the naked stress test

banking at the edge of sanity

The purpose of this substack is at least partly to deal with ideas that I can’t get out of my mind, and one such is the European Central Bank’s exercise this year for a “geopolitical risk reverse stress test”. I wrote it up for Alphaville, describing the mechanics as “an exercise in collective dystopian fiction writing”, and that’s basically what it is. Every bank has to start from the end of the scenario, in which they’ve made a large loss (three percentage points of their capital ratio – so for BNP Paribas this would be roughly twenty billion euros). Then they have to tell the story about how they got there, and it has to be one in which geopolitical risk was the big driver.

I like this approach! I think it’s much more productive than the normal kind of stress test, because it actually focuses management attention on the kind of things they need to be looking out for, rather than wasting ungodly amounts of time and effort on arithmetic exercises which always seem to boil down to “is the capital base adequate for the size and type of business”. But it is increasingly on my mind, because I am beginning to doubt whether it’s psychologically possible.

Consider this. It seems really quite unlikely to me that BNP Paribas is going to experience a loss of even two billion euros in a way that’s directly attributable to the current war with Iran. So, arithmetically, then need to be thinking about a geopolitical crisis that’s ten times as severe as the closure of the Straits of Hormuz. What does that even mean? How do you open up a spreadsheet and start typing in it if that’s your job? How do you walk into a conference room, point to a flipchart with “~10x Trump” written on it and say “aucunes idées, mecs?”

This is a real problem with scenario planning of all sorts; it is just intrinsically difficult to take it seriously enough. In any kind of simulation exercise, you have one big difference from the real thing, which is simply that you know you are in a simulation exercise, and that you aren’t actually facing the end of the world. Just like boxers will tell you there’s all the difference in the world between sparring and fighting, the main difference being that in sparring, when you can see that someone is having trouble, you ease up rather than going harder.

And anyone who has ever played around with a brokerage or spread betting account knows that paper trading is surprisingly uninformative about how you do with real money. The big reason being that jeopardy affects your decision making process. Usually in the direction of making it worse. For a few decades now, I have been objecting to one common practice of regulators, which is to allow banks to include the effects of “mitigating actions” in their stress test scenarios. The historical record shows that it is at least as common for management teams to take exacerbating actions when big crises hit.

People do know these things. I happen to know that when some big organisations carry out their periodic cyber risk planning and simulation exercises, it is not uncommon for them to bring in consultants who have worked in reality television, and who are experts on creating an atmosphere of stress, conflict and poor decision making[1].

Which is a good start. Although the everyday business of risk management is all about consistency and meticulousness, it’s important to make sure that in planning for and managing the “non-everyday” kinds of risks (which are really the only ones that matter), some sense of chaos and weirdness is maintained.As well as quants and accountants, risk management should have dramaturges and clowns.At the very least, we should take measures to ensure that everybody in these discussions is out of their comfort zone.Make it a requirement that chapter three of every risk report has to be sung out loud, or require that all data analysis has to be carried out in the nude, or get the supervisor to fire flares at the windows or something.

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[1] There are a lot of tricks of the trade; the big manual containing them is part of what you buy when you licence a format. I once went to a talk with someone who had worked on “Celebrity Masterchef Australia” or some such, who said that at the very first meeting, she had realised to her dismay that all the contestants seemed to know each other and be friends in a way that wouldn’t make good telly. “Right”, she said. “Let’s get started. Please could you line up, left to right, in order of how famous you are”.