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Opinion The Fed’s ‘stress tests’ overlook the dangers facing banks

The Federal Reserve
Thought Leader: Sheila Bair
July 11, 2023
Written by: Sheila Bair

Sheila Bair is a former chair of the Federal Deposit Insurance Corporation.

A common anxiety dream among college students is showing up for an exam only to realize that you studied for the wrong test. Being ill-prepared is the stuff of nightmares for banks as well. Unfortunately, the Federal Reserve’s recently completed “stress tests” gave high grades to banks for passing exams that fail to prepare them for the biggest risk that likely awaits them: a prolonged period of high and rising interest rates.

Conventional wisdom holds that rising rates help banks by allowing them to charge more for the loans they make to their customers. That is true at the beginning of a tightening cycle, but over time, rising rates present significant challenges for banks. The Fed needs to test for that scenario aggressively — and soon.

As we’ve seen already with several recent dramatic bank failures, when a bank has invested in long-term, low yield securities, even supposedly safe government-backed securities can lose substantial market value. This is because as rates rise, investors can buy more recently issued securities to get a bigger return. If a bank holds its securities until they mature, it can redeem them at par and not realize losses. However, if the bank is forced to sell those securities to meet depositor withdrawals, it will suffer significant losses.

Rising rates, meanwhile, will also eventually require banks to pay higher interest on their deposits — and that is already happening. For a bank, this might push the costs of those deposits above the returns they are receiving on their previously made loans and investments. This might not be a problem if banks can make new loans at rates that exceed their rising deposit costs. However, if short-term rates go up faster than longer-term rates — a situation known as “yield curve inversion” — banks could find that the interest they must pay to keep their deposits exceeds the returns they can charge even on new loans. Notably, the yield curve has been inverted for more than a year, portending a significant challenge for banks whose profitability depends on using short-term deposits to make longer-term loans to businesses and households.

The Fed’s defenders have also pointed out that it separately tests high interest rate scenarios in what is known as its “liquidity testing.” These are nonpublic tests that assess a bank’s ability to maintain access to the cash it needs to meet its obligations should it experience, as we saw in recent bank failures, a sudden withdrawal of deposits or other sources of funds.

But liquidity risk cannot be separated from a broader assessment of banks’ capital strength, which is the focus of the Fed’s more important, public stress tests. If uninsured depositors and other creditors view a bank as weakly capitalized, they will quickly pull their funds, leaving the banks struggling to raise cash. If the bank has to sell assets at a loss to meet redemption requests, this will deplete its capital, turning a “liquidity” event into a potential threat to solvency. This potent combination of risks needs to be fully comprehended in the Fed’s test scenarios.

To its credit, the Fed has acknowledged the need for “humility” when assessing large banks’ resilience and the importance of testing different scenarios. Michael Barr, the Fed’s new vice chair for supervision, has suggested that banks undergo a “reverse stress test,” which would force banks to identify scenarios that in the real world could threaten their existence. This would give the Fed a deeper grasp of emerging, existential threats.

There has been much discussion of expanding liquidity and capital testing to smaller banks, which was cut back in 2018. But flaws in the tests make them of questionable value in assessing banks of any size. Fix the tests before expanding them. Otherwise, like students studying for the wrong exam, the Fed is only distracting banks from the real risks they face.

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