A top Federal Reserve Board official said Monday that better stress tests could prevent managers from over-relying on the kind of "financial myths" that helped drive the 2008 crisis.
In a speech at Boston University, Federal Reserve Bank of Boston President Eric Rosengren cited four myths leading up to the crisis: the real estate market would not decline, securitization protected mortgage-backed assets, banks were shielded by the "originate to distribute" model and investment banks could never suffer a run on short-term funding.
Rosengren said firms' allegiance to those assumptions had hazardous effects, and better stress tests could "challenge commonly held views, so that boards of directors and regulators of firms better understand the fundamental drivers of risks in organizations and in the financial system."
"There are a variety of market participants that could better protect their own interests — and the financial system — if they spend more time understanding the key assumptions being made in financial modeling, and have a clearer understanding of what could happen if those assumptions were invalid," he said.
"Properly done, stress testing should provide valuable information to organizations on key risk drivers. This needs to be more than feeding a handful of macroeconomic assumptions into a model. It requires an understanding of the events that could lead to that macroeconomic outcome, and what other indirect effects might be likely to occur."
