The purpose of the stress tests is, in essence, to persuade us that the banking system is in good shape on the basis of a make-believe exercise which purports to show what might happen in the event of a supposed severe stress scenario as modelled by a central bank with a dodgy model and a vested interest in showing that the banking system is in great shape thanks to its own wise policies.
We are expected to believe that the central bank has managed to rebuild the banking system despite enormous pressure placed on it by the institutions it regulates, whose principal objective is to run down their capital ratios (or equivalently, maximise their leverage) in order to boost their returns on equity and resulting short-term profits, and never mind the systemic risks and associated costs imposed on everyone else or the damage their high leverage did in the Global Financial Crisis.
These latest Bank of England’s stress tests were published in the Bank’s November 2018 Financial Stability Report, the core message of which was that the UK banking system was doing just great, but that a No-Deal Brexit would be a disaster. Wrong on both counts.
I will focus here on the first issue, the state of the banking system.
In essence, the Bank paints a reassuring picture of bank resilience. The message is that the UK banking system is now so strong that it could sail through another crisis that is more severe than the last one and still be in good shape. How do we know this? Because the stress tests tell us, claims the Bank. However, the truth is that the Bank’s stress tests are useless at detecting bank fragility.
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