I reviewed the following report from the Federal Reserve to Congress today, and found it disappointing.  From my prior experience as an actuary, and the time that I spent on the asset-liability committee of a small bank, I know that  the banking industry is far behind the life insurance industry on risk control.  The Fed would have done far better to have studied the works of the Society of Actuaries and the National Association of Insurance Commissioners, and learned from their efforts.

10 Reasons the Fed Should Use More of an Actuarial Approach

Now, I know that the contingencies of banks are far less predictable then those of life insurers.  Further, life insurers have long liabilities, whereas the liabilities of banks are short, and thus, they are more subject to runs.  But liquidity risk management does not play a large role in their document — and this is a severe defect in what they write.  Almost all failures of financial firms are due to loss of liquidity.  The word liquidity only appears once in the document, on page 15.  This shows the amateurish work of the writers.

The Fed focuses on a lot of process issues that don’t matter as much as the substantive issues of discovering forward-looking measures of risk, and changing business processes to reflect those risks.

Here are some examples:

1) Internal controls matter, but it is a rare internal control auditor that can truly analyze a complex mathematical process.  They don’t have the capacity to review those processes, or they would be doing it and earning far more.

2) Risk identification is important, but the Fed document would have not helped in 2007-2009.  How do you detect risks that have (seemingly) never happened before?  Further, if you do detect a major problem that has happened before, and it would impair some very profitable businesses, why do you think management will kill profits to appease your lunacy?

3) Governance is important, but the board gets data so late that it is useless.  This is not worth bothering with.  Management has to do the job here.

4) The language on capital targets is weak, and allows the banks way too much latitude in performing their own calculations.  The Fed needs to be far more specific, and prescribe the scenarios that need to be tested.  It need to prescribe the loss severities, asset class by asset class.  It needs to prescribe the correlations, if any, that can be used in the models.

5) The document does not speak of ethics.  Valuation Actuaries do the same work on a higher level, and they have an ethics code.  That may occasionally make them oppose the management team that pays them, but it is a necessary check against managements trying to manipulate results.

6)  The piece spends too much time on the dividend policies of bank holding companies, and no significant time on the abilities of the subsidiaries ability to dividend to the bank holding companies.  The proper focus of a bank regulator is on the health of the operating subsidiaries.  Who care if the holding company goes broke?  Big deal, at least we protected depositors.

Banking regulators should adopt the same policy as insurance regulators.  Outside of ordinary limits, they can deny any special dividends from subsidiaries to the holding company.

7) The piece does not get forward-looking estimates of risk.  On new classes of assets, you don’t have historical data to aid in estimates of risk.  At such a point, one must look at similar businesses that have gone through a failure cycle, or do something even more difficult: do a cash flow model to estimate where losses will fall if asset values decline for an unspecified reason (okay, no more ability to buy…)

8 ) Macroeconomic factors rarely correlate well with the factors that lead to losses on assets.  Most of that effort is a waste.

9) As Buffett said (something like): “We’re paid to think about things that can’t happen.”  This is why the Fed has to specify scenarios, and be definite.  The mealy-mouthed language of the document can be gainsayed.  Life Actuaries have better guidance.

10) So all of the banks did not pass the mark.  With the vagueness of the guidelines, no surprise.  Let the Fed put forth real guidelines for bank stress tests, and let the banks scream when they get them.  Better to have slow growth in the banking sector than another crisis.

By David Merkel, CFA of Aleph Blog