Federal Reserve Considers Alternative Stress Tests

Michael S. Barr, the Federal Reserve’s vice chair of supervision, has suggested the government should explore more possible scenarios for bank failures beyond the traditional method of stress testing. In a statement on Tuesday, Barr stated the importance of “reverse stress tests,” which would examine “different ways institutions can die” rather than using hypothetical hardships.

Stress tests were first introduced in 2008 following the global financial crisis and determine the amount of money banks should have in capital buffers and pools of capital. This year’s stress tests are especially significant due to the recent failures of three banks: Silicon Valley Bank, Signature Bank, and First Republic Bank. They are also the first stress tests under Barr’s supervision since he was sworn in on July 19, 2022.

The reduced value of bank security portfolios after a series of interest-rate hikes is often pointed to as one of the main triggers for recent bank failures. This problem is referred to as duration risk and can lead to losses on the value of lower-interest-paying securities while rates are going up.

Barr’s suggestion for alternative methods of stress testing indicates that the government is taking a proactive approach to managing longevity risk and bank failures.

Silicon Valley Bank Suffers Fatal Run on Bank Due to Losses and Deposit Limits

In a shocking turn of events, Silicon Valley Bank suffered a fatal run on the bank due to losses on transactions and deposit limits. The bank was forced to sell securities at a loss in order to cover withdrawal requests from worried depositors. Complicating matters further, the bank had accumulated a large amount of deposits that exceeded the $250,000 maximum payout by the Federal Deposit Insurance Corp. if there was a bank failure. The advent of mobile-banking apps only exacerbated the situation by allowing uninsured depositors to flee at the speed of a click.

Last year’s stress tests did not account for the effects of rising interest rates on bank security portfolios, as it was expected that there would be a recession in the latter part of 2022 and 2023, resulting in lower interest rates.

However, there has not been a recession and interest rates continue to rise. Experts predict that this year the Fed will study the effects of rapid interest-rate hikes and other factors that led to the failure of Silicon Valley Bank.

Keith Noreika, former acting comptroller for the Office of the Comptroller of the Currency, suggests that “it would make sense if the Fed wants to get a real picture, they could start with the actual value of a bank’s securities portfolio.” Noreika, who is now an executive vice president and head of banking supervision and regulation at Patomak Global Partners, believes that the existing regulatory view on a bank’s longer-term investments (known as held-to-maturity assets) is problematic since they are valued at their historic cost instead of their current market value.

It remains to be seen whether new regulations will be put in place to prevent another catastrophic run on a bank like Silicon Valley Bank in the future.

Banking Rules and Stress Tests: A Closer Look

When it comes to short-term investments, known as available-for-sale (AVS) securities, banks may or may not have mark-to-market disclosure requirements. It all depends on whether the bank made an Accumulated Other Comprehensive Income (AOCI) election back in 2015. Smaller banks were given the option to opt-out, and Silicon Valley Bank and others were grandfathered into it. However, this has led to more rigorous stress tests for Silicon Valley Bank in 2022, under different guidelines.

According to Noreika, most banking rules exist because of nontransparent assets on balance sheets, particularly loans. Regulators want to ensure that the public has confidence that the loans are backed by actual assets.

Earlier this year, bank troubles that made headlines dealt with the more transparent issue of the amount of insured deposits on a bank’s balance sheet, as JPMorgan Chase & Co. CEO Jamie Dimon noted in his annual letter to shareholders.

“Interest rate exposure, the fair value of held-to-maturity (HTM) portfolios, and the amount of SVB’s uninsured deposits were always known — both to regulators and the marketplace,” said Dimon.

Stress tests aim to provide an assurance that banks can withstand potential economic hardships. However, they are not omnipotent, according to Noreika. Often, stress test scenarios do not match reality and have sent people in different directions. Even if banks looked at the marked-to-market value of securities this year, it may be too little too late.

Looking ahead to the stress-test statements from the Fed this coming Wednesday, analysts are not expecting any big surprises from this year’s tests. Banks have already signaled that their stock buybacks will be modest due to economic uncertainty and pending capital requirements under the Basel III banking rules.

Experts Weigh in on Stress Test Expectations for U.S. Banks

As the Federal Reserve conducts its annual stress tests on the nation’s biggest banks, industry experts are weighing in on what they expect the results to reveal.

KBW, a financial services firm specializing in the banking industry, anticipates that commercial real estate and consumer businesses will be hit hardest, resulting in lower stress capital buffers for many big universal banks. Morgan Stanley is expected to see the most significant decline, while Citizens Financial Group Inc., PNC Financial Services Group Inc., and Truist Financial Corp. are expected to experience modest increases.

However, M&T Bank Corp. is projected to perform well, with their stress capital buffers experiencing only a 1% decline due to a favorable asset mix shift and strong pre-provision net revenue.

But it’s not just the asset side of the balance sheet being scrutinized; experts are also expecting regulators to pay close attention to liabilities. Tomasz Piskorski, a professor of real estate at Columbia Business School, cautions that many U.S. banks are vulnerable to depositor fears. Uninsured deposits can result in banks being forced to sell assets at a loss, and another bank failure could spark another wave of panic withdrawals.

While PacWest Bancorp has struggled this year, investors have found some stability in the stock in recent weeks. As stress test results continue to come in, it will be interesting to see which banks emerge as winners and which need to improve their risk-management strategies.

Regional Banks Facing Fundamental Problems

According to researchers, about 1,600 banks may fail if all $9 trillion of uninsured deposits are withdrawn from the United States banking system. Even with only half of that amount withdrawn, approximately 186 banks could fail. The Federal Reserve and the FDIC have already had to take action to support insured deposits and sell struggling banks to prevent numerous fails. Dozens of banks could have failed if no action was taken in March and April. Recently, several banks have bought out others in deals brokered by the FDIC, such as First Citizens Bancshares acquiring Silicon Valley Bank, New York Community Bancorp buying Signature Bank, and JPMorgan Chase purchasing First Republic Bank. Despite these actions, regional banks are facing underlying challenges such as insufficient capital to cover uninsured deposits, high bank leverage, and reduced securities portfolio value. Bank asset value is reportedly $2 trillion less than indicated by book value asset accounting holding loan portfolios until maturity. Additionally, half of US banks have a current asset value below their liabilities’ face value. Banks funded mainly by uninsured deposits are at risk for solvency problems if uninsured depositors refuse to lose their money in the event of bank failure. Researchers stated that regional banks will continue to be under pressure in the foreseeable future.

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