What Does Facebook's IPO Have to Do with Stress Tests?

Last week, we witnessed the largest initial public offering of a technology company in U.S. history — a company that offers its main service for free, lives entirely on the internet, and is run by a 28-year-old. The euro fell into deeper jeopardy, not merely because of news from the debt markets and at the ballot box, but because Greek and Spanish borrowers reacted to that news in real time, withdrawing much of their euro-denominated savings from domestic banks. And a $2 billion bank loss, based on computer-driven and model-based decision making, almost instantaneously impacted policy discussions and market movements, even before facts became clear.

These seemingly disconnected stories—Facebook's IPO, the euro's continuing woes, and Chase's trading loss — have one thing in common: technological change, and the transformation of markets and communication that has followed in its wake. The role of technology has been a primary feature of recent financial gains and disruptions, from hedge-fund billions, to program trading in the 1987 crash, to high-frequency trading in the 2010 "flash crash." But it will be an even greater given in the years ahead, bringing with it increased volatility, an even greater need for real-time economic assessments, and calls for even greater transparency. Those who ignore these pressures will continually overreact, under-react, or react too late to market events.

At its heart, technological change amounts to a measurable change in pace — faster accretion and depletion of market value by products and companies, faster flows of information, and a faster flow of market actions on the basis on that information. This change is so profound as to alter what we can analyze and how. In the process, it can make previously unimaginable changes possible. Government debts can lose credibility in a matter of days; markets can lose faith in entire segments of the economy, and destroy vast amounts of wealth in mere weeks. Tropes about consumer and creditor behavior — households' willingness to default on their credit cards before their mortgages, for example — can quickly prove false.

For bankers and regulators alike, this can be a nightmare. Sound finance and sound regulation depend on conveying predictability, building faith in the strength of institutions and economic activity. But static management and supervisory tools, like immutable definitions of sufficient capital and liquidity that ignore shifting market conditions, can only do so much when the "laws of finance" start falling by the wayside.

Dynamic stress testing can capture some of these previously unimaginable changes, and provide information bank managers can use. But as conceptualized to date, stress testing has usually envisioned a limited number of changing macro-variables and a capital allocation response. In addition to the prescribed governmental stress tests, bankers themselves should conduct periodic "scenario analyses," and use them to inform their short-, medium-, and long-term planning. These "scenario analyses" would look at changing market realities and relationships caused by various factors, from the technological to the demographic and geopolitical.

Behind dynamic scenario analyses, banks must have a dynamic management team. Greater volatility in market affairs affects credit terms, portfolio composition, hedging strategies, and much more — just think of how the euro crisis has altered bond pricing and the availability of bank liquidity. Here, too, a dynamic approach is critical. For example, a bank might appoint an individual or a team to continually monitor its strategies and positions, and apply its judgment, properly considered — not just hard-and-fast-rules — to the evolving realities of the marketplace.

Bank managers must also come to grips with a "total transparency" world. Ironically, as consumers, investors, and policy-makers have received more information more quickly, they've also wanted more information, and wanted it quicker. These demands are now a daily reality, and they're only becoming more important. A decade ago, it would have been close to unthinkable for regulators to make any supervisory information — such as that coming from the stress tests – public. E-mails, phone conversations, meetings with colleagues — virtually everything can become public when the media and others come calling. Virtually nothing is private, which itself leads to potential challenges with modern privacy laws.