Professor Kevin Dowd of the Adam Smith Research Trust has published a controversial and worthwhile rebuke of the BOE's stress testing regime. The white paper, entitled "NO STRESS II", identifies what is says are key flaws in the regulator's stress testing regime.
The criticism is centered around reliance on a single, soft measure of stressful environments for the banks and related low pass standards. Dowd argues that the BOE as both regulator and designer of the stress tests is conflicted, in effect, and favour high pass rates. Moreover, he appears to suggest that the very ideal of one battery of stress tests almost never seem to capture the true next set of risks facing the system. Another critique is the test's use of risk weighted assets in the CET1 to RWA ratio. This is a ratio which McKinsey and others highlight as an better capital ratio, but Dowd would say that such a measure does not really explain risk profiles adequately. As such, the stress tests fail to meet the requisite level of credibility to ensure full faith in banks today. Really what Dowd appears to me to be saying is that the very concept of stress tests can easily be called into doubt. Instead, pundits should focus on the very best means to measure capitalisation of bank risk profiles. In doing so, he is highlighting the challenge of capturing all forms of credit, market and operational risk in one metric, and thus suggesting a factor which can be used to assess banks in a more dynamic fashion.
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