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Banks that go bust

Why the IMF is on the wrong track


One of the lessons of FinCR (financial crisis and recession) is clear. We have to get better at stress-testing. That is, we have to understand better than we did what circumstances can push banks over the edge into insolvency, and how regulators can spot weak banks in advance. Or so the story goes.

The fast-expanding army of stress-busters has been in a spin trying to find the holy grail. Is there a magic formula? By looking at a bank or other financial institution, and asking a lot of questions, bottom-up as well as top-down and topsy-turvy, can “we” tell which ones are weak and might fail?

A massive international effort has been put into finding the answers. Hundreds of academics and officials who would be better employed helping a bank or other financial institution survive in the marketplace  swan around the world attending seminars.

The IMF’s inquiries are typical of the way these efforts generate further expensive research and innumerable meetings.

The answer they will announce at the IMF’s annual meeting in Tokyo next week – once you have stripped out the double-speak – will be simple: “No. We can’t tell in advance.” However, they will say, if further research were conducted on a much bigger scale, it is possible, just tantalisingly possible, that “we” could know the answer.

This is what ministers and governors of central banks will be told during the IMF meetings.

Will they agree to fund more research? I give you one guess.

This is The Money Trap.

It is the old story of the Oracle of Delphi. Please, Oracle, tell us what we must do?

The whole idea is terribly mistaken. It is not the job of governments or their agencies to stress test banks. It is the job of their management.

Regulators know virtually nothing about banking – nothing valuable, that is. They know in theory, but not in practice, otherwise they would be bankers and not regulators.

The same applies to all the talk of macro-prudential regulation. It is the job of bankers to ensure their institutions are shock-proof – even against so-called systemic risks. That is how prudent banks have survived over the decades and centuries.

They will do that if their own survival is at stake. But of course most of them far prefer to be wrapped in warm, fluffy, regulatory blankets , tucked up in bed and dozing off. Who wouldn’t?

Banks always did go bust, yes, but the survivors learnt from watching them. Central banks might provide lender-of-last-resort liquidity in a systemic crisis but this was subject to “constructive ambiguity”. They did not save individual institutions from their own folly or attempt to “stress test” them in advance.

When governments took over supervision financial crises got worse. Banks don’t need to watch each other any more – the biggest discipline of all in good markets. Now they need only watch the source of money and support – governments and central banks.

Stress-testing is one way in which governments try to neutralise the subsidy given to big banks without tackling the root cause of that subsidy directly.  Like other parts of the safety net, it encourages excessive risk-taking.

Here we are near the heart of the money trap. This is the illusion that official agencies can  protect the public from such risks. They can’t.  Their intervention tend to make the risks even bigger.

The IMF does have roles to play in combating the ongoing crisis (as I have made clear  in previous comments), but this is not one of them. It can best contribute to stabilising banks by telling member governments to cease and desist from actions that distort incentives and store up more trouble for the future.

PS  Stress-testing  is but one small part of the out-of-control regulatory juggernaut. The Dodd-Frank legislation looks likely to comprise 30,000 pages of rule-making, a thousand times larger than Glass-Steagall back in the 1930s. In Europe, recent regulatory directives or regulations cover capital requirements, crisis management, deposit guarantees, short-selling, market abuse, investment funds, alternative investments, venture capital, OTC derivatives, markets in financial instruments, insurance, auditing and credit ratings.