The role that stress tests play in improving financial stability through enhanced market discipline and transparency has come into focus once again following a string of recent bank failures.
Government mandated stress tests first came into the picture during the aftermath of the Great Financial Crisis, following an unflattering period for banking where the industry became so unpopular it was the subjeThe events of March 2023 have drawn attention to the way financial institutions approach riskmanagement. The collapses of Silicon Valley Bank, Signature Bank and Silvergate Bank are just the latest in a series of monumental events that have defined the 2020s.ct of protests and politics around the globe. Intense lobbying then preceded the Dodd-Frank Act, wherein the US government mandated stress tests for banks over a certain threshold of assets in 2012, and the threshold was subsequently raised in 2018. While this regulation was intended to prevent bank failures and resulting market shocks, we saw in March 2023 that banks which do not meet the government’s threshold are not immune to market shocks which are just as disruptive to the global financial markets.
It is time for banks under the Federal Reserve threshold to take stress testing into their own hands, rather than waiting for risk management to be mandated. TS Imagine’s RiskSmart platform has been serving the financial markets for 30 years. It is used by banks of all sizes, including several of the world’s largest, as well as large asset managers, hedge funds and other sophisticated investors who need to monitor and manage all types of risk. To illustrate the breadth of RiskSmart, following the collapse of Silicon Valley Bank over two days in March 2023 RiskSmart clients ran 15 billion stress tests on the platform.
To illustrate, below we compare the 2008 and 2023 banking crises using RiskSmart’s stress test technology.
At the onset of the pandemic in 2020, the stimulus increases and overall increase in the Federal Reserve’s balance sheet led to an excess of deposits at commercial banks (see figure 1 below). As with all commercial banking deposits, we can assume they were invested elsewhere in the markets. In the case of Silicon Valley Bank and the other commercial banks which failed, a large amount of their investments made during the pandemic were in longer term US Treasuries, Retail and Commercial Mortgage-Backed Securities. These assets incur very little credit risk but significant interest rate risk, specifically orientated around duration.
For Silicon Valley Bank, which initially hedged its interest rate risk but then reversed its risk management strategy just a quarter before its collapse, subsequent interest rate increases by the Federal Reserve as it attempted to tackle inflation proved to be life-threatening for the bank. The reduction in liquidity in the financial system alongside the frequency and increase of the rate rises meant that the banks were not able to increase deposit rates. Rather, those deposits exited the banks looking for yield through instruments such as Certificates of Deposit and T-Bills. The mark to market losses on the affected banks investments then compounded the weak capital base and a bank run ensued.
Keeping pace with the speed of money
Fractional reserve banking has always meant that if everyone were to withdraw their deposits at the same time, the system would become insolvent. While this concept isn’t new, advances in technology and information flow means that money moves faster than it ever did before. For Silvergate Bank, $13.3 billion of demand deposits were withdrawn within seconds through their own exchange network and Fed Wire transactions. This happened more slowly at Silicon Valley Bank, but still relatively quickly: it took 44 hours for all their demand deposits to be withdrawn.
2008 vs 2023
While the 2023 banking crisis stemmed from a liquidity problem around duration and the midsize banks’ ability to manage their risk and capital correctly against rising interest rates, the banking crisis in 2008 was triggered by an unwind of toxic, opaque, and overleveraged real estate derivatives. Since 2008, the largest banks have been protected from this risk, as they are all compliant with Basel III global capital standards and US mandated stress tests. The ones facing issues at this moment do not meet the government mandated stress testing threshold, and have an industry-specific, volatile deposit base, or an unusually high ratio of securities on their books.
The flight of deposits to large banks happened during both events, and all banks should factor into their stress tests
The issues at Silicon Valley bank, Silvergate Bank and Signature Bank, like those which occurred during the Great Financial Crisis, cause a tremendous amount of apprehension in the market. This causes deposit to migrate to large, diversified banks, pushing consolidation towards the top, and causing an imbalance for the thousands of banks under the threshold. There is also economic risk associated with this, as the flight away from smaller banks could tighten lending standards for midsize banks and strain economies.
Even before 2008, we have seen a flight to large banks deposits flowing away from the midsize and small banks to the largest banks. In fact, in 1971, there were close to 14,000 banks in the United States with around 23,000 branches. Whereas in 2021, there were just over 4,000 banks with over 72,000 branches. And the top ten banks held about half of all bank assets (see figure 2 below).
In all scenarios, there was nowhere for the risk to go
Bank deposits can easily flow from one bank to another but are unlikely to move out of the banking system altogether. In the US, if the assets were to exit the banking system, remaining deposits would be nominally backed up by the FDIC even it if meant printing new money to do so. The Federal Reserve’s deflationary quantitative tightening initiated in 2022 has drawn cash reserves out of the small banks more quickly than the large banks. Comparisons in figure 3 below show that banks under the threshold are already back at cash ratios they reached during the 2019 repo spike (liquidity floor), while large banks are much further from these liquidity issues.
Advancements in technology means that depositors can easily move money 24/7, 365. Given these advancements, banks will likely be required to allow for more liquidity. With the Fed Now online payment system coming online in just a few months, we expect regulators to review this and implement immediate government mandated risk-management measures to manage the unintended consequences of the fast-moving international payment system.
All eyes on the Federal Reserve
The shrinking of the Federal Reserve’s balance sheet seemed to disproportionality hit US community banks and may mean the Federal Reserve will need to expand its balance sheet again (i.e. print more money) in order for banks to meet the demand deposit withdrawal. When addressing the recent crisis, the Federal Reserve said that “the U.S. banking system is sound and resilient” and yet the Federal Reserve is aware it must contain the regional bank collapse right now. Small and medium banks account for 50% of US commercial and industrial lending, 60% of residential real estate lending, 80% of commercial real estate lending, and 45% of consumer lending as shown from the Goldman Sachs Investment Research Team below in Figure 4:
On top of this, Chairman Powell must retain control of the Treasury market. Within the last 7-8 years the two biggest buyers of US government debt were the US banking system and the Federal Reserve. However, the Federal Reserve is now no longer buying them. Rather, the dollar strengthening is causing foreign selling and the holders of Treasuries on the margin side is mainly US banks. This means that the Federal Reserve will either need to stop rate rises to alleviate the stress on the banks, or force the banks to take losses on their treasury portfolios.
This happened in 2019 when fed funds rates went over interest on excess reserves and ended with a repo rate spike, to which the Federal Reserve required to reverse course. This looks to be what the market is implying with the forecasted cuts between now and Q1 next year (see figure 5 below). Meaning the release valve instead may point toward inflation…
TS Imagine’s RiskSmart platform covers multiple asset classes along with their associated risk analytics and risk factors which allow clients to self-manage their risk accordingly. Alongside this, RiskSmart has a stress test feature which banks can use to build bespoke stress tests, using standard, out of the box historical scenarios and projection tools. To illustrate how a bank of any size can use our stress test engine for the current period based on the above market outlook, we could build risk factors as follows:
Stress Test Input Factors:
- Rates Yields decreasing by 250bps (USD-GOVT” predictive shock)
- Equities rallying by 30% (“.SPX” predictive shock)
- Commodities (e.g. Crude Oil) rising by 20% (“CLc1”, predictive)
- US Dollar Decreasing by 5% (“USD” global shift)
For more on how we build these stress tests and the flexibility in our input model for the risk factors contact an expert.