Why Banks Need to Ramp Up Stress Tests

Concerns are growing over the health of the U.S. banking system as rising inflation points to the likelihood of the Federal Reserve increasing interest rates. Banks face prospects of both higher and reduced profitability if interest rates rise. As interest rates rise, banks could enjoy bigger spreads – the difference between what they charge borrowers and what they pay depositors – but they could also get hurt if their borrowers are unable to sufficiently absorb the higher cost of money, according to Wharton finance professor Itay Goldstein.

“Stress tests are the ideal tool” to check the resilience of banks to external pressures, Goldstein said recently on the Wharton Business Daily show on SiriusXM. (Listen to the podcast above.) “Inflation is really a unique risk, because it is not similar to a decrease in real estate prices, or a decrease in GDP. Different banks have different exposures to inflation because of the particular nature of inflation. We need to imagine an inflation scenario and run different banks through it to see how exposed and how prepared they are.”

When interest rates are low, “it’s very difficult [for banks] to make a meaningful spread,” Goldstein said. “And everyone was noticing that this is hurting bank profitability and was a threat to bank profitability going forward. [As] inflation goes up, rates will start going up and banks will have more opportunity to charge those spreads.” The Federal Funds Target rate has been in the range of 0% to 0.25% since March 2020.

On the other hand, banks are also exposed to mismatches in the profiles of their assets and liabilities, and the impact of higher interest rates on their borrowers. The very nature of the business of banks is to have long-terms assets, or assets that mature years in the future, like loans and mortgages, Goldstein noted. Matching those on bank balance sheets are short-term liabilities, which they keep rolling on a frequent basis, he added. “When inflation goes up and rates go up, the value of long-term positions decreases faster and in a more pronounced way than the value of short-term positions. [Consequently], banks will see a decrease in the value of their assets, [which will be] more than that in the value of their liabilities.”

The environment for banks gets more complicated when higher interest rates have varying impacts on borrowers. “Some borrowers will find it more difficult to pay back their debts to banks than others,” said Goldstein. “There is really a lot to look at, and wherever you look, banks are exposed.”

Checking Stress Levels

The way to get clarity around those pressures is to run stress tests on banks. Stress tests for banks were introduced after the 2008 financial crisis, but they must be redesigned to make them more realistic, according to Goldstein. “In a stress test, we will basically come up with some very severe scenarios that we don’t think will happen, but might happen,” he said. “Through those, we will expose different vulnerabilities of banks, and ask them to be prepared.” The preparations for adverse scenarios include higher capital adequacy ratios, where banks set aside more capital cushion for every dollar they lend, he added.

But the problem with the prevalent model is, “how do you know which scenario to pick?” Goldstein said. “Over the years, there have been attempts to come up with different scenarios. But to be honest, a lot of these scenarios are not super-imaginative.” They rely on occurrences in the past such as the global financial crisis in attempting to gauge banks’ exposure to say, real estate prices or GDP growth, he added.

“Stress tests over the years have become a bit rigid, in the sense that there is always this one scenario that is considered,” Goldstein continued. “Starting to run through different scenarios – inflation being one of them – and seeing how banks are prepared would be a good way to implement the lessons.” Wharton finance professor Richard Herring had also called for bank stress tests to be strengthened and widened in an April 2020 Knowledge@Wharton interview.

How Worrisome Is Inflation?

“Consumer prices in the U.S. have soared since April, recording annual inflation rates of 5.4% in June and July,” Goldstein wrote recently in The Banker magazine. “Such rates have not been seen for well over a decade.” He pointed to several factors fueling that rising inflation: price increases triggered by pent-up demand for various products and services, combined with supply shortages owing to supply chain interruptions; and the government’s monetary and fiscal stimulus packages in response to economic stresses in the aftermath of the pandemic.

While it is “very hard to tell” how much higher inflation rates could go, “we’re certainly not out of the woods” as yet, Goldstein said. At the same time, “there is some optimism that it will be transitory, given the unusual time that we are at and the fact that you have these supply and demand imbalances that should pass, eventually,” he added. Much of the recent spike in inflation is because of the monetary and fiscal stimulus rollouts over the last 18 months, “and that those are temporary as well,” he noted.

Federal Reserve Chairman Jerome Powell had also said in June that he expected higher inflation to be transitory. He had noted that many goods and services have seen one-time price increases after the reopening of the economy, such as air travel and hotel rates, or new and used cars. But that explanation did not allay Powell’s concerns: he had pointed out in a July Senate testimony that inflation was uncomfortably above the levels the central bank seeks.

Reading into stimulus packages does not always yield the right pointers to future inflation; in fact, they could lead to overblown fears. After the runaway inflation in the late 1970s followed by a tapering after the early 1980s, fears of high inflation resurfaced with the stimulus programs that followed the 2008 global financial crisis, Goldstein noted. “But it didn’t materialize, and we didn’t have inflation.”

As a result, “when we think about inflation, we don’t know exactly what to expect,” he continued. “This is why, through the exercise of a stress test, you need to be particularly creative and think what exactly is going to happen through inflation. What assets and liabilities are more exposed? What rates of inflation are we talking about? How is it going to interact with other variables? This does require different scenarios. You can’t just limit yourself to one and say, ‘We are good for this one, so we are fine.’”

One big danger is of inflation becoming “a self-fulfilling expectation,” said Goldstein. “What is really scary about inflation is when it starts taking a life of its own. The concern is that when you worry that inflation is going to continue, you ask [your employer] for a raise. And then the firm has to start raising prices in order to pay for these raises, and this is a snowball that keeps on going. It is very hard to tell if we’re going to get into that [situation] or not. This is why we all have to be cautious. We have to be aware that this is certainly a possibility.”