The Fed’s ‘stress tests’ were supposed to save banks from the exact crisis now engulfing markets. Here’s how they were so spectacularly wrong

The Fed’s banking stress tests failed to predict the actual stressors banks would face in 2023.
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Overnight, the top threat to America’s economic future is distilled in one ominous word, “contagion.” It’s the talk of the financial world that the quick, jarring jump in interest rates helped destroy Silicon Valley Bank by pounding the value of its bond holdings, leaving Big Tech’s onetime favorite lender short of the funds to cash out fleeing depositors. But all the midsize banks have also suffered big losses in the fixed-income portfolios that provide the liquidity that both reassures customers they’re totally safe, and that banks will need if even a portion of their clients pull their cash from checking accounts and money-market funds to buy Treasuries that are suddenly offering sumptuous yields. Even if the Fed’s and FDIC’s extraordinary campaign to contain the contagion works, the crisis will likely prompt regulators to clamp rigorous new strictures on midsize lenders that will make loans for businesses and homebuyers a lot harder to get.

Put simply, even though the Dodd-Frank reforms forced the banks to harbor huge capital cushions that should ensure their safety, fear is running rampant that SVB will set off a string of falling dominoes among the regionals, greatly shrinking the availability of credit and increasing the odds of a deep recession. The SVB virus has already spread, forcing the $30 billion rescue of First Republic by a group of lenders led by JPMorgan Chase.

What’s shocking is that the famous “stress tests” established by Dodd-Frank designed to envisage all kinds of “severely adverse” scenarios, totally missed the storm that stirred the crisis, that historic leap in interest rates. “In the stress tests, the Fed thought the problem would be falling GDP; defaults on commercial real estate loans; a spike in unemployment,” Thomas Hogan, former chief economist at the Senate Banking Committee and now a senior fellow at the American Institute for Economic Research, told Fortune. “Instead we got the opposite of that, a good economy, low joblessness, and few defaults. The things the Fed thought would be a problem are good now. And the thing they deemed not to be important, the risk of a big rise in rates, is causing the failures in the financial system.” Here’s how the Fed’s radar was so off target; why the stress tests themselves weren’t at all predictive of what the banks would face; and what that means going forward.

A 2018 law lowered requirements for midsize banks

Following the Great Financial Crisis, the Fed began imposing stress tests, but only for the largest banks. Then, came the Dodd-Frank legislation. It mandated exams for a far broader universe, all lenders holding $50 billion or more in assets, starting in 2013. The law required the Federal Reserve and other regulators measure the impact on the banks’ future capital and profitability each year under scenarios where the economy suffered a steep downturn, or other blows that specifically hit banking, including a liftoff in rates. For the next several years, the banks over that $50 billion threshold, including all important regional players, underwent extremely demanding tests called CCAR, or Comprehensive Capital Analysis and Review. Guided by Dodd-Frank, the Fed since 2009 pushed the banks to double their equity capital in an effort that has enormously bolstered lenders’ strength for withstanding hard times.

But the regionals lobbied for lighter treatment. They argued that given their smaller size, the tests imposed a much bigger strain on their money and manpower than for the biggest banks. The Trump administration, then in full deregulatory mode, championed a law called the Economic Growth, Regulatory Relief, and Consumer Protection Act that in 2018 won bipartisan passage in Congress. The bill raised the starting point for Fed stress tests from $50 billion to $100 billion. It also established different standards for two different classes of major banks that had been under a single regime: those with assets of $100 billion to $250 billion, meaning the midsize players, and the whales at $250 billion and up, a JPMorgan Chase, Citigroup, or PNC. The new measure effectively freed the regionals from the some of the toughest Dodd-Frank requirements.

The legislation gave the Fed wide latitude in setting the details. It stated only that the checkups for the $100 billion to $250 billion banks be “periodic,” and left the frequency up to the Fed. Whereas the $250-billion-and-up banks are still stress-checked annually, the central bank put the $100 billion to $250 billion group on a biannual cycle, where they’re measured only in the even years. A rule called Standardized Liquidity Ratio gets waived for the midsize banks, meaning they can hold less liquid capital than the top-tier lenders, for example, if they have lots of their funding via deposits, and don’t depend much on short-term borrowings to back their loans. The $100 billion to $250 billion group is no longer obliged to supply “resolution plans,” popularly known as “living wills,” showing how management would unwind the institution in case of failure. 

A bank enters the every-two-years plan not in the quarter when its assets reach at least $100 billion, but only after it’s averaged that number or above for four quarters. Even when a lender reaches the $100-billion-for-four-quarters bogey, it isn’t immediately subject to testing. The Fed oversees a two- to three-year phase-in period where it guides the bank through practice runs to prepare for the official tests. For example, Charles Schwab reached the over $100 billion category in 2019, but didn’t have its first exam until 2022. Silicon Valley Bank didn’t fulfill the $100 billion mark in average assets until the end of 2021, and therefore wasn’t included in the 2022 test, nor had it ever endured a Fed exam.

