Federal Reserve exploring 'reverse stress testing' after SVB collapse, Fed's Barr says

Federal Reserve Vice Chair of Supervision Michael Barr said Tuesday the Fed is exploring “reverse stress testing” that could be used as a tool to make banks more resilient. This comes as the central bank examines ways to reform bank culture in the aftermath of Silicon Valley Bank’s failure in March.

Barr’s comments were also made a day before Fed Chair Jay Powell is set to testify to Congress as part of his semiannual monetary policy report.

Investors remain focused on the Fed’s next move in interest rates after pausing its rate-hiking campaign last week, but lawmakers are expected to remain focused on the fallout from the collapse of SVB and other banks this spring.

“Instead of thinking of a stressful scenario and then see how it would play through on, say, the balance sheet of a firm, you look at a bank and you say: ‘Well, what would it take to break this institution?'” Barr said at a conference at the New York Federal Reserve on reforming banking culture.

Barr said reverse stress testing could be used as a tool to help supervisors recognize more exogenous issues that could go wrong instead of patterns from the past regulators have been trained to catch.

Federal Reserve Board Vice Chair for Supervision, Michael Barr, testifies before a Senate Banking, Housing, and Urban Affairs Committee hearing in the wake of recent bank failures, on Capitol Hill in Washington, U.S., May 18, 2023. REUTERS/Evelyn Hockstein

Barr noted Tuesday that regulators were caught off guard by the speed with which Silicon Valley Bank lost 85% of its deposits, an event that went down in just two days compared to prior runs that lasted ten days or more.

“That’s not a pattern people had seen before,” said Barr.

“We really have to work harder at the kind of things where there [are] patterns we haven’t seen before…and so I think [it] begin[s] to help us as supervisors understand the ability to look around the corner.”

Barr also said the Fed is looking inward as to why it’s slow to move on supervisory issues.

“We have also begun to look more at ourselves and think about our own culture as an institution,” said Barr. “One of the things that not only our SVB report, but also the report in the global financial crisis and reports earlier than that, found is that we tend to have a culture that makes it difficult for the institution to act quickly with respect to supervision.”

The Fed flagged and was well aware of Silicon Valley Bank’s issues, but was slow to act to enforce infractions.

Near the end of 2021, supervisors found deficiencies in the bank’s liquidity risk management, resulting in six supervisory findings related to the bank’s liquidity stress testing, contingency funding, and liquidity risk management.

In May 2022, supervisors issued three findings related to ineffective board oversight, risk management weaknesses, and the bank’s internal audit function. By November of 2022, supervisors delivered a supervisory finding on interest rate risk management to the bank. And in mid-February 2023, just weeks before the bank failed, Fed staff highlighted SVB’s interest rate and liquidity risk, and said they were actively engaged with SVB.

“Silicon Valley Bank failed because of a textbook case of mismanagement by the bank,” Barr wrote in a report in late April.

“Its senior leadership failed to manage basic interest rate and liquidity risk. Its board of directors failed to oversee senior leadership and hold them accountable. And Federal Reserve supervisors failed to take forceful enough action, as detailed in the report.”

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