Lessons from the Eurocrisis: If the fire marshal is saying that you shoulda had a fire detector, it might already be too late.

In the current battle against an all-out conflagration in Euroland, markets are twitchy about European (and other) banks in the event that the firefighters don’t get ahead of the blaze.  If markets lose confidence in those large banks exposed to the problems in Europe (or anywhere else, for that matter), the next chapter in the financial crisis will be a barnburner.  Indeed, the imposition of severe austerity measures is motivated in part to reassure markets that banks holding the debt of troubled countries are going to get paid.

At the same time that austerity measures are being announced in Italy, we are also being reassured about the stability of European banks.  The European Banking Authority now intends to conduct another bank “stress test”, intended to demonstrate the resilience of banks in a future crisis (“New Bank Stress Test announced for February”, today’s Wall street journal, ).

Ahem… a stress test was conducted last summer, but its credibility is suffering amidst fears that it “lacked rigor” (in the delicate wording of the WSJ).  Will this next stress test put our fears to rest?

I am not a great fan of these stress tests – unless we are just focusing on their public relations value.  Authorities simply cannot design a really demanding test.  If it is so rigorous that prominent financial institutions might fail, the stress test would provoke the financial crisis that authorities hope to diffuse.  So the creators of the test are inclined to make sure that all but the most pathological banks can pass it.  And once the methodology of the test is announced (and perhaps long before), banks will scramble to arrange their affairs in a manner that enables them to look good while the stress test is underway.

Even setting aside all of these problems, it is a notoriously difficult to design a stress test that anticipates the future. Depoliticized stress tests might do a reasonable job of seeing how today’s banks might have weathered the last financial crisis, but the next financial crisis will have its own unforeseen pressures.  The attributes that might enable banks to weather previous financial crises may not “work” so well in new circumstances.  For example, financial assets that once were viewed as unimpeachably liquid may not be so liquid in a future crisis, depending on the path the flames take.  The future is not always the recent past extrapolated.  

[Remember the cautionary tale of Citibank? Following the oil crisis of the early 1970s, the chair of CITI is reputed to have been comfortable with Citi’s  heavy concentration in  third world debt, since “countries never go bankrupt” (see Jeffrey Sachs, Developing Country Debt and the World Economy, Chicago: The University of Chicago Press, 1989).  Based on this wisdom, major US banks “debt pushed” to the third world, and by 1982 the exposure of the largest US banks to LDC debtors was 288% of capital (Sachs and Harry Huizinga, “U.S. Commercial Banks and the Developing-Country Debt Crisis.” Brookings Papers on Economic Activity, 1987.)  US banks were in a bad way once the third world debt crisis hit in full, and regulatory permissiveness played a key role in letting them limp through the 1980s (they were allowed to lend debtor countires money to pay their interest, and count this as current income). The banks survived, but the third world is still paying for the consequences.]

 

Bank stress tests – and other market calming measures- smell of what they are: an attempt to mollify markets lest panic makes a regional fire into a systemic inferno.    Sometimes these reassurances work. Sometimes they don’t. 

The key is really to have the regulatory safeguards in place long before the ne’er-do-wells start playing with matches.  Not that some perfect set of rules could anticipate all loopholes and prevent all future financial crisis.  But we could do better than we are doing.  It is shocking to me that – despite the severity of this ongoing financial crisis- so many lessons have not been learned (more on that in another post.)  Case in point: the inability of the G20 to make meaningful progress on the problem of “Systemically Important Financial Institutions” during their recent meetings in South Korea (maybe that will be another post too).

Given that the aftermath of bank problems seems to be fiscal austerity for those that did nothing to create the financial mess, stringent financial regulation is an important defense against downloading financial problems unto regular folks. This is not just Europe’s problem. Canada is especially lacking in regulatory introspection these days, given that our officials never tire of bragging about Canadian banks’ performance in 2008.   Sometimes the most vulnerable among us are those that think that “it” can never happen to them.