The stress test that the Fed uses, which involves a 50% decline in stocks, a 25% decline in real estate, and 11 % unemployment is totally ridiculous. [Supervisory Scenarios 2014 32 page pdf]. It assumes that one wouldn't have a dynamic strategy involved to curtail risk on the way down, and that an event that has only happened 3 times in last 125 years would happen again, and that banks should run their assets as if it were to happen imminently rather than handling them dynamically with decision making under uncertainty the way all are taught in business school.

It must be a propaganda method to diffuse attention from all the hundreds of billions that they gave to the banks during 2008, and a method of flexionism if you get the drift that Mario Puzo and Janine Wedel write about. It is amazing that this bank or that bank only failed the test qualitatively. What a sponge for flexionism is such a "qualitative " test which allows the greatest amount of bargaining and begging. What a world we traverse.

Rocky Humbert writes: 

I just browsed the Fed document to which Vin alludes. It can be found here.

I didn't read the document closely, but it's unclear what the pass/fail criteria entails. That is, whether the test is "insolvency" versus "solvency" or some level of capital after the stress. Perhaps someone else knows the answer to this?? It's key to understanding whether the stress tests are ludicrous.

Structural engineers design buildings and bridges for Category X hurricanes and Y richter scale earthquakes. It is accepted that these are extreme and rare conditions and engineering for these stresses involve substantial costs. It is also accepted that the structure may sustain damage in the calamity but will not experience sudden catastrophic collapse. My guess is that the same sort of mindset is at work here. Dynamic risk management is not possible in structural engineering for obvious reasons. In financial institutions, if one believes that the amount of stress/risk in the financial system is static, then dynamic risk management may not work either — because risk will simply move from one institution to another institution … but the overall stress remains in place. Would anyone disagree with this characterization.

Ultimately, I believe the question is whether the Fed should be engaged in ANY stress tests. Once the answer is yes, then we are debating about the magnitudes. And the debate is similar to whether the new Tappan Zee Bridge must tolerate 100, 150 or 200 mph winds before it collapses….

The key difference is that an contractor can put a price on the incremental cost of each 50 mph tolerance. I am unaware of any cost benefit analysis from the Fed in setting its stresses. And I propose that this absence of cost/benefit analysis is where an objective critic should focus his energies. 

anonymous adds: 

Then, there is the further question. Since the Fed has the only checkbook that never needs to be balanced, why is it engaging in the pretense that it cannot "save" any member bank no matter how "stressed" it becomes? I understand why it is important for everyone who trades to follow the entrail readings of the Delphic Committee; but, as the R-Man notes, it becomes difficult to understand how there can be "any cost benefit analysis from the Fed in setting its stresses".

As I reread Sumner's History of American Currency, I find myself wondering if the R-Man's fellow alumnus could possibly understand our modern minds. Could he truly understand how we define money as central bank credit and then actually worry about whether the sovereign can run out of the ability to print/digitize its legal tender? I doubt it.

From the Preface:

"I regard the history of American finance and politics as a most important department which lies as yet almost untouched. The materials even are all in the rough, and it would require a very long time and extensive research to do any justice to the subject. I hope, at some future time, to treat it as it deserves, and I should not now have published anything in regard to it, if I had not felt that it had, at this juncture, great practical importance, and that even a sketch might be more useful perhaps than an elaborate treatise. It follows from this account of the origin and motive of the present work, that it does not aim at any particular unity, but consists of three distinct historical sketeches, united only by their tendency to establish two or three fundamental doctrines in regard to currency."

Yale College, 1874.

Mr. Isomorphism writes in: 

Anonymous, I find your final paragraph especially compelling, even more than the rest of your argument. However probabilities of catastrophe cannot be estimated. It's dubious whether they can even be quantified. Also human or social costs resist economic quantification. Against an unmeasurable times an unquantifiable, what basis do regulators have for precisely calibrating the cost and dimensions of their bulwark?

It seems to me one cannot reasonably do MB=MC, but rather very loose upper and lower bounds are the best one could argue with.

P.S. Even in normal times, eg the FDIC's various ratios are not calibrated against an historical "utility function". If a balance is achieved it's surely between the personalities and the powers of the regulators and the regulated.


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