in previous years.
Stress tests take a negative set of economic assumptions and ask how each bank would fare in those circumstances. As such, their usefulness is constrained by how well the assumptions reflect something that might actually happen. If it has never happened before, there is at least some chance that a stress test would not even consider what could be a severe problem. The usefulness could also be limited by secondary effects not foreseen by those who designed the test.
In 1998, the Long-Term Capital Management hedge fund had little exposure to Russian bonds, and probably would have easily passed a stress test based on a possible Russian default. But when Russia did default, others that owned Russian bonds were forced to sell assets that the LTCM fund did own, driving down prices of those assets and setting off the events that caused the heavily leveraged fund to come close to collapse.
The Bookstaber paper pointed to a 2008 International Monetary Fund report on Iceland, issued shortly before that country's financial collapse. "The banking system's reported financial indicators are above minimum regulatory requirements and stress tests suggest that the system is resilient," the monetary fund concluded.
Recently, the 19 largest bank holding companies in the US submitted to the Federal Reserve Board their assessment of how they would fare under various cases put together by the Fed. The principal difference between this year's "severely adverse" case and last year's is that this year's version requires the banks to assume "a much more substantial slowdown" in China and India along with a new, severe recession in the US, characterised by an unemployment rate that approaches 12 per cent, by a stock market that loses half of its value and by real estate prices falling 20 per cent from current levels. There would also be severe recessions in Britain, the eurozone and Japan.
It may be notable that even in the most negative case the Fed could dream up, China's economy continues to grow. What is new this year is that the public will get to see two views — views that could be significantly different — of how each bank would fare under that worst case, as well as under less horrible conditions.
Each bank's own assessment will be released in March, along with the Fed's view of how that bank would do. Officials say the Fed staff members working on the stress tests will not see, and therefore not be influenced by, the bank's views.
If there are substantial differences in the results for any bank, that will serve as a reminder that the models the banks use to estimate their exposures can vary significantly from bank to bank and between the banks and the regulators. The immediate impact of the stress tests will show up in whether the Fed approves each bank's capital plan — its plan for how much it will pay out to shareholders in dividends and share repurchases. The Fed will approve what a bank proposes only if it thinks that minimum levels of bank capital would be preserved under the severe stress test.
A year ago, Citigroup suffered the embarrassment of having the Fed publicly reject its capital plan. It may not be unrelated that the bank's board has since ousted the chief executive responsible for preparing that plan. For now, the Fed's view of what is necessary will prevail. But does the Fed have enough information to really know how the banks would fare if a new recession arrived? If Bookstaber is right, the answer may be that it does not. (Floyd Norris/The New York Times News Service)