Thursday, July 8, 2010

New Topic: Stress Tests

I got the following email from a loyal reader recently:
I’m interested in the details of banks’ stress tests and kind of searching how they are applied and what the shortfalls of those tests are.

What were the assumptions in the scenarios and what sort of critiques were been made by economists/analysts?

I read the article “Why banks failed stress tests” by Andrew G Haldane and he highlights 3 main inefficiencies in those tests:

• disaster myopia

• network externalities

• misaligned incentives

What is your interpretation on the subject?
Writing about banks' stress tests was in my mind for a long time- not the least because I have been asked to write on the Eurozone economic developments by a Turkish journal. I am now thinking that I will do a number of blog posts on the subject. I plan to do a "literature review" tonight and post it. Then, I plan to read the reader's paper and comment on it. And finally I am hoping to post on my take on all this over the weekend and maybe write something for the Hurriyet Daily News or Forbes. So thanks a lot to the reader for goading me into this.

And to give you the scoop of my initial thoughts on the matter: I find the euphoric reaction to today's stress tests announcement extremely premature. Maybe it is just me, but I am struggling to see why reports that the stress tests would be less rigorous then assumed would be a positive development . For one thing, it is just sweeping the dust under the carpet- once that dust does come out, a lot of banks (and even governments) will start sneezing, and I am not sure there will be enough Tylenol to go around...

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