Stress Tests and Capital Adequacy Explained

The highly anticipated FED stress test results may very well serve as fuel for further gains or, more likely in my opinion, as a sought after excuse for turning the tide (in the short run).

The idea of stress testing is an intuitive one. You test something to determine whether or not it is able to withstand various types of shocks without falling apart. The recent financial crisis has brought the issue of stress testing of financial institutions, predominantly banks, closer to the public eye but what really lies behind these stress tests?

The notion of capital adequacy

Banks and other financial institutions are, in their basic form, mediators of money accepting deposits from the public on one hand and issuing credit on the other. Banks earn, again very basically, from a financial spread between the interest rate of credit issued to that paid on deposits accepted. As any other corporation the net of a bank's asset and liabilities is the bank's capital.

This capital plays a very significant role in assuring the soundness and viability of a bank as it can be perceived as a cushion, of sorts, which absorbs various losses the bank may have due to the risks involved in its operations.

Regretfully, I don't have to explain the importance the soundness and viability of the banking system has in any economy. Therefore, the capital held by banks is highly regulated by the government.

Any company, when bankrupt, may cause heavy losses to its close economic environment. But the companies that were in business with the bankrupt company had, or should have had the ability to manage the risks in doing business with that particular company and were compensated for that risks by profits generated through that business.

When a bank goes bankrupt the general public, which had trusted the bank to be conservative enough to keep the deposit side intact, suffers. The public has very little in the way of tools to ensure and manage the risks in their dealings with banks (other than carefully choosing our bank).

Capital adequacy in banks is therefore highly important and closely monitored. A bank should have, in essence, adequate capital to cover the risks it incurs in its lending and financing operations.

Risks are abundant in banks and include mainly the credit risk incurred in lending activities of not being repaid by the lender but also significant market risks due to the financial nature of the business and significant operational risks due to the complexity of banks' operations.
Banks are also exposed to many other risks such as legal risks, liquidity risk, business risk, reputational risk and endless others.

How is capital adequacy regulated?

In order to regulate capital adequacy very detailed requirements of how a bank should handle its capital are issued by regulators everywhere. The most famous of these regulations are the Basel regulations published by the Basel committee of the Bank for International Settlements (BIS) which is an international organization that promotes international cooperation in monetary and financial issues and which central banks turn to for regulatory guidance and insight.

The regulation regarding capital adequacy issued by the BIS are known as Basel I and Basel II and contain detailed requirements and guidance on capital adequacy.

Essentially, this guidance break down the bank's off and on balance sheet items and translates these items into what are known as Risk Weighted Assets (RWA) where each asset receives a certain weighting dependant on the risk associated with it.

For example, a US government bond will receive a negligible risk weight while credit issued to a non-ranked company will be weighted as 100% risky asset. These risk weighted assets are than summed to receive the total risk weighted assets of the bank and are translated into a capital requirement accordingly.

The regulation is very detailed and includes requirements both on the risk weighted asset side and the capital side. Banks cannot recognize, for example, any sort of capital as regulatory capital for the purpose of demonstrating capital adequacy.

Banks are expected to have capital buffers which are excess capital a bank holds, over the regulatory requirements, to withstand unexpected risks and scenarios.

The problem, as we've experienced, begins when banks get involved in business that has not yet received proper regulatory treatment. This issue will always be an open issue as regulators usually react to market developments, thus always lagging behind.

For the purpose of calculating capital adequacy a detailed and common segmentation of business is published and regulated by the regulator. When something does not fit the mold it usually receives a treatment that is not necessarily appropriate or no treatment at all.

This is how financial crisis spring to life.

What are stress tests?

Stress tests are tests performed by banks and regulators to examine the capital adequacy of a bank under various stressed scenarios which may present difficulties for the bank's business. The goal of the stress test is to examine whether a bank has sufficient capital buffers to withstand the impact certain economic and business scenarios may have on it.

Stress tests are conducted by banks on a routine basis to make sure they can adequately handle adverse changes in their business and positions in the market and withstand any reasonable impact unexpected materializations of risks may have.

The results of stress tests serve banks in determining the capital buffer they should hold, as a function of the banks conservatism and regulatory environment.

Most regulators have published specific generic scenarios banks should use for stress testing their capital adequacy. These include adverse market conditions, usually in the form of combinations of historic worse case macro-economic parameters. This, however, is not enough.
Banks must adopt stress tests which specifically target the weakest points in the bank's strategy and balance sheet to ensure the viability of the bank's business in more turbulent times.

