FSA wants tougher stress tests

As the FSA here in Britain announces new - tougher - stress markers for UK banks we can only hope that the underlying economic model holds up in case another economic crisis hits the banking system. We all know what happened to the Value-at-Risk Model - it was less than useful when it was needed most. The problem with stress-tests in banking is that it is impossible for the banking system as it is at present to provide for every conceivable disaster scenario as that would mean that ultimately the banks would have to hold all deposits 100 per cent in cash.

Lower Leverage-ratio under fire

The Federation of German banks has commissioned a study of the impact of stricter leverage ratios. Not surprisingly, the authors (Markus Rudolf and Michael Frenkel from WHU Otto Beisheim School of Management) come to the conclusion that the introduction of lower ratios would have to be handled very carefully - and may not even be desirable. To the contrary, we think that the suggested ratio of 20-25 times equity capital as a maximum range of leverage (as suggested in a consultation document presented by the Bale Committee last December) leaves the banking system still dangerously overextended.

Who needs rating agencies?

Warren Buffet certainly does not need them as he prefers to do his own analysis. We also suggest that investors do their own cooking. The only instances that makes ratings useful for investment decisions happen to be the situations where the consensus and/or ratings appear to cause a mispricing in the underlying security that allows a canny investor to benefit by taking the opposite side of the trade. As long as ratings are based on hard facts, usually numbers found in company accounts or data in national statistics, it is a simple matter of arithmetic to deduce the risk associated with a particular issuer. Where ratings rely on judgement calls they become highly subjective and should not be worth more than any other market opinion. Conflicts of interest exist when ratings agencies are given access to non-public information. As it is not possible for other investors to verify the information themselves, some lazy or naive investors get seduced to put excessive reliance on ratings decisions. This risk is exacerbated when laws or customs give ratings an official blessing - for example by requiring collateral posted with the European Central Bank to be of a certain credit quality testified by a rating.