Stressing the Stress Tests

In the spring of 2023, Silicon Valley Bank, Signature Bank, and First Republic Bank failed, owing to predictable rate hikes by the Federal Reserve. It’s clear from these recent events that the current US stress-testing system is ill-suited to mitigate risk associated with the banking system, especially when looking at smaller regional banks that aren’t subjugated to annual stress testing. Stress testing as a regulatory tool is also exposed to significant legal risks following recent Supreme Court jurisprudence that draws into question the viability of the status quo. Today, regulators and other interested parties must change tacks to craft a stress testing regime that is fit for purpose. This article seeks to inform that debate by laying out key features of a successful stress testing program against which we assess the current regime in the United States. We make four recommendations: (1) using multiple scenarios to allow exploration of a wider set of risks; (2) disclosing (stressed) fair value for the assessment of all securities held on banks’ balance sheets; (3) stress testing of funding and liquidity risk; and (4) subjecting more banks to the stress tests. Taken together, these reforms would usefully improve the dynamism of the financial regulatory regime.