For example, in a utopian world banks that issues complex financial instruments would have considered the ramifications a liquidity problem may cause thus limiting this once very profitable business. Alas, we are not living in a utopian world and banks went bankrupt for all intents and purposes only to be bailed out by the government.

The BIS (Basel Committee) has recently published the Principles for sound stress testing practices and supervision (after the crisis had stuck, naturally). According to these principles stress tests play a role in:

• providing forward-looking assessments of risk;
  
  
• overcoming limitations of models and historical data;
  
  
• supporting internal and external communication;
  
  
• feeding into capital and liquidity planning procedures;
  
  
• informing the setting of a banks’ risk tolerance; and
  
  
• facilitating the development of risk mitigation or contingency plans across a range of stressed conditions.

Stress tests are a very important tool for risk management in banks and serve many aspects of it as demonstrated above.

The Supervisory Capital Assessment Program - The Fed's stress tests

The FED has conducted stress tests in the biggest banks in the US to determine their capital adequacy and the adequacy of their capital buffers under the current crisis. The NY times had published the guidance on How to Design and Conduct a Bank Stress Test as released by the FED.

The results are highly expected in the market and will be published in May, 4. So far the Fed had hardly commented on the results of the tests conducted.
The scenarios examined include changes in Real GDP, unemployment rate and housing prices.

Black Swans – The problem with stress tests

Conducting stress tests is very much like preparing future wars based on the experience gathered in past wars. Future wars will always be different and scenarios will always be surprising.

There are two basic types of stress tests: Historically based stress tests which are essentially worst case scenarios and User defined stress tests which are more fitted to each bank but are usually limited to the imagination of banks and, again, their experience.

The black swan theory, which has gained increased popularity in the recent crisis, targets the key weakness of stress tests. The black swan theory argues, in this context, that models cannot capture hard to predict, large scale and rare events which are exactly the events that shape our world and our financial markets (like the recent crisis).

Model must assume certain distributions and assumptions and will always miss on something. Usually the even they were built to capture.

Awaiting the results

The stock market anxiously awaits the results of stress tests and their impact on the capital of the largest banks in the US. It is important to note that failing a stress test does not mean the bank is bankrupt, or in trouble. It is a measure of how prepared banks are to handle adverse economic situations.

I believe the results will be highly ambiguous and will be taken by the markets depending on sentiment. If market plays want to sell the results will be interpreted as terrible and if a continuation of the recent rally is in order that the results will be surprisingly good.

Related Posts:

• On Causality and Correlation in Economics
• The Japanese Banking Crisis of the 1990's: Are We Facing a Similar Stagnation?
• Senior Regulators to Senate: Surprised at the failure of Voluntary Regulation. Where They Really That Naïve?
• Do you understand investment risk?
• Uncertainty and Risk differentiated – Is a Tactical Surprise Preferable to a Strategic Surprise?
  

Images by: Helico, Andwar

On Causality and Correlation in Economics

Causality is perhaps the most fundamental element of empirical evidence available to economists. However, it is also the source of many misconceptions due to its elusive nature.

There are some things we take for granted. The relationship between cause and effect is so deeply rooted in us we sometimes forget they are merely a result of a clever induction made through observation on the repetitive nature of the two.

Causality is a fundamental corner stone to any empirical science. In economics causality is the basis for models and theories observed ranging from basic supply and demand curves to the most sophisticated economic models around.

The social science of Economics is more formal than other social sciences in the sense it includes theoretical models which are not directly dependent on correlations but rather on assumptions of maximization of utility at their basis. Nevertheless, at the end, utility maximization and its behavioral associations are bound to end include causality as a central assumptions of the coherency of nature.

More intricate relationships between various economic indicators such as interest rates, inflation, expectations, government spending, private consumption and many others are based on observations on different correlations between these parameters over time.

The problem of induction

David Hume is a famous Scottish philosopher known for its strict empiricism (A theory in philosophy which asserts all knowledge arises from experience rather than innate ideas and reason). The following may clear up this issue of the sources of knowledge a bit more.

David Hume, being the strict empiricist that he was, pointed out the problem with the logical problem embedded within the inductions we make based on experience. To put it simply, any attempt at proving our inductions to be correct will ultimately be based on induction itself and therefore cannot be constituted a logical reasoning. The argument would look something like:

• Every time I've dropped an object it fell to the ground
  
  
• Hidden statement: Nature is coherent/consistent or "that which has been is that which will be".
  
  
• Therefore, when dropped, all objects fall to the ground.

To justify my hidden statement I must turn to the same statement assuming that if nature has been consistent so far it will continue to be.

