Fed’s Key Bank Test Overlooked Interest-Rate Risk For A Decade

The Federal Reserve’s stress tests, which determine whether US banks can survive an economic crisis, have not included scenarios resembling the economy of 2023 and the financial conditions that led to the downfall of Silicon Valley Bank last week. The annual stress tests have typically modeled mild to severe recessions with declining inflation and short-term interest rates. But, with almost a decade of oversight and two exceptions in 2013 and 2015, regulators have failed to capture the realities of the pandemic recovery, during which a year of rapid rate hikes eroded the value of bank portfolios. Experts have said that a realistic stress-test scenario only has merit if it encompasses all scenarios, including the sudden and sharp raising of interest rates.

The Basis for Stress Tests

The Fed officials have repeatedly touted the annual stress tests as their primary supervision method to assess the strength and resilience of the country’s major banks. However, the narrow range modeled by them lacks the reflection of actual economic conditions. Aaron Klein, a senior fellow in economic studies at the Brookings Institution, said, “A stress test is only as good as the scenarios it tests.” Moreover, the lack of rate-hike modeling highlights a significant hole in how Fed officials evaluate financial risk.

Lawmaker Scrutiny

Washington lawmakers have been scrutinizing the Fed’s resiliency measures to assess whether they serve as effective safeguards against financial instability after SVB’s collapse. Last week, the bank became the largest US lender to fail in over ten years after an unsuccessful attempt to raise capital and a cash exodus from the tech startups that had fueled its rise. SVB, for years, failed to reach the $50 billion threshold for annual stress-testing set by the Fed. As the company grew, its executives successfully lobbied for a 2018 law that raised the higher threshold, exempting mid-sized banks from annual testing requirements. As a result, SVB, with assets between $100 billion and $250 billion, would only have been subject to periodic testing and wasn’t tested last year.

A Missed Opportunity

A stress test may not have been the right tool to identify SVB’s problems inherent to the company’s business model. However, according to Steven Kelly, a senior researcher at the Yale Program on Financial Stability, the Fed missed an opportunity in 2022 to add interest-rate risks to the stress test. Instead, the central bank raised rates from near zero in March 2022 and announced that year’s stress test scenarios just a few weeks before SVB’s collapse. Kelly said that while a stress test may not have been useful for identifying the problems inherent in the SVB model, its collapse highlighted the need for more nuanced stress tests that included risks of current economic conditions.

Related Facts

• The stress test is the most transparent of the Fed’s supervisory tools.
• The Fed is adding market shock to its 2023 stress tests that more closely reflect current economic conditions but won’t penalize banks if they don’t pass.
• SVB executives successfully lobbied for a 2018 law that raised the threshold for annual stress testing, exempting mid-sized banks from the requirement.

Key Takeaway

The narrow range of scenarios included by the Fed in its stress tests, which fail to account for a sudden and steep raising of interest rates or other market shocks, highlights significant shortcomings in how the central bank evaluates financial risk. While a stress test may not have been the most effective tool to identify inherent issues in SVB’s business model, its collapse highlights the need for more nuanced stress tests that include potential risks specific to current economic conditions.

Conclusion

The Federal Reserve’s stress tests have failed for nearly a decade in modeling economic conditions resembling the current economy and financial conditions that could precipitate bank failures. SVB’s collapse has further demonstrated the shortcomings of these tests, and lawmakers in Washington have scrutinized the Fed’s resiliency measures to assess their effectiveness. Moreover, the Fed’s narrow range of scenarios, lacking reflection of actual market risks, highlights significant gaps in how financial institutions evaluate potential risks.