#stress tests

21 04, 2025

Karen Petrou: The Fed Just Puts Ribbons on Rags

Shane Smith2025-04-21T09:14:50-04:00April 21st, 2025|The Vault|

Four months after announcing plans for minimal changes to its stress tests, the Fed last Thursday screwed up its courage and proposed a couple of them. The remaining, still-small changes will come after the Fed rests up, but none of this seemingly-strenuous effort addresses the fundamental problem with both capital regulation and the testing designed to ensure it suffices: none of these rules make total sense on its own and all of them taken together are a cacophony of competing demands and ongoing collisions with other standards. Prettying up the stress-test rule is thus only putting ribbons on a ragged assemblage of ill-fitting pieces in clashing colors with large, large holes.

Now-ousted VCS Michael Barr promised a “holistic” capital construct during his 2022 confirmation hearings, but he nonetheless clung tightly to one-off rulemakings without any cumulative-impact analysis. Mr. Barr thus opposed last week’s stress-test changes, but for all the wrong reasons. He thought they went too far; in fact, they don’t go anywhere near as far as they could and should.

The new stress-test proposal most substantively says that banks will henceforth be judged by a three-year rolling average of their tested capital levels, rather than on the current, volatile annual schedule. But, averaging numbers that don’t make sense tells one nothing about the utility of each test. Think about a household with two chihuahuas – average dog weight about ten pounds. Next year, a Labrador romps in, and the average goes up, but the yard can still hold three …

7 04, 2025

Karen Petrou: Why Regulators Will be Flat-Footed if Bad Now Turns Soon to Worse

Shane Smith2025-04-07T09:15:06-04:00April 7th, 2025|The Vault|

One of the comforts with which bank regulators will doubtless console themselves after last week’s market rout is that the largest U.S. banks have the capital not only to withstand this, but also the probable, profound consequences of the President’s punitive tariffs. However, because U.S. regulators mismeasure capital resilience, this confidence is misplaced. Using the economic-capital approach I recently endorsed shows that, while U.S. banks still are strong, they are not fortresses.

FedFin recently analyzed two new studies demonstrating that geopolitical risk is hard on bank solvency. To this, one of course can say that there’s no real-world need for exhaustive studies of dozens of countries over decades – common sense buttressed by history makes this all too clear. These hard lessons and the data that describe them do, though, make clear that it’s more than worth revisiting the United States after the Smoot-Hawley tariffs to get a sobering idea of the negative feedback loop between geopolitical risk, macroeconomic hazards, bank vulnerability, and – back to the beginning, geopolitical risk. Any talk of the 1930s is alarmist and also inapplicable in numerous respects, but it is the most pertinent example of geopolitical risk over the past century and thus demonstrates the need now to be very, very careful – not something this White House appears to be good at.

Economic-capital measures are a more robust platform to assess bank resilience than regulatory capital and are thus of particular pertinence at this dangerous moment. Regulatory-capital measurements are so complex and often …

17 03, 2025

Karen Petrou: A New, Unified Theory of Effective Bank Regulation

Shane Smith2025-03-17T09:13:31-04:00March 17th, 2025|The Vault|

There is one perennial, overlooked, and devastating irony in the vast body of bank capital and liquidity regulation: the better a bank’s liquidity score, the less regulatory capital it has. Although liquidity and capital are inexorably linked when it comes to preserving bank solvency, the need to comply with two contradictory standards forces banks to change their business model to meet both ends in the middle at considerable cost to profitability and long-term franchise value. This is of course a major threat to solvency of which bank regulators are either blissfully unaware or, worse, heedless. Federal banking agencies have stoutly refused to undertake the essential cumulative-impact analysis we’ve fruitlessly urged on them most recently in Congressional testimony. A new Federal Reserve Bank of New York study shows not just why they should judge rules by sum-total impact, but also how they could do so and thereby have a much better sense of which banks might actually go broke before they do.

I refer you to the full FRB-NY paper for details. It crafts an economic-capital construct calculated by netting the net present value of financeable assets versus par liabilities as a baseline measure which can then be tested under various stress scenarios that start with illiquidity and end in insolvency and vice versa. This leads to a robust measure of survivability that combines the impact of credit risk, liquidity, and the real-world market conditions current rules ignore. In essence, economic capital is derived from the hard-nosed, real-time factors that wise …

10 08, 2023

FedFin on: 9th Inning Results

Arezou Rafikian2023-08-11T16:25:22-04:00August 10th, 2023|The Vault|

FHFA today released the results of the ninth stress test it’s run on Fannie and Freddie since Dodd-Frank demanded this in 2010. Using pretty much the same flawed models as the Fed, FHFA finds Fannie and Freddie pretty much as they are even under acute stress.

The full report is available to subscription clients. To find out how you can sign up for the service, click here.…