In Hume's eyes there is no logical justification to assume the sun will rise tomorrow simply because it had done so in the past.

Needless to say induction is crucial to science and the problem of induction presented by Hume has received great attention from philosophers ever since. Karl Popper, a famous philosopher of science (among others) suggested a clever way out of this problem by stating science will advance through efforts of disproving existing theories thus strengthening the correct ones and correcting the false ones. For example, the argument that all swans are white is correct until a black swan will be spotted.

Causality and Correlation

David Hume also took a swing at Causality or Causation following his treatment of induction. Hume stays committed to his reasoning all the way to the skeptic conclusion which is unavoidable according to which causality as a concept has no meaning as we cannot conceive the connection between cause and effect in any means available to us (I will explain shortly).

"…It appears that, in single instances of the operation of bodies, we never can, by our utmost scrutiny, discover anything but one event following another, without being able to comprehend any force or power by which the cause operates, or any connection between it and its supposed effect… All events seem entirely loose and separate. One event follows another; but we never can observe any tie between them. They seemed conjoined, but never connected. And as we can have no idea of anything which never appeared to our outward sense or inward sentiment, the necessary conclusion seems to be that we have no idea of connections or force at all, and that these words are absolutely without meaning, when employed either in philosophical reasoning or common life".

Trying to explain cause and effect in terms of experience is bound to lead us to Hume's reasoning. The connection between cause and effect can be described as either proximity in time, proximity in space, an obligatory connection or any combination of these. Still there will always be examples of events which answer to all these criteria and are not cause and effect. Hume gives us the example of the rooster that believes he bring out the sun with his cry every morning.

In order to lead our lives we all assume causality exists and will hopefully continue to govern our structured world. Many false theories however, are the result of assuming causality where only correlation exists. In economics and other social sciences the risk of erring in this way are very significant.

From the explanation above and the rooster example the difference between correlation and causality should be clear by now. The fact two phenomenon display certain similarities in their behavior, either in time, space or a connection does not mean they are, indeed, cause and effect. They may be simply correlated.

Correlation

Correlation is an important statistical figure which indicates the strength and direction of a relationship between two phenomenon or variables. For example, the price of wheat and bread are correlated. Putting the philosophical discussion aside, we believe these prices are correlated because the price of wheat serves as a cause for the price of bread. However, the prices of bread may be correlated with the daily yield on the Iranian government bond. There is no justification to assume causality here.

No less dangerous is assuming, perhaps, that the prices of bread influence the price of wheat. Getting the direction of the correlation wrong is a very easy mistake. Especially when we are researching variables we don't know much about.

Rudi Giuliani's fight against crime

A good example of the problems with assuming causality and using correlation is that of the significant decrease in crime in New York in the 1990's. The crime rate in New York had dropped significantly seemingly due to Mayor Giuliani's strict zero tolerance policy and the "broken window" thesis.

Researches today argue as to the real cause behind the decrease in crime rates in 1990's NY. Apparently some researches today claim Giuliani's success had merely been coincidental and that crime rates all over the country were dropping due to the economic growth in the 1990's and the decrease in the relative share of certain age-groups in the population. Several cities across the US have shown even more dramatic decrease in crime rates whit out Giuliani's fight against crime.

In their fascinating book Freakonomics (which is a must for any economics enthusiast) Steven Levitt and Stephen Dubner are presenting a very unconventional approach to economics and have presented a theory correlating legalization of abortions in America with the famous decrease in crime presented above. According to Levitt and Dubner the legalization of abortions has led to fewer unwanted births and to a decrease of the number of youths in the population exactly in the 1990's which in turn led to less crime and Giuliani's credit for the fight.
Although I agree with Giuliani's "broken window" thesis there is no real way to know what the cause behind the effect was.

This example serves to show how difficult and confusing it can be to prove causality between two variables and to incorporate that into any successful theory.

Conclusion

As always, all theories, especially when it comes to the social sciences need to be taken with a grain, or a whole bag, of salt. Adopting a skeptic attitude towards surprising findings will quickly sharpen your instincts and ability to tell reasonable from fantasy.

Understanding the problems with induction and causality and also the difference between correlation and causality is, perhaps, one of the most important aspects in leading a rational life. It will also help you quickly turn the page on that recent study which shows the amazing relationship between children who ate peanut butter sandwiches and their success in business later in life.

Related posts:

• Challenging Happiness – Exploring the Irony of Human Nature
• Capitalism with Social Equality: A Powerful Though Experiment Demonstrates Our Moral Obligations
• The Little Savings That Could
• On the Psychological Effects of Ownership and Overpricing
• Outsourcing Our Chores - Do We Overvalue Our Spare Time?

