Why, as Britain’s Queen asked last year, did no one see the banking crisis coming? The premise of the question may even be flawed. Some did, though surprisingly few given the thousands of eyes that are supposed to scour the horizon for signs of financial risk. One sobering answer comes from the International Monetary Fund’s latest financial stability report. According to the IMF, spotting potential bank failures is an almost impossible task.
Capital adequacy ratios, for example, gave no clue as to which banks would go under. Even purer measures that compared common equity to assets were of little help. Indeed, capital ratios for those banks requiring intervention were actually higher than the group average. Examining liquidity ratios or non-performing loans versus total loans would also have been no help.
Dodgy banks did share some characteristics. They had smaller provisions and higher levels of debt relative to equity. They also had high returns on assets. This is informative as bailed-out banks had inferior returns on equity. That indicates their returns on assets were boosted by high debt, rather than risk-taking. Share prices were also inflated relative to earnings and book values.
This has policy implications, in particular for those devising stress tests. For one, obsessing about capital adequacy can be of limited value. Problems can leap from the sick to the healthy. Generalised bank panics that cause, say, a liquidity freeze, can also punish indiscriminately. At a company level, rising volatility of equity options is one signal of stress. So, too, are levels of off balance sheet debt; how that is reported in company accounts needs to be standardised.
The reality, however, is that for something to smack the whole system on the side of the head requires everybody to be looking the other way. The best regulators can wish for is to encourage as much transparency as possible, hope that someone is watching, and that others pay more attention when the alarm sounds.
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