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Possibility for a ‘safe and sound and free’ banking system?

An interview with Professor Kevin Dowd

A report published by the Adam Smith Institute on 3 August 2016 revealed the “fatal flaws” in the Bank of England’s annual stress tests of UK’s banks’ financial resilience. The report was written by Kevin Dowd, Professor of Finance and Economics, at Durham University Business School. Professor Dowd’s report generated considerable discussion in the media.

The Bank of England’s stress tests are designed to ensure a safe UK banking system and yet Professor Dowd dismisses the tests as “worse than useless because they provide false comfort.” Stress tests are meant to be a method to measure the strength of banks in the wake of a financial crisis, but Dowd suggests the UK banking system delivers a fabricated reassurance that the baking system is safe, when it is in fact “highly vulnerable.”

Professor Dowd said: “My hope with this report was to question the stress tests, and by doing so, to eventually get the programme aborted. However, my expectations were not high. Last year’s first edition received no response from the Bank of England, although it did get some media coverage.

“I was amazed at the media reception for my most recent report. I’m surprised at how positive it has been— or at least, what I have seen so far. I wonder if the reception might be due to the fact we linked the stress tests to current developments in the European banking system - in particular, to the Italian banking crisis, the increasing concern with the big French and German banks, and to last week’s stress test report by the European Banking Authority,” said Professor Dowd.

So, what comes next?

Professor Dowd says the first step would be for the stress-testing programme to be widely recognised as an unsuccessful, indeed counterproductive, experiment that cannot be fixed. “I don’t expect my report to persuade the Bank of England to abort or change the stress-testing programme. You have to see the broader context: the stress tests are only one of a broader Bank narrative according to which the banking system has been fixed and you can see the resilience of the system through the stress tests. All this narrative is wrong,” he says.

“Stress tests also damage the banking system and the economy more generally in so far as they encourage poor risk management practices and create systemic risk that the risk models themselves cannot see,” Kevin says in his report. “My fear is we will have another crisis soon that could have been avoided, and we will see bailouts on a bigger scale than ’08.” 

Is there an alternative to stress testing?

Reform accounting standards first, he says, so analysts can assess banks’ financial strength from their accounting reports. But if you want to go further, we need to rebuild banks’ capital positions and above all impose a regime of strict personal liability on senior bankers so they bear the personal consequences of the risks they take. Only then will we have the safe and sound banking system that we want.