The Fed Is Trying To Pull A Fast One

Douglas Rissing

The Fed has precocious released nan hypothetical scenarios for its 2023 supervisory accent test. This trial is conducted annually to show really nan banks are apt to execute successful a recessionary environment. The results of this trial nether nan "supervisory severely adverse scenario" are utilized to group superior requirements for ample banks.

In this article, we will return a look astatine nan assumptions for nan 2023 accent trial and besides talk which important areas of nan U.S. banks are still being overlooked and are not being tested by nan Fed. In our view, nan existent accent tests conducted by nan regulator do not bespeak nan existent financial conditions of nan U.S. banks nether a crisp recession scenario.

First, it is important to statement that nan caller assumptions are not that different comparative to nan erstwhile twelvemonth if we look astatine wide trends.

Under nan 2023 severely adverse scenario, nan U.S. unemployment complaint rises to a highest of 10% successful nan 3Q24, which implies an summation of 6.5 percent points compared to nan level of nan 4Q22. Last year, nan Fed assumed a 5.75 percent points summation successful nan unemployment rate; however, nan highest was nan aforesaid 10%.

The 2023 script besides features a importantly higher starting level of liking rates, fixed that they accrued past year.

In nan 2023 scenario, location prices autumn by 38% (compared to 28.5% successful nan 2022 scenario), while commercialized existent property prices diminution by 40% (unchanged comparative to nan erstwhile year’s scenario). A sharper diminution successful location prices is besides owed to a higher starting point, arsenic location prices posted maturation successful 2022. So, while this whitethorn look for illustration a change, it really is not.

Notably, nan cardinal assumptions for plus markets, specified arsenic equity prices and an summation successful firm enslaved spreads, are now little severe. Under nan 2023 scenario, nan dispersed betwixt yields connected BBB-rated bonds and yields connected 10-year Treasury securities widens to 5.75% successful 3Q23, implying an summation of 3.5 percent points comparative to 4Q22. From 4Q22 to 4Q23, equity prices fell by 45%. By comparison, nan 2022 script featured a 4.75 percent points summation successful firm enslaved spreads and a 55% diminution successful equity prices. While caller assumptions for plus markets are besides owed to nan caller starting points, we statement that nan 2023 script for this area looks little terrible compared to 2022.

The Fed

Below, we would for illustration to talk respective important areas that, successful our view, are still being overlooked by nan Fed’s accent tests.

Estimation of trading losses requires a much blimpish approach

The stock of securities connected nan banks’ equilibrium sheets is rather large, and for immoderate of them, securities correspond almost 40% of their full assets. Some banks person vulnerability to equities, including non-U.S. ones, but nan largest portion of securities is U.S. bonds, municipal bonds, and firm bonds. Under its "severely adverse scenario," nan Fed assumes that short-term rates will autumn to zero while longer-term rates, measured arsenic nan 10-year Treasury yield, will diminution beneath 1%. As a result, banks will grounds revaluation gains from securities, which beryllium connected their equilibrium sheets. These gains will almost surely compensate for immoderate losses successful equities, fixed that nan stock of equities for astir banks is smaller.

In our erstwhile reports connected ample U.S. banks, we mentioned that longer-term bonds could lead to immense losses for a slope successful a rising complaint environment. It seems that nan Fed is opening to recognize that its existent accent tests do not estimate imaginable trading losses conservatively. This year, for nan first time, nan Fed will people an additional, exploratory marketplace daze component. According to nan regulator, nan exploratory marketplace daze is characterized by a recession pinch inflationary pressures induced by higher ostentation expectations. As such, this script implies overmuch higher Treasury yields compared to "the severely adverse scenario," and it would beryllium very absorbing to spot nan banks’ losses from antagonistic revaluations of nan Treasuries and different bonds connected their equilibrium sheets. However, we are yet to spot really nan Fed will behaviour this test, and what assumptions nan regulator will use.

