Regulate the process, supervise the risk

The EBA’s announcement on stress testing methodology and scenarios left banks with more questions than answers, but following Andrea Enria’s announcement earlier this month, we now have a far clearer picture of what the next round of stress tests will look like.

The tests will involve 90 banks (a longer and more varied list than last time) and they will be required to maintain a core tier one capital ratio of at least five per cent.

This is all well and good – the numbers are higher than last time. But there wasn’t really much cause for celebration until we discovered that regulators wouldn’t just be looking at passes and fails at five per cent, but also at overall risk management processes.

There are many more factors than capital rate that have a bearing on the survivability of a bank. If you don’t believe me, consider this: would the financial crisis have been avoided if all banks had held core tier one capital of five per cent? No. What’s more, setting such a defined form of capital with such a wide range of institutions on the list in fact creates a rather non-level playing field.

The problem comes down to the fact that you just can’t regulate risk. By its very definition, risk is un-knowable. You can supervise risk and regulate the supervisory process, but you need to allow it to adapt to market events – the downgrade of Japanese GDP due to the tsunami being a good example.

Because of the unique business model of each institution, the ideal situation here would be for each institution to be assessed on an individual basis, but clearly that’s challenging on a European-wide scale. With the tests gathering momentum and banks preparing for battle, the best we can hope for now is that the EBA won’t succumb to pressure and will keep the results private come June.