The Bankwatch

Tracking the consumer evolution of financial services

Disaster Myopia and other causes of banks’ problems

Andrew Haldane, Executive Director for Financial Stability, Bank of England diagnoses the failure of bank stress tesing in this speech given at the Marcus-Evans Conference on Stress-Testing.   He speaks of the Oct 87 crash, the LCTM hedge fund 98 failure as well as the 2007/8 crash.

Why Banks Failed the Stress Test:  Bank of England pdf

He sees three categories of failure:

Disaster Myopia

Essentially this is positive thinking that increases the longer since the last disaster.  He only somewhat jokingly wonders whether “10 years is the threshold heuristic for risk managers.”

Network externalities

He speaks of the financial system as a network of connected parties.  “When assessing nodal risk, it is not enough to know your counterpart;  you need to know your counterparty’s counterparty.”

Misaligned incentives

“Financial innovation lengthened the informational chain from ultimate borrower to end-investor.  The resulting game of Chinese whispers meant that, by the time information had reached the investors at the end of the chain, it was seriously impaired”

and

“There was absolutely no incentive for individuals or teams to run sever stress tests and show those to management”.

He draws on the recent experience at HBOS whereby the whistleblower who dared suggest the bank was growing too fast was summarily fired by Sir James Crosby.  Sir James went on to become deputy head of the FSA and advisor to Gordon Brown till he was forced to resign last week.

Based on work at the FSA and is own assessments, he puts forward a five point plan:

  1. Set a stress scenario that is sufficiently extreme
  2. Regularly evaluate the scenarios
  3. Keep the process dynamic and iterative
  4. Translate the results into impact on bank liquidity and capital planning
  5. Employ transparency with the regulators and the financial markets

Finally, the charts contained in the appendix are illuminating showing one view that indicates the ‘golden decade’ of 1998 – 2007 was sufficiently out of sync with the period 1857 – 2007 to indicate imminent disaster.  While this is armchair economist thinking, it is sobering to realise that this is based on the same data that was available to us all during the last 10 years.  The first problem of ‘disaster myopia’ is very real.

Written by Colin Henderson

February 16, 2009 at 15:47

2 Responses

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  1. Hope these guys have read the Black Swan. From this blog post, it sounds like they might be trying to predict the next one – which completely missed the point.

    Terry

    February 17, 2009 at 10:56

  2. […] as being less “regulatory arbitrage” and more “regulatory camouflage”. (my post on summarising Haldane)  (Haldane – BofE […]


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