Is the Fed looking at some of the major risks in the banking system?

“Last week, the Fed released the hypothetical scenarios for its 2024 annual stress test. The assumptions for the 2024 stress test have changed very little compared to last year’s ones. With that being said, this year’s test will include an additional exploratory analysis that will assess the resilience of the banking system to four major risks.

We have been discussing these four risks (and others) for almost two years, so anyone reading our banking articles over this time period is well aware of them. While we have been analyzing these major issues, we also were scratching our heads as to why banking regulators, including the Fed, continue to largely ignore them. At the end of the day, the regulators have much more data compared to what the banks are disclosing publicly. Clearly, when even public data reveals these issues, the regulators should be well aware of them.

We believe the fact that the Fed publicly announced that it will assess the resilience of the banking system to these four major risks is another sign that the regulators are gradually preparing markets and depositors for a potential banking crisis, which will be imminent if any of these risks are realized.

According to the Fed, two out of four new elements will focus on a rapid repricing of a large proportion of deposits at large banks:

Two of the hypothetical elements include funding stresses that cause a rapid repricing of a large proportion of deposits at large banks. Each element has a different set of interest rate and economic conditions, including a moderate recession with increasing inflation and rising interest rates, and a severe global recession with high and persistent inflation and rising interest rates.

Almost a year ago, we published an article on the Fed’s 2023 stress tests. We were surprised that the Fed assumed only low-to-zero interest rates and very low inflation in its scenarios, and ignored the possibility of higher rates and higher inflation:

After all, U.S. banks had been operating in a low-to-zero interest rate environment quite recently, and while it put pressure on their interest income due to lower margins, it did not lead to major failures. Obviously, a stress test that assumes higher inflation and higher interest rates would be more helpful.

So, finally, the Fed will assess the resilience of banks to higher rates and higher inflation. Obviously, this should have been done much earlier given what balance sheet structures most U.S. banks, especially larger ones, have. On the assets side, they have mostly long-term fixed-rate loans and securities, while on the liabilities side, they have short-term floating-rate deposits. Obviously, such a mismatch will be a major risk in a higher rate environment with persistent high inflation.

The other two shocks of the exploratory analysis hypothesize the failure of five large hedge funds. According to the Fed, these shocks will be applied only to the largest and most complex banks. Last week, we published an article on the so-called shadow banking intermediaries, majority of which are hedge funds. As of the end of January, loans to these shadow banking lenders surpassed the $1T mark, which is almost half of the system’s total equity. Even head of the OCC, one of largest U.S. banking regulators, said that these lightly regulated shadow banking intermediaries were pushing banks into lower-quality and higher-risk loans. Clearly, this stress-test that explores the failure of five large hedge funds should have been done much earlier, before these shadow loans reached the $1 trillion mark.

Bottom Line
In our view, the Fed has been aware of these potential market shocks for quite some time, and the regulators should have assessed the resilience of the banking system to these four major risks much earlier. We believe the fact that the Fed has finally included them in its stress test is another sign that the regulators are gradually preparing the market and depositors for a possible banking crisis, which will become imminent if one of these four risks is realized. Moreover, the U.S. banking system is currently facing another set of significant risks, which we have already discussed. As such, we believe retail depositors should be well prepared for a potential banking crisis.”