The Fed’s severe stress’ scenarios missed the huge rise in rates

In February of 2022, the Fed disclosed the full array of banks to be tested for the year, and what it considered the worst possible economic scenario. The lenders would get passing grades if they held sufficient capital to weather what the central bank viewed as the heaviest possible headwinds all gusting at the same time. The 2022 roster comprised 34 U.S. banks, and included all the regionals under the Fed’s definition of assets over $100 billion. Since the midsize crowd is evaluated only on even years, it was excluded in 2021, when the number shrank to only America’s 21 biggest lenders, the Wells Fargos, JPMorgan Chases, and Citigroups. On review in 2022 were such regionals as M&T, Huntington, Citizens, and Fifth Third that (since they’re below $250 billion in assets) didn’t get screened in 2021, and given the every-two-year rule, aren’t on the list for 2023 that the Fed issued in February.

The Fed provided two sets of forecasts. The “baseline” expresses what the central bank sees as the most likely outlook, while the “severely adverse” playbook posits the most negative future the Fed deems possible. Both scenarios cover from Q1 of 2022 through Q1 of 2025. But the Fed also gave quarterly predictions for GDP, inflation, interest rates, and other metrics for all of those 13 quarters. So let’s look at what the Fed rated as likely and worst-case for where we are now, just over a year later in the first quarter of 2023.

The Fed got the baseline scenario pretty much right in predicting a healthy economy, and more or less hitting the marks on robust GDP growth and low unemployment. But it was spectacularly wrong on inflation and interest rates. Consider that in February of 2022, when the Fed issued these numbers, the consumer price index (CPI) was already advancing at 6.5%, and the 10-year Treasury yield had spiked to 2% and was rising fast. Yet somehow, the Fed had inflation dropping to 2.3% in Q1 of 2023, and going a touch lower by early 2025. It predicted that right now, the three-month Treasury would be yielding 0.9%.

The real numbers: Inflation hit 6% in February, after rising 6.5% in 2022. Even after the big fall triggered by the banking crisis, the 10-year yield stood at 3.4% in mid-March. As for the three-month Treasury, it’s paying 4.4%, over four times what the Fed expected.

Moving to the “severely adverse,” the Fed saw the direst outlook as a confluence of a deep global recession, “amplified by a prolonged continuation of remote work” that leads to a meltdown in commercial real estate, coupled with bad times in the stock market. For the Fed, those were the danger signs. Once again, inflation and rates not only didn’t pose alarm in the central bank’s projections, they’d go practically dormant! Falling GDP and dour investor spirits would lower the CPI trajectory to 1.4% by Q1 of 2023, and it would stay sub-2% all the way into 2025. As for the three-month Treasury, don’t ask. The Fed projected it would be stuck at a minuscule 0.1% right now, one-fortieth of the actual number. The Fed announced in June that all the banks surveyed passed the stress tests.

“What the Fed saw as the big potential threats didn’t materialize, and the threat that did materialize they didn’t see coming,” says Hogan. “By the end of 2021, Chairman Powell had retired the word ‘transitory’ in talking about inflation, but he didn’t act until much later. He only started raising rates in March of 2022. So the Fed had to raise very fast, and that problem was caused by ignoring inflation for so long.” Hogan adds that the Fed performed complicated, sophisticated stress tests, yet it didn’t consider that the huge jump in the money supply was bound to spur inflation so high that only a stiff rise in rates could tame the beast. And as we’ve seen with SVB and First Republic, soaring rates can turn what look like stable regional banks into hotbeds of risk overnight.

The road ahead

It’s indeed possible that what the stress tests failed to predict and what set off the panic—that soaring rates would shrink the regionals’ liquidity—won’t ignite into further bank runs. “The Fed and FDIC brought out all the bazookas in guaranteeing all deposits at SVB and Signature Bank, and [in] opening the Fed’s lending window to the banks,” says Todd Phillips, a regulatory consultant and former FDIC official. “Where we go from here will be more about stiffening regulations. Rolling back the requirements in 2018 was a mistake. You had Congress and regulators saying, ‘Don’t be aggressive on banks this size.’ Now, we’re seeing the results.” The Trump law granted the Fed, FDIC, and Office of the Comptroller of the Currency (OCC) the right to reverse the breaks for midsize banks if they find it necessary. No new legislation is required. The authorities could independently shorten the stress-test cycle for regionals from two years to the annual cycle required for the giants. The regulators also have the authority to reinstate the requirement for living wills, and to eliminate an exemption specifically for midsize banks that allows them to avoid counting unrealized investment losses against their capital.

The upshot: We’ll likely see a raft of reforms forcing big regionals to hold much more liquid capital. Getting there could drive them to raise equity, diluting shareholders, and pounding their stock prices. The higher capital requirements would also restrict the share of their funding that they can lend to customers, tightening credit and heightening the chances of a deep recession.

Today, the Fed holds many tools besides stress tests for ensuring banks stay on solid footing. Even in the exams, it’s frequently called rate trends correctly. Michael Barr, the vice chairman in charge of supervision, was already assessing whether midsize banks were holding too little capital, and weighing fresh rules to raise their buffers. Hopefully, the Fed’s been closely following the midsize banks weakened by the drops in their bond portfolios and advising and demanding ways for them to show that they harbor robust liquidity that will reassure depositors and restore the confidence and trust that are the backbone of the world’s greatest banking system.  

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