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Fed stress tests: No time to relax

Banks received a mostly clean bill of health from the Federal Reserve’s latest stress tests. After a catastrophe like Covid, does that mean the sector is now safe?

Photo: iStock

Big banks operating in the US have just come through not one but two stress tests. The first, more formalized, was the regular post-global-financial-crisis affair that is conducted by the Federal Reserve, under its comprehensive capital analysis and review (CCAR) regime, and its associated forward-looking component, the Dodd-Frank stress testing (DFAST).

The second, more chaotic, was Covid.

The real-world test informed the hypothetical one. The Fed inserted an additional round of testing in December 2020. And it tweaked its models to take into account what it calls “the Covid event”, specifically in the areas of auto and credit card, commercial real estate and first-lien mortgages in forbearance.

That all the banks passed the Fed’s tests, despite projections of $474 billion of losses in a severely adverse scenario, tells us they look well prepared for whatever the regulator can imagine. But does the fact they passed the Covid test tell us they were prepared for that?

Policymakers would do well to bear in mind what stress tests capture, and what they don’t

For some, it might. After all, the most diversified banks have been rewarded handsomely for their exposure to booming conditions, particularly in both primary and secondary fixed income and equity market businesses.

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