Image by: Dawnzy58

Challenging Happiness – Exploring the Irony of Human Nature

The irony of human nature - anxiety for those that have everything and depression for those that have nothing

The human state of mind has been cleverly characterized by someone to be either anxiety or depression. It seems that either you have attained what you desire and you are constantly afraid of losing it or you haven't and therefore you are depressed.

I've read this rather bleak outlook on life yesterday along with another I'd like to share.
It seems that many successful individuals, who are and had "lived their dream", are frustrated and unhappy, even more, perhaps more than the rest of us, common folk, if I may generalize. There is no shortage of examples of successful people who were not able to cope with success and had cracked under it.

Still, I'd like to avoid the course of cliché or the common argument true happiness exists only in the more "noble" things in life like reason, religion, art, love or anything else that comes to mind.
Rather I'd like to question the idea of happiness in itself and hopefully draw some conclusions in the end.

Is there happiness to be had?

Philosophers of language enjoy dissecting words and meanings and happiness is defiantly one of the most interesting concepts we have.

To put is in very simple terms – Is there happiness to be had at all? Couldn't happiness be just a concept embedded in our language misleading us all?

The question of meaning is deep and challenging. Concepts such as happiness, along with truth, god, soul, mind and others are under constant scrutiny. The idea in itself is simple and powerful – The fact a word exists does not deduce any sort of meaning what so ever.

I think we can all agree, empirically speaking, that happiness is not an enduring state of mind but rather comprised of moments. We sometimes feel happiness surging through us but that may well be the effect of our body chemistry. This notion of experienced utility has been discussed and researched by Noble Laureate Daniel Kahneman which argued happiness is the subjective feeling in each moment defined, in turn, as the minimum range of time a person is self-aware of his or her feeling. Readers of The Personal Financier know I'm very fond of his work on psychology and economics.

Hollywood has probably contributed to the western notion of happiness more than any other influence by putting happiness into terms of family, love, success, money, power, freedom etc.
In fact, the state of happiness in individuals, or the capability to be happy, as we relate to it, is considered to be more than 50% genetic in its source. This simply means not all of us were cut out to be happy.

Happiness and worldly possessions

The notion material achievements do no lead to happiness, as demonstrated, with some humor, in the anxiety-depression paradigm is very deeply rooted in human civilization.

The bible, philosophers and modern day cliché coachers have all discussed the inability of worldly possessions to make us happy. While the latter maybe selling something the former have genuinely tried to demonstrate the way to a happier existence.

Contemporary theories reinforce earlier views according to which money, as the essence of worldly possessions has a much lower contribution to happiness that is usually attributed.

The reason, as modern psychologists have demonstrated in empirical experiments, is not that money isn't important. Money plays a significant role, but only up to a certain minimum point. After the point basic needs have been fulfilled it's how much money one has in comparison with others that matters most. People have demonstrated destructive behavior in experiments where one was willing to lose 25% of his or her capital to "destroy" 50% of another's.

Career is very much the same. We measure ourselves on the social scale. How can one be happy when there's always someone younger and ahead?

Frustration – The irony of the human psyche

Our frustration ironically increases when we achieve our dreams and goals. Suddenly the gap in expectations explodes in our faces and we are overwhelmed by the emptiness of the peak.

More often than not our expectations are much grander than reality. Imagine your last vacation, for example, to a beautiful destination. Did its beauty surpass your expectations? It does sometimes, but usually reality has its surprises in store for us.

The irony of human nature and our psyche is apparent. We were programmed, either by God or evolution (take your pick) to constantly seek out new challenges and new goals. We are quickly accustomed to any situation that is, at the moment, our current situation and we always believe happiness is right around the corner.

By constantly striving we (arguably) better ourselves but fail, again and again, to find peace of mind and the sought after happiness.

Conclusions

Well, it seems that if you are lucky genetics has already assured you 50% chance at happiness. The rest of us may have to work a bit harder.

My personal belief is that being aware of our psychological "deficiencies" is one of the better ways to tackle the issue of happiness. By acknowledging the elusive nature of happiness, the need to constantly set and conquer new goals and by learning to appreciate the more humble states of calmness, tranquility and long-term satisfaction we may find peace of mind and general well being.

My personal tendency is to agree with the philosophic arguments according to which reason is the source of long-term well being (I avoid using happiness). The little exercise I suggest here is exactly that. Gaining awareness and employing reason into understanding the elusive nature of happiness and our human limitations.

