Why Banks Failed the Stress Test

Andrew G Haldane: Why banks failed the stress test – Speech by Mr Andrew G Haldane, Executive Director, Financial Stability, Bank of England, at the Marcus-Evans Conference on Stress-Testing, London, 9-10 February 2009.

It’s wonderful! We’ll start with sigma-rigging:

Back in August 2007, the Chief Financial Officer of Goldman Sachs, David Viniar, commented to the Financial Times:

“We are seeing things that were 25-standard deviation moves, several days in a row”

To provide some context, assuming a normal distribution, a 7.26-sigma daily loss would be expected to occur once every 13.7 billion or so years. That is roughly the estimated age of the universe.

A 25-sigma event would be expected to occur once every 6 x 10124 lives of the universe. That is quite a lot of human histories. When I tried to calculate the probability of a 25-sigma event occurring on several successive days, the lights visibly dimmed over London and, in a scene reminiscent of that Little Britain sketch, the computer said “No”.

… and proceed to …

A few years ago, ahead of the present crisis, the Bank of England and the FSA commenced a series of seminars with financial firms, exploring their stress-testing practices. The first meeting of that group sticks in my mind. We had asked firms to tell us the sorts of stress which they routinely used for their stress-tests. A quick survey suggested these were very modest stresses. We asked why. Perhaps disaster myopia – disappointing, but perhaps unsurprising? Or network externalities – we understood how difficult these were to capture?

No. There was a much simpler explanation according to one of those present. There was absolutely no incentive for individuals or teams to run severe stress tests and show these to management. First, because if there were such a severe shock, they would very likely lose their bonus and possibly their jobs. Second, because in that event the authorities would have to step-in anyway to save a bank and others suffering a similar plight.

All of the other assembled bankers began subjecting their shoes to intense scrutiny.

You don’t build a career by telling your boss what he doesn’t want to hear. This is why regulatory capital charges must be progressive, so that larger firms are more conservatively capitalized than smaller.

Update, 2010-8-5: See also FTU.PR.A Provides 11-Sigma Update … but remember WFS.PR.A

5 Responses to “Why Banks Failed the Stress Test”

  1. Louis says:

    If you can briefly explain or direct me to a reliable / simple explanations as to what was meant by Geithner with is “stress testing of banks” it would perhaps help me understand what is going on on the South of our border? As well, what is your take on the possibility of nationalising Citi or BoA. To me, it would even be worse than “buying” their toxic assets since, on top of inheriting those toxic debts through the nationalisation, the US tax payors would then also have to run the bank without the expertise to do so. Doing so will also impair the remaining banks’ possibiliites of raising private capital.

  2. jiHymas says:

    I have – long ago – highlighted a very good Australian paper regarding a stress-test.


    • Imagine the worst thing that could possibly happen.
    • Double it
    • Are you solvent?

    Wide-scale nationalization would be a last-ditch effort to save the system and is very unlikely. We will see more Bear-Stearns-like deals (sell Citibank to Wells Fargo for $1) before that happens. I suggest that it will only happen if there seems to be no other way to restore confidence – and I agree with you that the effect would probably be the reverse.

  3. […] Update, 2010-08-05: See also Why Banks Failed the Stress Test. […]

  4. […] particularly startling in the conclusion (although those who swear by VaR and are surprised by 25-standard-deviation fluctuations in their asset values might be a little startled!); the main contribution of this paper is its […]

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