When stress testing banks, what is not on the balance sheets, could be much more important than what is on!
When managing risks, before discussing risk avoidance, one need to establish very clearly what risks one cannot afford not to take.
And, in bank supervision, a risk one cannot afford to take is that of banks allocating credit inefficiently to the real economy.
But since our current crop of bank regulators never ever asked themselves what the purpose of our banks was before regulating these, they never thought about that.
And so they allowed banks to hold much less capital when lending to “the safe”, like to sovereigns”, to the AAAristocracy or to the housing sector, than when lending to “the risky” job creating medium and small businesses, entrepreneurs and start ups.
And that meant banks earn much higher risk adjusted returns on equity when lending to “the safe” than when lending to “the risky”.
And that means the banks do not lend anymore to the “risky”… especially now when the banks are suffering from too little capital… the result of lending too much against too little capital to some “safe” who turned out risky, like Greece.
And that means the real economy is suffering… and our unemployed youth is running the very clear and present danger of becoming a lost generation-
And so when stress testing banks regulators should look at what is not on the balance sheets, which causes real stress in the economy… and so that they better understand what they did and why they should be ashamed of themselves.
By the way, Timothy F. Geithner’s recent book “Stress Test” completely ignores this distortion, which comes to show how little they understood and how little they still understand of what is going on.
“A ship in harbor is safe, but that is not what ships are for” John A Shedd, 1850-1926.
PS. The ECB released a detailed description of the Comprehensive Assessment and, of course it is not comprehensive enough to include what I here have referred to.
PS. The most adverse, the truly frightening scenario, which will NOT be stress tested for, is the what happens if bank regulators keep on distorting the allocation of bank credit as they do now.
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