Fed stress tests fall short, finance professor says

By Steve Gelsi

Tomasz Piskorksi of Columbia Business School says Fed didn't include scenarios that killed Silicon Valley Bank, First Republic

The U.S. Federal Reserve's bank stress test didn't reflect the market conditions that led to the demise of Silicon Valley Bank and First Republic last year, a finance professor who studies bank vulnerabilities told MarketWatch.

Tomasz Piskorski, a professor at Columbia University's business school, said the Fed's stress test results unveiled late Wednesday "underestimated risks in the banking sector" such as those that brought down Silicon Valley Bank and First Republic in 2023.

"If the guidelines of this year's stress tests were based on Silicon Valley Bank's balance sheet on Dec. 31, 2022 - three months before it went bust - I would not be surprised if it would have been deemed as 'fine'," Piskorski said.

Silicon Valley Bank was hit with higher interest rates that made their hold-to-maturity assets less valuable and indirectly sparked a run on the bank's uninsured deposits. First Republic also was hit with a run on deposits.

But the Fed's stress test scenarios didn't fully factor in sharp losses in hold-to-maturity assets and higher interest rates posing a significant risk for banks.

The Fed's 2024 test also measured banks against a slowdown in the economy with interest rates near zero. Silicon Valley Bank failed when the economy was still healthy and interest rates were moving up.

"They didn't fully incorporate the lessons from 2023," Piskorski said. "It seems to me that the test did not fully take into account potential of higher interest rates and associated duration risk, and they assumed deposits would be stable."

Overall, the stress tests did show that banks could withstand a recession and commercial real estate risks, he said.

But the test only included the roughly 30 largest banks in the U.S.. Many smaller banks may be more vulnerable because of their higher interest rate and commercial real estate exposure, he said.

Piskorski's came amid a flurry of mostly critical public comments from various interested parties on the Fed's annual stress test, which was initially introduced as part of the Dodd-Frank legislation after the Global Financial Crisis.

Also read: Analysts praise banks and puzzle over Fed after stress tests

The Bank Policy Institute, a pro-industry group, said the said the Fed's projection of net revenues for banks - a major component of stress test performance - lacks transparency.

"The Fed fails to disclose the details of its modeling methods and relies on aggregated models that assign disproportionate importance to recent bank performance," the Bank Policy Institute said. "As these revenues fluctuate year over year, so do the Fed's stress projections, creating large swings in banks' capital requirements and making it hard for them to allocate capital efficiently."

Better Markets, a consumer advocacy group, said the stress tests were too easy on banks.

"100% of banks not just passing the stress tests, but 'sailing through them' is a clear indication that the tests are too weak and likely provide false comfort, lulling policymakers, regulators, and banks into a false sense of security," Better Markets said.

Also read: Bank complaints about higher capital requirements may be overblown, finance professor says

-Steve Gelsi

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06-28-24 0855ET

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