How stressed are the stress tests conducted on European banks?

Understanding of the stress test prerequisites a basic understanding of the Basel norms and the Capital Adequacy ratio. To put it in simple english, the Basel norms states that, the banks can’t build assets (lending) purely based on the borrowing (deposits). Rather, a portion of the lending is supposed to be backed by one’s own capital which will be proportionate to the risk of the assets

For example, if a bank has an exposure of 100 Cr. in a personal loan portfolio, and the value at risk for this portfolio is 20%, the amount of capital to be maintained to have an exposure of 100 Cr. in this loan portfolio is 20% * 9% * 100 Cr (9% is the Capital adequacy ratio advised by the RBI to the Indian banks) = 1.8 crore.

Having understood how the CAR is calculated, let us move to the next step of how this figure 20% is arrived at. Traditionally (Basel I norms), the central bank dictates this risk weight-age for various asset classes based on its analysis of the economy. (This has also been used by the central banks to restrict or enhance the flow of money to any particular sector).Basel II norms gives freedom to the bank to arrive at its own figure based on the borrowing characteristics of its customers and stop with just suggesting the mathematical model to compute this figure.

There are primarily two ways of calculating this figure. One is VaR method which calculates the value at risk for any portfolio in 99% of the case. This is done by mathematical simulation based on historical data. Another method involves, calculating key parameters like Probability of default (% of customers who will default in a portfolio), Loss given default (in case a customer default what will be the loss for the bank) and Exposure at default (The extent to which the customer would have utilized his/her credit line by the time he/she defaults). The product of these three parameters along with adjustments gives the risk of that portfolio. The Basel Committee advises to take historical data of at least 7-8 years to cover the variations in the business cycles.

The problem here is that, as you might have noticed, the banks hold capital only to the extent of value at risk 99% of the time or the average loss that may arise in a portfolio. Whereas today’s situation as evident is beyond this 99% range and certainly not normal. 

Also, the stress test is supposed to assume the worst case of defaults for all the portfolios and see whether the capital of the bank still holds good. Whether they have taken all the worst scenarios enough to make this test stressed? The most feared, the event of default of sovereign bonds is not at all taken! Though they assure that such an event will never occur, why should they be excluded? Shouldn’t the stress tests capture the worst case scenarios? 

Certainly, going by the basel formulas, most of the capital of the most of the banks should have been compromised by the ongoing economic crisis. This being the case, saying that just a few billion is enough to regain the cut off of 6% (set for this stress test) doesn’t sound convincing. Also while adjusting for the loses arising out of holding government securities, only trading books were considered and not the portfolio of bonds under “Held till maturity” (Bonds held under trading book constitutes just a fraction, usually in one or two tenths of the bonds held under HTM-Held till maturity). Is it appropriate to call this as “stress test”?

Is it possible for U.S to regain its trade balance? If at all possible, How?

As discussed in my previous post, “Why Yuan Devaluation won’t work?”, the problem can be easily understood with the lens of “International product life cycle” theory. The well established firms (as wisely put, the “nationless” firms) have started moving out to third world countries (will be more appropriate to call migrated) to achieve their objective, namely profit optimization, by availing low cost inputs.

In the era of globalization, no firm can retain its competitiveness by having its base in developed economies where factor costs are so high. It is true that companies like Apple need not have to go for low cost production and can command the premium they want. But this is true only if you are targeting high end customers who are ready to pay premium for the luxury they desire. It is obvious that only few companies have the R&D, capacity and vision to stay put healthy in this section and most other firms try to retain their position by covering up their weakness of low quality products through the volumes, i.e., by manufacturing in large scale catering to the needs of the majority middle/ lower income group. (A point to note, Even the premium product maker, Apple itself, outsources the manufacturing process to take the advantage of the low factor cost in China)

It makes no business sense for the firms to have their manufacturing base in U.S if you discount the other costs involved in Exports-Imports, Freights etc. In ideal scenario with minimal transaction cost, it makes perfect business sense to outsource most of the production work to the low cost countries and retain only the processes which involves lot of machinery and less of humans.

