How Now, New Cow: A Tale of New Regulatory Standards and Banking Stress Tests

Derek Klobucher

The why of improving bank stress testing is easy: It would improve industry confidence and regulatory compliance. It would also set straight a bunch of Europe’s biggest banks — the ones that failed revised stress testing conducted by Credit Suisse last year.

Tougher and equally compelling is the how: The European banking industry is up against myriad indirect threats. Sybase’s Stuart Grant recently addressed how to improve stress testing with the right mix of technology, standards and integration.

Avoiding an Utter Catastrophe

Using the right technology to model debt repackaging and other contracts may have helped prevent the latest financial crisis, but it was not in place, Grant wrote in the January/February (print only) edition of Financial Risks Today. Going forward, column-based analytic servers can manage the complexity that overwhelmed humans in 2008, but standards and regulatory authority must extend worldwide to instruments, institutions and people.

Getting everyone on Earth to play from the same sheet of music is pretty far-out. The ideal conditions for a firm in one part of Europe may be completely unworkable for another firm somewhere else, Grant correctly noted.

“What is perfect for one is not likely to be perfect for all,” Grant said. “There may not be a solution that will make everyone completely happy.”

What’s more, stress testing still has not addressed all of the significant risks facing the banking system, according to more than 80 per cent of capital markets executives in a recent Sybase survey.

That leads us to the critical point about new regulations: Whom should they try to please? The tech-savvy firm? The cunning trader? The vulnerable middle-class home buyer?

Regulatory standards are going to have to change, deciding whom they’ll favor. Either way, somebody’s not going to like the outcome.

Where’s the Beef?

New regulatory regimes, such as Dodd-Frank and Basell III, require stress testing as a way for regulators to evaluate the banking industry’s overall wellbeing. Bigger banks generally face tougher tests and higher liquidity buffers.

Testing would ensure that financial institutions could survive another financial crisis without taxpayer-funded bailouts. Further indication that bailouts wouldn’t be available next time, the FDIC approved a rule last month that would require too-big-to-fail banks to generate “living wills,” which would delineate how to liquidate the bank gone belly-up, according to Reuters.

“Like the FDIC, the CFPB was created in reaction to a crisis in the American financial system to correct market failures that harmed an overwhelming number of American consumers and businesses,” the new director of the Consumer Financial Protection Bureau, Richard Cordray, said at last month’s FDIC meeting. “Among other things, we both share the common goal of supporting confidence in our financial institutions.”

But again, whose confidence? The firm’s? The trader’s? Middle-class Joe’s?

Teaching the Old Cow New Tricks

We don’t seem to be talking about the latter. The European Banking Authority said last week that European banks’ recent balance sheet improvements earned them an informal pass on stress testing for 2012, according to Bloomberg.

This may seem like a reward to the banks for raising 26 per cent more capital than the EBA had originally mandated, but it smacks of favouritism. After all, when was the last time you didn’t have to take a test in school because your grades were good so far?

Banks playing teacher’s pet may not seem like a huge concern, but big investors can also be big campaign contributors.

And small investors are voters too. The financial services industry should keep them happy — and confident in the financial system.

Failing to conduct stress tests on banks regularly — no matter the reason — erodes the whyof improving stress testing. The how must have standards like everything and everyone else. That includes consistency.

So the new kid in town following the financial crisis (or should I say, “new cow in town,” to jibe with my headline?) must have the technology to process the massive juggernaut of Big Data that financial institutions manage. And that new regulator must do so in a way that inspires confidence among investors big and small.

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