Does anyone else get the feeling that regulators and supervisors of financial institutions such as insurers, banks and pension funds merely follow the fashion?
While the resident galah in every pet shop has been chattering about inflation in recent times, the talk at the financial institutions regulatory end of town in recent years has focused on stress testing in a fairly big way. The galahs will eventually catch up.
I have a theory that leaders of regulatory functions in each country copy each other. It’s as if a missive, carved in a stone tablet, is sent down from a mountain to the regulators who then spread the word around the world and insist on stress testing and scenario testing. This has been going on since before I left the workforce for a life of leisure.
Now, I feel we can agree that stress testing looks glamorous. There are graphs, tables, assumptions, standard deviations, outcomes, implications, mitigating actions and so forth. It looks smart, right? All those scenarios modelled and the inevitable anxiety waiting for the results of “How did we do?”
I freely admit that I do not know the origins of the term ‘Smoke and Mirrors’ but I have a hunch that it must have something to do with stress testing.
Here’s stress testing in its raw form. Regulator to regulatoree: imagine there was a problem that affected your business – what would happen? That’s a stress test. So regulators, being what they are, insist on a modelling of outcomes of that ‘problem’ to see the results on pricing, profitability, minimum capital obligations, etc. You see the issue? It’s all imaginary. Let’s assume this happens then that happens then this happens then that, what would be the outcome? Great news, we passed the stress test!
The regulators appear to think that an initial assumed problem will result in plausible effects that can be simulated through a set of assumptions. Mostly, this is correct whenever the initial problem is within the bounds of institutional experience. But managing those problems is what bankers, insurers, pension fund managers have been doing for well over 100 years, over 400 years in some cases. Those businesses have been dealing with problems since well before the regulators were out of short pants. It is the bolt from the blue, the black swan event, something outside experience that is the risk. No amount of assumed outcomes, models, graphs and presentations will inform business managers, regulators or customers of what would actually happen.
Stress testing is pointless, but damaging through wasted expense and false conclusions.