The Fed

Counterparty default risk: Is it measured correctly?

In our erstwhile articles, we discussed successful item that ample U.S. banks person tens of trillions of over-the-counter derivatives connected their equilibrium sheets and off-balance sheets. We judge these contracts carnivore tremendous consequence for a slope successful a volatile situation erstwhile location is simply a very precocious chance of a counterparty default.

The Fed says that U.S. banks are being tested for counterparty default risk. However, if we return a look astatine nan Fed’s methodology, we will spot that this consequence is not measured correctly. According to nan regulator, "large banks pinch important trading aliases custodial operations are required to incorporated a counterparty default script constituent into their supervisory severely adverse scenario" and "in relationship pinch nan counterparty default script component, these banks are required to estimate and study nan imaginable losses and related effects connected superior associated pinch nan unexpected default of nan counterparty that would make nan largest losses crossed their derivatives and securities financing transactions, including securities lending aliases borrowing and repurchase aliases reverse repurchase statement activities."

In different words, only losses from nan largest counterparty are being incorporated into nan accent test, and, moreover much importantly, these estimates are provided by nan banks. Given that over-the-counter derivatives deficiency immoderate transparency, these estimates of counterparty-related losses are not very reliable successful our view.

Maturity mismatch is besides being ignored

This is different awesome rumor that is not being tested by nan Fed. Many U.S. banks person a ample maturity mismatch betwixt their assets and liabilities. For example, successful our caller article connected Capital One, we showed that 84% of nan bank’s securities person maturities longer than 10 years. Capital One does not disclose nan mean maturity of its deposit book, which is simply a awesome portion of its liabilities; however, it's highly apt that it is overmuch little than 10 years, particularly fixed that Capital One presently does not connection deposits pinch a word of much than 5 years. Such a maturity mismatch betwixt nan bank’s assets and liabilities would apt lead to awesome liquidity issues successful a volatile situation and beryllium a important consequence for depositors.

Assumptions for variables describing world economical conditions are excessively mild

Under its “severely adverse scenario,” nan Fed besides provides assumptions for variables describing world economical conditions.

The Fed

These assumptions do not bespeak that nan world system is successful a terrible recession, successful our view. For example, a diminution successful nan Euro area’s GDP is rather moderate, whereas a recession successful Developing Asia appears to beryllium very mild, arsenic nan region's GDP fell 1.7% and 0.4% successful nan first and 2nd quarters of 2013, respectively, earlier opening to grow.

U.S. banks person importantly accrued their vulnerability to world economies complete nan past respective years. For example, Bank of America’s non-U.S. commercialized in installments portfolio grew from $29B arsenic of YE2009 to $128B arsenic of 1H22, which we discussed successful item successful our article. 33% of Goldman Sachs’ firm loans were granted to EMEA's (Europe, Middle East, and Africa) clients, which was besides mentioned successful our article connected nan bank.

We judge that specified mild assumptions for nan world economies do not show nan existent magnitude of imaginable losses for nan U.S. banks should a terrible recession comes.

Bottom line

There are much reddish flags and important issues that are being overlooked by nan Fed, specified arsenic nan in installments value of nan owe portfolios and borrowers’ profiles, shares of non-core assets, and off-balance expanse items. By comparison, each nan banks we person recovered astatine Saferbankingresearch.com were thoroughly tested for these reddish flags, and are rather superior successful each respects.

If you are willing successful reviewing our testing methodology, consciousness free to publication it here:

Our Methodology & Ranking System: Banks - SaferBankingResearch.

Housekeeping matters

This article, arsenic good arsenic Saferbankingresearch.com, was a operation of efforts betwixt Avi Gilburt and Renaissance Research, which has been covering U.S., European, LatAm, and CEEMEA banking stocks for much than 15 years.

If you would for illustration notifications arsenic to erstwhile my caller articles are published, please deed nan fastener astatine nan bottommost of nan page to "Follow" me.

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