The Federal Reserve just released the severely adverse economic scenario for the required Comprehensive Capital Analysis and Review (CCAR) stress tests for the largest banks in the country. The annual tests determine each large bank’s minimum capital requirement, so the results are significant to say the least.
As a CEO of an advisory firm that works with many community banks to run stress tests modeled on these same scenarios, I am stunned at the disparity between the Fed’s hypothetical scenario and what is happening in the economy right now. The Fed has prescribed a scenario that is just like another 2008. It assumes GDP collapses at a similar rate; the unemployment rate rises to a similar peak; housing and CRE prices decline by a similar rate. But that is not the shocking part. It’s what the Fed assumes about interest rates.
CCAR 2022 assumes declining interest rates because, of course, this is what the Fed does when combating a recession. However, this is the complete opposite of our current economic environment.
We have an inflation problem, and the Fed is under pressure it hasn’t seen in over 40 years to increase interest rates to deal with it. The worst-case scenario is one in which the Fed must increase interest rates much higher than expected to stop inflation, even if it means putting the economy into a recession. This is the “Sophie’s Choice” that then-Federal Reserve Chairman Paul Volker faced in the early 1980s. This scenario is often referred to as a “stagflation” scenario. Volker increased interest rates as high as 20 percent while the unemployment rate was hovering around 10 percent. We don’t need to go anywhere near that now to trigger such damage…can you imagine what the economy would look like if the federal funds rate is even at 5 percent?
I am not predicting a stagflation scenario as a base case scenario. Nor am I predicting it as even plausible. But if we wanted to have a serious talk about a tail-risk event that is a function of the current economic climate, a stagflation scenario must be at the top of the list. Geopolitical triggers such as the Russia-Ukrainian war will only exacerbate supply-side issues and ramp up pressure on energy prices.
What happened in 2008 was completely different. Inflation was not a concern. The Fed had plenty of room to bring down interest rates.
We will run CCAR 2022 scenarios for all our clients. After all, it is the Fed’s scenario, and we can use the results to help our client banks defend their capital requirements, concentration limits, and strategic plans.
But I will also be strongly advising our clients that we also run a stagflation scenario to ensure they have contingency plans, just in case. And it’s not to make regulators happy. This is smart and responsible risk management.
Whether you use a partner such as our company, or your bank runs scenarios in-house, I would strongly recommend every community bank begin to think about stagflation as a tail-risk scenario. Variable-rate loans will behave differently than fixed-rate ones. Cost of funds will increase and there will be a bloody fight for deposits (again). Cap rates and cap rate spreads will change the value of real estate collateral supporting loans. Fee income streams will dry up. This would be quite different than a 2008-style downturn.
One other thing, there is always at least one smart director on every board who will ask, “why aren’t we running this scenario?” Don’t be that CEO without a good answer.
Editor's Note: A version of this post was published in the American Banker on March 7.