Related Posts:

• Behavioral Finance in Everyday Life – The Lottery as a Case Study
• Is Rationalization the Key to Happiness?
• How Can they Possibly Afford That? Or Is Money in the Eye of the Beholder?
• Coming To Terms with Never Getting Rich – A Look at the Pre-Requirements

Image by: Sean Oneill

The Recent Rally in Stock Prices is Nearly Over

Stock markets around the world have surged by over 25% during March and April. I believe market players are already looking for a good excuse to start selling again…

During the past month we've witnessed an amazing good old rally in stock prices. The S&P jumped from its recent new low of 676 points to 856 points in a month's time (that's 26%).
A rally like this is typical to a stock market that has taken such severe blows. Unfortunately there is no way of timing it.

Those of us with decent short term memory surely remember a similar rally that took place during December and January 2009 where the S&P rose from its second recent low of 752 to 931 only to crash back to 676, as we know now. That was 23% rally by the way.

Obviously these rallies are impossible to time. Still, I'm sensing something in the air. The financial papers and headlines are usually good proxies for a change in atmosphere. I believe I detected a change in what had recently been a surge in optimism to more sinister financial news.

Recent Developments

To start things off several "financial gurus" have expressed their opinion on the recent rally in stock prices and have characterized it as a "bear market rally". Do not be tempted to believe these guys really know what they're talking about. I believe they don't know where the markets are headed any better than the rest of us. What do they know?

First and foremost we must remember these individuals and institutions hold certain positions in the market and these positions speak for themselves. I am most certainly not accusing anyone of fraud or deliberate misguidance. We just need to keep in mind the facts.

Second, they are probably aware of the influence of their opinion and use it wisely. Third and maybe most important these "predictions" also serve as a method of communicating between the different institutions and market players. Ironically reality is created through these predictions.

Here are some examples of opinions recently published:

• The French Bank Societe General had defined the recent rally "a dash for trash" as the stocks that everyone was looking to sell only a month ago have shown price increases of over 60%.
  
  
• American Investor Marc Faber had expressed his opinion according to which the markets will suffer another 10% drop before rising again.
  
  
• Famous investor George Soros had stated the recent rally is a bear market rally as the American economy is still struggling with a difficult recession. Furthermore the American banking industry is literally in a state of bankruptcy.
  
  
• Morgan Stanley analysts have predicted the market is still bearish as corporate profits, housing prices and bank balance sheets have yet to recover adequately.

Bad financial news plays a significant role in setting the course of the markets in either direction. Surprisingly, or not, financial news tends to side with the opinions of leading market players and financial institutions. The following is a collection of the news gathered over the weekend so far:

• Goldman Sachs is expected to issue $10 Billion in stocks next week in order to repay government aid funds. From a first glance this seems like good news. The problem is what happens with other financial institutions that are yet unable to repay the government? What does this say about their financial condition? Several articles have taken this tone in reporting about Goldman Sachs' intention.
  
  
• The Fed and Federal government have asked banks to avoid publishing stress test results and wait for the formal report to be submitted by the government. Such news could be considered ordinary as well but have been speculated upon fearing that several banks may not have enough capital to withstand their stress tests.
  
  
• The budget deficit of the US has soared in the last six months to unfathomable highs amounting to $956.8 Billion. Apparently this deficit has only been equaled by that of the Second World War.
  
  
• Two more banks in the US have collapsed. This brings the total of collapsed banks to 23 in 2009 vs. 25 in 2008.

What does this have to do with the long term?

All of these circumstantial evidence points, in my humble opinion only, to the upcoming end of the current rally in favor of a cooler period. Hopefully we won't witness any further sharp declines in stock prices and this might be a good time for me to re-enter the markets after a long period of waiting. I'm guilty of timing the markets, I know. It's simply irresistible.

We must remember that every period of one way movement in the markets is often corrected by an opposing period, however short, which represents capitalization of profits and "taking air" before conquering new highs.

These are only a handful of opinions regarding the state of the markets. We must keep in mind that the stock market, in theory, doesn't care much about the balance sheets of the upcoming quarter but rather what these represent in the long term.

Soon enough the tide will turn and someone will decide we've had enough. Stock prices will rise expecting the economy to recover and the economy will recover because stock prices are rising in a beautiful, ironic circle of forged reality. The markets are all about expectations. That is why they are unexpected and unforeseeable.

It's a Boy!

Dear readers,

I'm happy to announce that over the weekend I've become a father. We are DINKS no more. I promise not to have too many "expensive baby stuff" sort of posts.

Back to the hospital then...