The Treasury is expected to announce this afternoon their long-awaited results to the so-called banking stress tests. They’ve done a good job leaking the key bits of information this week so the market has had time to adjust. Actually, they’ve done a good job attenuating the whole banking system assessment process, which has allowed time for investor sentiment to improve with the recent glimmers of hope for the economy that some prognosticators are seeing. What will be interesting is to see the parameters of the tests. I’ve read that the tests assume a worst case scenario of job loss that we’re very likely to exceed, but I’ll wait to see the fine print.
I was very interested in Warren Buffett’s comment over the weekend. Widely reported and noted in the Boston Globe here, Buffett said that the stress tests largely ignored the strength of the bank’s business models. This question of the viability of the business model going forward is an interesting one, and an important aspect of any ongoing business model would be how the risk management procedures will change to avoid similar problems in the future. Raising capital or creating a bad bank or any of the other strategies to deal with toxic assets don’t address the fundamental risk management weakness that got us into this mess in the first place.
I would be interested in seeing an assessment of the banks’ ability to identify and manage risk moving forward. And a key dimension of that capability is their stance on operational risk. Marc Leipoldt in the recent issue of OpRisk and Compliance (requires login) argues that now is the time for operational risk to assert itself across the business and become "central to the bank’s risk management". Clearly, many of the issues facing banks today were the result of realized operational risks that may have slipped through the cracks in the market or credit risk function. For instance, where would we be if the instance of mortgage fraud were dramatically lower? According to some banking insiders, at certain players this accounts for a good portion of the bad debt they’re having to account for.
The stress tests will certainly be a good snapshot of where we are, but what about our ability to manage risk going forward?