Knot's group, part of the Bank for International Settlements' Basel Committee on Banking Supervision, issued a set of draft principles this week on improving stress testing in order to better protect the financial system against future crises.
The stress tests that banks performed were far too mild, Knot said - they typically modelled only minor stresses affecting a single business line, leaving firms unprepared for the severe system-wide crisis that they faced. Equally damaging was the failure of senior management to take the tests seriously.
"We spoke to a lot of industry participants who worked on designing stress testing regimes within their bank and they simply told us that 'we could design whatever we wanted, but senior management and the board were just not interested. To the extent that we tried to design severe stress tests, we were almost laughed away, with the response that this was so inconceivable and don't waste our time with something so remote.' So there was also an issue with senior management's involvement," Knot said.
Knot is also director of supervision policy at the Netherlands Bank, where he encountered this reluctance personally. "In spring 2007 we asked [all Dutch banks] what would happen if liquidity in the market for asset-backed commercial paper (ABCP) conduits completely dried up - the reputational risk would force them to take all these conduits back on balance sheet. We had a huge fight with our banks... [they said] 'we're not going to calculate something so irrelevant, there will always be a market, sometimes prices will be higher but the market will always be there'.
"Well, we've seen what happened a year later was precisely this - the market for ABCP conduits completely dried up, and many of the institutions had to finance these conduits they had sponsored themselves or take the assets back on balance sheet. If banks had been willing to at least contemplate this possibility they would have done this kind of stress test years ago and would have been much more aware of the contingent liabilities they had."
The modelling group called for more severe and widespread scenarios for stress tests, and greater involvement with the tests at senior management and board level.