Don't let a failure of imagination render bank stress tests useless

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Despite assurances from regulators and senior bankers, it seems a contagion is spreading quickly across the country's regional banks. Three regional banks have failed in the last three months, and with others on the brink, the Federal Reserve needs to act.

The collapse of First Republic and its implications for banks like PacWest, Western Alliance and First Horizon makes for grim reading for regulators. While no one knows the future, this crisis could spell the end for regional and specialized banks in the United States, for better or worse. However, the Silicon Valley Bank (SVB) review published in late April clearly shows that U.S. financial authorities are already firmly aware of their responsibilities and recognize that they must make bold moves to arrest the situation. 

The Fed's plan to tighten up many of the rules eased by Congress in a bipartisan vote in 2018 and further loosened by the Fed itself in 2019 is a sound and much-needed intervention. Senior officials have accepted that regulatory standards were too low, contributing to the sector's weakening position. However, this process may need to be accelerated to quickly shore up system confidence. 

Likewise, the Federal Deposit Insurance Corp.'s decision to explore whether to increase deposit insurance coverage clears the way to raise its threshold above the $250,000 mark should provide further stability. Although over 99% of U.S. deposit accounts hold less than $250,000, the current system remains exceptionally susceptible to the sort of bank runs triggered by the wealthier depositors that took down First Republic and SVB.

Also, good stress tests are a fundamental tool for macroprudential supervision. However, recent events have exposed areas where the Fed and banks could improve or rethink their approach. 

For instance, in February, the Fed's macroeconomic scenarios for the 2023 stress test forecasted a steep decline in interest rates, which returned to low levels for the entire three years of the scenario. The mismatch between the Fed's 2023 stress scenario and the steep increase in interest rates in the real world suggests some banks may have become lax in managing risk effectively. 

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Regulators could recommend aligning these stress-test scenarios and rules to real-world indexes. Otherwise, it could continue to breed industrywide complacency. 

Regulators are starting to understand the role of social media. The banking industry and regulators can improve their monitoring signals of impending vulnerability in markets and on social media platforms to get ahead of future shocks. Furthermore, the banking industry should work closely with policymakers to assign more powers and resources to the Office of Financial Research to provide greater support and insulation against social media-led contagion. A win-win approach for all parties involved. 

Banks and policymakers do have a decent chunk of additional responsibility here too. This is a big problem to unpick and will require further collaboration between parties to develop tighter regulations, supervision, enforcement and oversight to meet this challenge head-on. 

However, the required remedial measures urgently rest with the Fed and FDIC. They hold the key to stabilizing the markets in the very short term. For the past few years, both regulators and banks have suffered from a failure of imagination when it came to planning for worst-case possibilities. The rise of interest rates wasn't improbable; it was inevitable.

The moment to act is now.