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Economic stress tests

In the past few years, when the US and European economies have been reeling under economic recession, regulators in those economies have been conducting what are known as 'stress tests' - a series of parameters against which the economy and its financial institutions are judged.

How they fare against these parameters gives an indication of the state of the economy and the risk appetite of the financial institutions like large banks.

Stress tests do not always project the correct picture as often the 'models' that banks use are different and there is a real incentive to make things look good.

The comparison is inconsistent across banks because each bank runs the test itself.

The parameters used in a stress test comprise real GDP (a nation's total output of goods and services, adjusted for price changes like inflation or deflation), unemployment rate, national house price index (measures average price changes in repeat sales or refinancing on the same properties), and equity price index.

The inaccuracy is because most often, regulators do not look at the realistic downside scenario of the economy.

Hence, regulators are fooled into thinking that the system is healthy. Banks, in turn, think that they have plenty of capital because they passed the stress test. So, essentially, the regulator is not stress testing, he argues.

The example of the March 2011 US stress test that came out with assumptions for GDP growth of 2.4% in 2012 and 3.4% in 2013 - though a good scenario , is far-fetched .

I believe that the US and the European tests are used by regulators to try to calm the market down, which is akin to misleading the market, which should be avoided.

An inaccurate stress test is like a spiral: regulators are not focused on the problem because they think there is no problem. Banks take too much risk because they think they are less risky given that they passed the stress test. Ultimately , a bad stress test increases the chance of another crisis in the economy.

Source: Times of india

Wednesday , 14   December , 2011