July 8, 2023 / VOLUME NO. 269

Dispatches From the Last War

In late June, the Federal Reserve released the results of the 2023 stress tests. The exercise measures the ability of large banks to withstand a severely adverse hypothetical crisis. In this case, the crisis included a global recession, large declines in real estate values, a spike in unemployment and falling interest rates. 

The Fed said that the tests showed that large banks could weather that kind of a crisis. The announcement comes several months after the closures of Silicon Valley Bank, Signature Bank and First Republic Bank, which failed for reasons that have nothing to do with credit quality or falling rates, and begs the question about the utility or conclusions of these exercises.

That tension has been on the minds of Fed governors, evidently. 

“[I]t is very difficult to resist the natural human tendency to fight the last war. In 2008 we saw banks come under stress from outsized credit losses and insufficient liquidity. … In our stress tests, we have considered severe stress scenarios that produced losses on banks' books, including outsized credit losses,” said Federal Reserve Chairman Jerome Powell in a June 29 speech. “But, of course, SVB's vulnerability came not from credit risk, but from excessive interest rate risk exposure and a business model that was vulnerable in ways its management did not fully appreciate …” 

But in some ways, the spring banking crisis underscored the value of these exercises. Powell points out that post-crisis regulations like capital surcharges, liquidity ratios and high supervisory standards made the largest banks more resilient — which was on display this spring. Powell said that the crisis demonstrated “a need to strengthen our supervision and regulation of institutions of the size of SVB,” which had $211.8 billion in assets at the end of 2022. And in response to the stress tests, institutions like Capital One Financial Corp. and Citizens Financial Group have announced that they’ll have higher preliminary stress capital buffer requirements. 

But the gap between the drivers of the spring bank failures and the imagined stressed scenario shows just how much the 2007 financial crisis and Great Recession still lingers in the minds of bankers and regulators alike. The hope now is that both shift their focus to future risks and make changes that stave off the brunt of the next crisis. 

"[T]his stress test is only one way to measure … strength,” Michael Barr, Federal Reserve vice chair for supervision, said in the release announcing the stress test results. “We should remain humble about how risks can arise and continue our work to ensure that banks are resilient to a range of economic scenarios, market shocks, and other stresses.”

• Kiah Lau Haslett, managing editor of Bank Director

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“When you make these retention awards, it’s really important to evaluate the impact. If you make these awards, are people staying? Are they leaving? Are we achieving the desired outcomes?” — Shaun Bisman, Compensation Advisory Partners

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