So how can they counter the heavy imports? They can add some more value to the goods they imported and export it back to the emerging economies. But as we have already seen, the products produced in western world can compete only in high income segment. So this option of adding value and re-exporting is not feasible. Then what is the solution? When the U.S opened up its economy for free trade, it also should have freed up the labor market. With the current defensive policies of the governments like minimum wage, etc., the American firms tend to lose their competitiveness vis-a-vis the companies having base in the emerging economies. It can only worsen their economy to tempt these giants to move out to get a cost advantage and that is what happening now, resulting in huge trade deficits in U.S. It now tries to solve the structural problem just by manipulating the currency, asking the China to devalue its currency.

Another problem with the U.S is its own currency. U.S, with its dollar being the reserve currency it is in a very similar position to that of Greece. Just how Greece cannot devalue its currency (The Euro which it shares with other member nation) and rebalance its economy, U.S also cannot easily devalue its currency so easily. Only way it can lose its value is losing the confidence in it, which can be very lethal making the issue very tricky.

Does it mean China is a winner in this game? No! China has its own structural issues. Just like how U.S firms have the problem of serving the high end customers in terms of the value it generates through its products, China’s problem lies in the purchasing power of its customers, who unfortunately are not its citizens rather U.S’s citizens. So it is not enough that China takes care of its citizens, but also have to take care of U.S’ citizens by supplying it with low-cost debt for its survival, in whose absence both the economies have to collapse.

Why is this imbalance? Shouldn’t there be a mechanism (invisible hand) which corrects situation? Exactly, that is what happening. But in a painful way. The Chinese can keep on subsidizing the U.S only to an extent. After which it can’t sustain and let the Yuan appreciate, thereby making its citizens wealthier (Pain for the U.S because, all the goods they enjoy at low cost will become costlier to the extent of their imports from China and Yuan’s appreciation. This may lead to further repercussions in the economy) But for that to happen, a lot of structural needs to be done, to let the citizens reap the benefits of the hard work they have put for decades while the currency appreciates. Else, the dispersion of benefits will be skewed, resulting in China returning back to square one with its citizens not having much purchasing power. It has to replay the game starting with export again. So it won’t let the Yuan appreciate so easily. It demands lot of patience in planning and execution and will take its own time so as not to hurt its economy.

Once the currencies regains its balance, the factor costs of inputs will also regain some balance and it will make business sense for the firms to come back and until then, the U.S will continue to have deficits.

Note: In the discussion, I have ignored the transaction and freight costs involved in exports and imports. In reality, the firms will return well before the currencies exactly balance each other.

Why Yuan Devaluation won’t work?

The problem with the US trade deficit is structural rather than caused by currency pegging. US claims that, it is at disadvantage vis-à-vis China because of inappropriate exchange rates and hopes to bring down the trade deficit by devaluing dollar vis-à-vis Yuan. But data of the last few years shows that though dollar gained strength vis-à-vis Yuan, it has significantly lost its value against other currencies (like Yen) but still hasn’t seen any improvement in trade deficit with the respective countries (Japan).

One thing to be noted is what happened during the 1970s and 1980s. Though Yen (America by then accused Japan similar to what does against China of currency manipulation) raised drastically from around more than 300 Yen a dollar to almost below 100 Yen dollar, the trade balance of U.S still suffered. Though by then the reason is altogether different (Business and manufacturing efficiency), the point I wish to stress here is that, U.S, instead of looking within itself, has tried and trying to solve its problems by manipulating others.

The problem here is that the bigger firms of U.S has altered their approach in business, either moving out the production shop out of U.S or outsourcing the job to other emerging economies in order to achieve cost advantage, while working only on R&D and strategically & technically important manufacturing activities in their country (as explained by the theory on International product life cycle). Until the companies move back to America, the country’s trade deficit will only continue to increase. What are conditions, which favor the companies, return to their motherland? Will they return? Will discuss these in the next blog entry.