Explosive Report Warns of the Next Black Swans for U.K. Banks

An explosive report published on Wednesday by the Adam Smith Institute says the Bank of England should scrap stress tests designed to check whether U.K. banks are safe because they make them more, rather than less, vulnerable in case of a crisis. Investors should take note of this report, as it offers warnings about where the next "black swan" events could materialize.

The report is published a day before the Bank of England's September monetary policy meeting, and it likely will be an attention-getter. Governor Mark Carney is also the chair of the Financial Stability Board, an organization that promotes global financial stability and brings together senior policymakers from the G20 countries. It therefore is likely that these warnings will reverberate beyond the U.K. borders.

Essentially, the report says the central bank's stress tests will not detect whether banks are overstretched and that they not only are lulling bank executives, but also investors, into a false sense of security. The arguments presented in it are open to debate, but they are worth following.

Among other things, the report argues that because the stress tests look at book values for assets and securities rather than market values, the banks' leverage is understated. Also, market values that are lower than book values indicate that the markets do not believe the book values, so this could be a sign of trouble ahead.

It also says minimum capital requirements are "way too low" and that the tests are based on "discredited and gameable metrics," such as risk-weighted assets and Tier 1 capital. These include assets such as eurozone countries' debt, which, as the debt crisis has shown, are not risk-free, but under these rules are considered safe.

Moreover, the report argues, losses projected in a stress scenario are too low.

For example, the central bank's scenario for 2016 entails drops of 31% for house prices and 42% for commercial real estate. These declines, combined with a 4.3% fall in GDP and 4.5-percentage-point rise in unemployment, would lead to systemwide losses of £44 billion ($58.5 billion) over the first two years, according to the Bank of England's stress tests. But the Adam Smith Institute's report says this loss figure is too small, because it equals a loan-loss rate of around 3%, when a "typical" loan-loss rate in a banking crisis would be around 10%. It is even below the 4.1% loss rate from the European Banking Authority's stress tests, which, the report noted, "few observers took seriously."

Kevin Dowd, the author of the report, does not mince his words. "The stress tests are about as useful as a cancer test that cannot detect cancer. They seek to demonstrate a financial resilience on the part of U.K. banks that simply isn't there," he writes in the report published on the Adam Smith Institute's website. So, investors should not rely on the stress tests to form their opinions about how safe the banks are.

An index of major U.K. banks seems to indicate that markets are beginning to warm up to these banks again. True, the current price/earnings (P/E) ratio of the index is still at 13 versus 14.2 for a major index of U.S. banks and 17.7 for global stocks, indicating they are still valued less than other sectors. But over the past year, the major U.K. bank index returned 28.4% versus a total return of 27.6% for the major U.S. banks index and 18.8% for global stocks, in a sign that investors are returning to British banks' stocks.

Those who do should perhaps heed Dowd's warning: "The biggest risk facing the UK banking system now is the Bank of England's own complacency."