Banks continue to lobby for weaker financial regulation: capital requirements are excessive, liquidity requirements are overly restrictive, and stress tests are too burdensome. Yes, in the aftermath of the 2007-09 financial crisis, we needed reforms, they say, but Basel III and Dodd-Frank have gone too far.
Unfortunately, these complaints are finding sympathetic ears in a variety of places. U.S. authorities are considering changes that would water down existing standards. In Europe, news is not promising either. These developments are not only discouraging, but they are self-defeating. Higher capital clearly improves resilience. And, at current levels of capitalization, it does not limit banks’ ability to support economic activity.
As it turns out, on this particular subject, there may be less of a discrepancy between private and social interests than is commonly believed. The reason is that investors reward banks in jurisdictions where regulators and supervisors promote social welfare through tougher capital standards....
We are huge fans of stress tests. In many ways, they are the best macroprudential tool we have for reducing the frequency and severity of financial crises.
The idea behind stress tests is simple: see if all financial institutions can simultaneously withstand a major negative macroeconomic event—a big fall in real output, a large decline in equity and property prices, a substantial widening of interest-rate spreads, an adverse move in the exchange rate. And, importantly, assume that in response to these adverse circumstances banks have no way to sell assets or raise equity. That is, the stress test asks whether each intermediary can stand on its own without help in the middle of an economic maelstrom. But for stress tests to be effective, they must be truly stressful. The tempest has to be the financial equivalent of a severe hurricane, not just a tropical storm.
This brings us to the latest European Banking Authority (EBA) 2016 stress tests. As we mentioned recently, the European financial system may be the biggest source of systemic risk globally. So, these tests are important not just for Europe, but for the world as a whole. Unfortunately, they just aren’t severe enough, so there is little reason to be confident about the resilience of European finance...
