Misaligned incentives Finally, and perhaps most contentiously, incentives and governance. Principal-agent problems crop up in all aspects of economics. But it is questionable whether there is any event in recent history where these agency problems have been exposed so frequently and extensively as during the current financial crisis. It is easy to see why. Financial innovation lengthened the informational chain from ultimate borrower to end-investor. The resulting game of Chinese whispers meant that, by the time information had reached investors at the end of the chain, it was seriously impaired. In the narrower context of stress-testing, these principal-agent problems appear to have operated at two distinct levels. First, internally, through the relationship between risk managers and the risk-takers within financial firms; and second, externally, in the relationship between financial firms and the authorities. The former principal-agent problem has been rather less discussed, but appears to have been potent during the credit boom. Decision-making within firms is an arm-wrestle between risk and return, between risk managers and risk-takers. When returns are high and risks appear low, this arm-wrestle can become one-sided. Power switches from back to front offices and risk managers become the poor relation. 9 And what is true within individual firms is then amplified by behaviour across the system as a whole, as firms conduct their own arm-wrestle with competitors for higher returns on equity. The Bank’s market intelligence suggested this “keeping up with the Jones’s” was a potent force within financial firms during the upswing.

In future, the Bank aims to be able to offer through the FSR some greater clarity to financial firms about the sorts of vulnerability scenario it thinks they could use as one (and only one) input to their stress-testing machinery. This might include both solvency and liquidity-type scenarios. As the FSA have proposed, banks should also test to destruction their balance sheets through “reverse” stress tests, in order to identify potential areas of balance sheet weakness. •  Second, regular evaluation of common stress scenarios. Having banks conduct regular evaluations of their positions relative to a set of common scenarios (provided by the authorities) would be an improvement on current practices in several respects. First, it would allow some degree of benchmarking of results across institutions; second, it would allow a degree of benchmarking, and hence peer review, of models; and third, it would hopefully help in ensuring stress-testing exercises form an input to management decisions and are not an annual regulatory ritual. Comparing these bottom-up exercises with top-down evaluations conducted by the authorities – the like of which have appeared in recent Bank FSRs – can also help in benchmarking results and models. •  Third, an assessment of the second-round effects of stress. The results of these common stress evaluations should be the starting point, not the end point. These common stress tests need to be made dynamic, so that the second and subsequent round interactions, and their consequences for system-wide risk, can be evaluated.