But first, with thanks to the IMF for the charts, here are some facts about banks’ price-to-book ratios. When I proposed to the Bank of England in 2016 that parallel stress tests based on market values be run, they responded with a number of counter-arguments, which I will review below together with some remarks on illiquidity issues and some comments on Bank of England stress tests of banks. Simplest, and what I mainly have in mind, is what I’ll call the ex ante method of using market values to calibrate the starting point for the test. Thus, market values would be one basis for setting the initial capital levels that are then subject to stress. The ex post method would go further and consider the projected evolution of market values during the stress, to test whether the degree of stress is market-consistent. This could be done in at least two ways, which are discussed below. In particular, I will contend that for major banks with price-to-book ratios less than one, stress tests based on market values should be run and published by regulators alongside existing stress test results. Like many economists, I will argue that market-based measures should play a greater role in regulatory assessment than is current practice.2 Stress tests are an increasingly important element of that practice. What, if anything, should regulators do about that? Not worry about it? Go over to market-based measures? But then what about the risk of nasty pro-cyclical dynamics? The two may come apart, however, as they did spectacularly in the crisis of a decade ago. For a number of major banks they are apart again now, and have been for a while.
There are accounting measures, upon which the edifice of prudential regulation depends, and there are market measures. In the nature of things, values of illiquid assets are hard to measure. Depositors, for example, can get liquidity on demand while their funds are invested in part in illiquid assets such as loans. Among other things they provide liquidity transformation. Indeed, the measurement problem is inherent to what banks do. Given the potentially huge economic and social costs of bank failure through capital inadequacy, this is a serious policy issue. You can count how much money is in a pot but you can’t measure bank capital with much accuracy at all. It also promotes a spurious sense of precision. The fallacy is dangerous not just because it confuses assets and funding.
He got the point instantly and somehow managed to make the interview both intelligible and free of the pot-of-money fallacy. obligations to depositors, bond-holders, etc.). It is the difference between two big numbers – the estimated value of their assets and their liabilities (i.e. A pot of money is an asset, but equity capital is on the liability side of the balance sheet – part of banks’ funding structure. But he wasn’t sure and he took the trouble to check. No, it’s not like that at all, I explained (off air, thank goodness). Given the terms in which bankers, commentators and, alas, regulators including central bankers often speak about banks “holding” capital and so on, it is entirely natural that John Humphrys would think that the pot-of-money metaphor was apt. We need to make it intelligible to the listeners. So is it alright to talk about bank capital as like a pot of money that they keep on one side for a rainy day?” The subject was bank capital requirements, on which I thought the Bank of England had adopted a softer than prudent policy stance.1 A few minutes before the interview, as the news was being read, John Humphrys came into the room where I was waiting and said something like this: “It’s a complicated topic. I underwent a stress test of a personal kind at 8 o’clock one morning three years ago when I was about to be interviewed on BBC Radio’s Today programme by the formidable John Humphrys.