By some metrics, the US financial system is in great shape. All 31 banks that underwent the Federal Reserve’s stress tests this year maintained adequate capital even in a “severe” economic scenario. Yet that’s not as reassuring as it sounds: The tests are flawed, banks still have a poor understanding of their own risks, and regulators may yet succumb to a dangerous complacency.
As critics have been pointing out for years, such tests are an inadequate gauge of resilience. The scenarios they test don’t always capture the full spectrum of plausible risks that the system may face — such as how a sharp rise in interest rates would take down some banks, as it did Silicon Valley Bank and others early last year. They also don’t account for the ripple effects that amplify financial distress. A severe drop in stocks, for instance, might lead to a rush into Treasuries that upends the repo market.
Then there’s the question of what it means to have adequate capital. Regulators currently set minimum levels for the largest US banks that vary by bank; last year’s ranged from 7% to 13.8%, which sounds robust. Yet the ratio is calculated as a percentage of the bank’s “risk-weighted assets,” a measure that treats entire categories of assets as having no risk — and therefore needing no capital backing at all.
Last year, regulators proposed a new way of measuring risk weightings that they said would result in significantly higher minimum capital levels at the biggest banks. The proposal was overcomplicated and flawed, and the industry campaigned aggressively against it. The Fed seems to be backing off, and banks are preparing to return more capital to shareholders.
Imposing tougher rules may be even harder now that the Supreme Court has limited the deference given to federal agencies in interpreting statutes, which may leave proposed regulations more susceptible to challenge. Supervisors — already under pressure after last year’s bank failures — will need to rely on their existing powers to flag growing risks and force changes to ensure they’re addressed.
To start, they need to make sure banks are capable of recording and measuring their own risks. After the 2008 financial crisis showed that many of the world’s biggest banks couldn’t do this, the Basel Committee on Banking Supervision adopted a set of rules that systemically important banks were supposed to comply with by 2016.
Scarily, few of the biggest banks have satisfied all the requirements, according to one report. On average, compliance with key requirements related to the timeliness and accuracy of risk measurements deteriorated between 2019 and 2022. In other words, some banks had become less capable of quickly understanding their real risks.
US supervisors should take an aggressive approach to ensure that banks get into compliance, even if that means assessing laggards with penalties or restricting them from distributing capital to shareholders. Boards and senior management shouldn’t be allowed to deprioritize or underinvest in the software systems that track risks.
More important, stress tests and a less assertive regulatory approach shouldn’t lull anyone into a false sense of security. No one knows exactly what risks are lurking in the financial system, including the banks themselves.
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