Judy Shelton on how the Fed's stress tests missed the Silicon Valley Bank failure

A: I will say the call for more stress tests overlooks the fact that the stress tests that became a part of the post-2008 regime were really oriented toward what will the bank do to survive if the Fed drops rates to zero again.  And it's uncanny, given that the Fed has over a trillion [dollars] in unrealized losses on its own portfolio that wasn't alert to this sort of dilemna in the valuation of bank assets.

Q: Yeah, theoretically the Federal Reserve is broke.

~ Judy Shelton, senior fellow, Independent Institute, "How Did Silicon Valley Bank Miss Its Ticking Time Bomb?," Fox Business, 1:30 mark, March 27, 2023

 

Jerome Powell warns about not varying the annual stress tests on banks

As financial institutions and the financial system evolve, stress testing will need to keep up. When the next episode of financial instability presents itself, it may do so in a messy and unexpected way. Banks will need to be ready not just for expected risks, but for unexpected ones. Thus, the tests will need to vary from year to year, and to explore even quite unlikely scenarios. 

If the stress tests do not evolve, they risk becoming a compliance exercise, breeding complacency from both supervisors and banks. We might also, inadvertently, encourage the development of a banking system where, over time, all banks would look much alike rather than the banking system we want and need, one with diverse institutions with different business models. We simply can't let these things happen. 

~ Federal Reserve chairman Jerome Powell, prepared remarks for stress-testing conference at the Federal Reserve Bank of Boston, July 9, 2019

(As quoted in "Fed’s Powell Says Stress Tests Must Evolve to Avoid Bank Complacency: Annual exam must explore unexpected scenarios or it might fail to prepare financial system for next downturn," The Wall Street Journal, July 9, 2019.)

2013 Dodd-Frank stress test: government bond losses assumed temporary and not marked-to-market

Losses on securities held in the available-for-sale (AFS) or held-to-maturity (HTM) portfolios are projected other-than-temporary impairment (OTTI) over the planning horizon.  OTTI projections incorporate other-than-temporary differences between amortized cost and fair market value due to credit impairment, but not differences reflecting changes in liquidity or market conditions. 

Some of the AFS/HTM securities, including U.S. Treasury and U.S. government agency obligations and U.S. government agency mortgage-backed securities (MBS), are assumed not to be at risk for the kind of credit impairment that results in OTTI charges.

~ Dodd-Frank Act Stress Test 2013, p. 43, March 2013

Sheila Bair on how bank stress tests did not include a recession and rising rate scenario

There's been a significant weakening of these stress tests to begin with, but I think most important is that they don't really stress the scenario that I am worried about and a lot of people are worried about, which is that we go into a recession, inflation remains persistent, interest rates keep going higher... that perfect confluence of events that is exactly what happened when Paul Volcker was chair of the Fed.  Actually he had to go through two recessions to get inflation under control, maintain interest rates at very high levels.  That may well be what the Fed needs to happen and that is the extreme stress scenario that they should be preparing for, but that is not the scenario the banks had to show that they should survive and be resilient.

~ Sheila Bair, former FDIC chair, interview with The Claman Countdown, July 6, 2022