ALL BANKS SHOULD FACE THE SAME TESTS ON RISKS / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( VERY HIGHLY RECOMMENDED READING )

All banks should face the same tests on risk


By Alfredo Sáenz

Published: October 19 2010 22:18

The architects of coming global financial reforms must soon decide how best to identify, measure and curb systemic risk in the banking system. Their initial reflex was to propose the break-up of banks that were seen as “too big to fail”. The shortcomings of this approach quickly became apparent, so the focus is now on a surcharge in the form of higher capital requirements, levied on those institutions deemed to be systemically significant. But this focus is too narrow.


The Basel Committee on Banking Supervision said on Tuesday that it will make systemic risk one of its main priorities in the coming months. As it does, it should consider introducing a wider set of incentives to ensure all banks improve their resilience and financial stability.


Two important arguments need to be kept in mind when examining risks that can affect the entire financial system. First, systemic risk is only in small part correlated with size. The failure of a small or medium-sized bank can trigger a systemic crisis, as Britain’s Northern Rock showed. There are also several large banks, and I would count Santander among them, that have acted as systemic stabilisers by dint of their ability to absorb other failing institutions and maintain lending throughout a crisis.


Second, a group of relatively small banks can also trigger a systemic crisis by assuming the same type of exposure and concentrating a disproportionate share of risk. The US Savings & Loan crisis of the late 1980s was an example, when many small institutions put too many of their eggs in the same baskets of property and construction. In short, all financial institutions can contribute to systemic risk, and their contribution depends upon the interplay of many variables, including size but also solvency, liquidity, risk management, interconnectivity and other factors.


Crucially, systemic risk is also a moving target, and a rapidly moving one at that. The factors that make banks systemically risky are in continuous flux, making monitoring and reducing risk even more challenging. The danger is that simply trying to classify banks as systemic or otherwise would see some punished even though they do not pose much risk – while ignoring many that do.


Given this, regulators and supervisors should be looking not at a flat capital surcharge on a group of banks identified as generating systemic risk but instead at a series of incentives to steer all banks in the direction of reducing this risk. Better compliance in reducing systemic risk would mean a lower systemic surcharge; an increase in systemic risk would trigger a higher surcharge.


Just as importantly, the measurement of systemic risk should be a continuous process, covering all institutions; adopting a static, fixed measurement for systemic risk would fail to address the problem.


Such a system would see supervisors rate banks on a standardised scale according to how well they fulfil various requirements, as well as on regular stress tests to gauge their capacity to absorb severe shocks. A clearly defined and conservative approach to risk management and governance would be important, favouring those banks whose strategies promote long-term stability rather than short-term profit, assuring resilience across economic cycles.


Further criteria would include well-developed and regularly updated recovery and resolution plans, sometimes called living wills, which would include specific measures to avoid the collapse of a bank in difficult situations or to unwind it in an orderly manner. Regulators must also examine whether a bank is managed and structured in ways that reduce its risk.


All these measures can imply costs, sometimes significant ones. Moreover, having a business model or legal structure that fosters financial stability may involve a trade-off against higher profitability, flexibility or capital efficiency. These are costs that can and should be borne because of the benefits, in terms of stability, to the bank’s customers, employees and shareholders as well as to the financial system.


However these costs should also be recognised by the regulatory framework, and rewarded in the form of a reduced surcharge. Without this we will be unable to provide the right incentives for banks’ managers to limit systemic risk and reduce the probability of future financial crises.


The writer is chief executive of Santander


Copyright The Financial Times Limited 2010.