‘Fatally flawed’ Bank of England stress tests peddle myth of financial security — report

(RT) – Bank of England (BoE) stress tests of Britain’s banking sector are “fatally flawed” and peddle the myth that the financial system is secure, a report by the Adam Smith Institute says.

The report, published Thursday, was authored by Professor of Finance and Economics at Durham University Kevin Dowd. It calls for the yearly tests to be scrapped and warns that they hide serious weaknesses in a vulnerable UK banking system.

In the aftermath of the 2008 financial crisis, stress tests have
been used by the authorities as a way of gauging banks’
robustness. Following the global economic turmoil that followed
the US subprime mortgage crisis, the methodology for conducting
these tests was revised.

At present, it is deemed favorable to test financial
organizations in groups. However, certain sectors of the
financial industry such as asset management and central clearing
houses remain exempt.

Dowd, who previously criticized the tests at a Treasury select
committee hearing, told the Financial Times that the BoE have set
the benchmark for minimal capital requirements too low. This
practice leaves the BoE vulnerable to banks rigging their
self-styled risk-analysis models, he said.

‘Credibility problem’

Capital requirements relate to the amount of capital a financial
institution can hold. In Britain they are regulated by the BoE.

Dowd said the BoE is blighted by a “credibility problem”
because its role of promoting financial stability dampens its
regulatory rigor.

The Professor of Finance and Economics, who also works as a
consultant advising governments on banking stability, said
Britain’s 2014 stress tests were too easy on lenders.

He argued the BoE should have forced banks to meet a minimum
leverage ratio, which weighs lenders’ capital against their total
assets. Such a move would make it more difficult for banks to
manipulate their in-house risk-analysis models, he said.

RT asked the BoE to comment on Dowd’s findings, but a
spokesperson for the Bank declined.

Unstable banking system

Move Your Money ethical finance researcher Joel Benjamin backed
Dowd’s assessment that the BoE is blighted by a credibility

“The major issue still facing the UK economy is that the
financial sector is too large relative to the productive UK
he said.

Benjamin said the BoE’s stress tests are “a carefully
manicured smokescreen to rebuild tattered confidence in the

“Given the UK government still own Lloyds and RBS, there is a
clear motive to fudge the figures and build investor confidence
ahead of an RBS resale,”
he said.

Benjamin argued that Britain’s largest accountancy firms
“play an active role” in this process “by signing
off on accounts, which allow banks to bring forward profits, and
defer penalties and known impairments on their balance into
future years.”

Benjamin said Britain’s banking system is plagued by a poor
regulatory climate, and is ripe for white collar crime. UK media
coverage of weaknesses in Britain’s banking sector is virtually
non-existent, he warned.

“The $111 billion black hole in HSBC’s balance sheet
was reported by Forensic Asia and CNBC, but ignored by UK media
outlets — most notably the BBC and Telegraph, where
Harry Wilson’s article to this effect was
skewered, leading to his resignation from the paper,”

Adam Smith Institute (ASI) head of research Ben Southwood agreed
that the UK banking sector is characterized by a number of
weaknesses. He suggested “excessive uniformity” could be

However, in contrast to Benjamin, Southwood said regulators’
post-crisis response “may be harmonizing the banking system
too much.”

Southwood echoed Dowd’s suggestion that stress tests should be
scrapped. But he suggested moving towards a system where “key
in the
banking sector
self-regulate could be problematic.

Southwood said such a strategy would be doomed to fail unless
“authorities credibly commit to not intervening in a
and “risks and crises are actually
He also expressed doubt over whether
authorities would cease to intervene in the face of another

The BoE says banks operating in Britain will be obliged to meet a
3 percent leverage ratio to pass its 2015 stress tests. If this
benchmark was applied to the Bank’s 2014 stress tests, 50 percent
of Britain’s banks would have failed. Among those who would have
received a negative rating were the Cooperative Bank, Santander
UK, Lloyds Banking Group and Royal Bank of Scotland.

If the BoE factored in all additional capital buffers banks must
contend with into its tests, all of Britain’s eight top lenders
would have failed these stress tests, Dowd’s report found.

As the global financial crisis struck, Dowd noted these stress
tests failed to uncover the impending crash of the Irish,
Icelandic or Cypriot banking systems.

“Methodological flaws include the dependence on a single
questionable stress scenario, inadequate data, poor metrics and
unreliable models, especially risk models,”
his report said.

Dowd suggested the BoE is not serious about stress testing. He
said this service should be outsourced to the private sector.

‘Least resilient of all G7 economies’

New Economics Foundation (NEF) Senior Researcher for Monetary
Policy Josh Ryan-Collins said NEF rates the UK’s banking system
as the “least resilient” of all the advanced G7

Ryan-Collins said Professor Dowd is correct to highlight that
stress tests failed to predict “three recent systemic banking

But he argued these
stress tests remain inadequate to this day because they fail to
analyze the banking system as a whole.

“Our index of Financial Systems Resilience (FSR) takes the
leverage measure preferred by Prof Dowd but adds six further
resilience factors, including aggregate asset and liability
composition, the level and nature of interconnectivity between
banks and the diversity of ownership of types of banks,”

Ryan-Collins said.

“On this broader measure of resilience the UK has the most
vulnerable banking system of the G7 economies.”

Ryan-Collins said the UK banking sector’s large size makes it
“uniquely vulnerable to financial shocks.” Other factors
which render it unstable are its strong ties to the global
financial system, particularly the shadow banking system, he

Ryan-Collins argued that the UK banking sector lacks diversity,
and is effectively dominated by a group of large “privately
owned, shareholder-driven banks.”

“UK banks assets’ are also more concentrated in the mortgage
and financial sector than most other advanced economies banking
systems, again making us more vulnerable to financial or house
price shocks,”
he said.

Ryan-Collins called upon the BoE to reform its stress tests and
other regulatory mechanisms to include the resilience factors
referenced in NEF’s recently published FSR report.

“Metrics on these factors — across the banking system as a
whole — should be developed and measured regularly,”

Ryan-Collins insisted a range of structural reforms are paramount
— particularly the separation of retail and investment banking.

He predicted the Conservative government’s planned sell-off of
RBS will negatively impact on an already vulnerable banking

“Selling off the Royal Bank of Scotland will create yet
another very large, privately owned shareholder owned bank
focused on short-term returns and mortgage lending — the last
thing the British banking system needs,”
he said.

The New Economics Foundation “proposes splitting RBS into 130
regional and local banks that are owned by local public
Ryan-Collins said.

“The new citizens’ bank would focus on business and consumer
lending in defined local areas, replicating the highly successful
approach of the German Sparkassen system and the older UK Trustee
Savings banks.”

This piece was reprinted by RINF Alternative News with permission or license.