Fed flunks crucial part of bank stress tests

March 8, 2013

By Agnes T. Crane
The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

The Federal Reserve has flunked a crucial part of its bank stress tests. The watchdog is happy enough saying what might happen to big banks if the economy tanks like in 2008: they could lose up to $462 billion. But it’s shy about revealing the effects of a sharp rise in interest rates. That’s just as real a risk that the Fed should disclose to investors.

The regulator did at least run the numbers this time round. But it didn’t release the results, instead stating in a footnote that it’s considering whether to do so in the future. It’s hard to justify staying silent on findings from a scenario that seems more likely than others. After all, another 2008 crisis does not appear to be lurking around the corner. Leverage is down and capital is up. And it will take years before the U.S. consumer embraces the kind of credit culture that fed Wall Street’s securitization machine at the heart of the crisis.

That’s not to say the published results are irrelevant. But interest-rate risk looks more pertinent – even the Fed, along with other regulators, has warned banks to be mindful of the pain it could bring. But it’s unclear how much bankers are taking such advice to heart given expectations that the central bank will keep rates low for years. And deposits, borrowing costs and hedges could all take a hit from a shock.

That much should be clear from the “adverse scenario” the Fed ran on banks’ balance sheets – the first time it has conducted this Dodd-Frank-mandated test. Here the Fed imagines stagflation: the economy falls into a modest recession while inflation pushes borrowing costs higher. Given the buildup of interest-rate risk in credit markets after years of exceptionally low yields, the results from this scenario would be more interesting and relevant to the safety and soundness of the financial system than the “severely adverse” test released on Thursday.

Earlier this year, the Fed ran its own balance sheet through a number of interest-rate scenarios and published the results. It should do the same with the banks it regulates.

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time will tell the real story….

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