How the Fed’s stress tests failed to stop a banking crisis

CFOs have always used scenario planning and stress testing. But in the past few years, from the pandemic to inflationary pressures to rising interest rates, I think it’s safe to say these methods have gotten a workout. 

When it comes to the fall of Silicon Valley Bank last week, the bank’s models to predict risk and performance are said to have been flawed. The Federal Reserve, the primary federal supervisor of the SVB, issued a warning to the bank over its risk-management systems back in 2019, the Wall Street Journal reported. And some short sellers knew SVB was in trouble months ago, Fortune reported. 

There were red flags, yet, SVB’s collapse wasn’t prevented. A new report by Fortune’s Shawn Tully provides some insight into the situation: “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.”

“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.”

The stress tests themselves weren’t predictive of what the banks would face, and the report provides some background. After the 2008 financial crisis, the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed to prevent excessive risk-taking by banks. In 2018, a bill was passed that raised the threshold from $50 billion in assets to $250 billion in assets for when companies qualify as a “systemically important financial institution.” 

“The $250-billion-and-up banks are still stress-checked annually, and the central bank put the $100-250 billion group on a bi-annual cycle, where they’re measured only in the even years,” Tully writes. “A rule called Standardized Liquidity Ratio gets waived for the mid-sized banks, meaning they can hold less liquid capital than for the top tier lenders.” And “Silicon Valley Bank didn’t fulfill $100 billion mark in average assets until the end of 2021, and therefore wasn’t included in the…