Author: Adam Mustafa, CEO
In the field of banking risk management, there's an old saying about “fighting the last war.” This mindset reflects our industry’s tendency to focus on the last major crisis as a model for what we might face in the future. While this focus has value, it also reveals a critical blind spot: Are we preparing for the right risks? Should banks consider scenarios beyond the familiar ones shaped by the crises of 2008 or the bank failures in 2023?
As stress testing evolves, many banks have adjusted their models to prepare for events similar to those of recent years. For example, Comprehensive Capital Analysis and Review (CCAR) stress tests continue to focus on simulating a repeat of the 2008 financial crisis. After the banking disruptions of 2023, numerous banks revisited their liquidity stress tests to cover the potential outflow of uninsured deposits. But the bigger question remains: Are these the scenarios that banks should primarily be focused on?
There’s no crystal ball to predict future crises, but one looming risk deserves more attention. It’s a systemic risk that’s been quietly building in the background: the federal deficit. Here’s why the deficit could represent the next major financial storm and why banks should consider preparing for it.
The Hidden Risk of Federal Deficit and Treasury Yields
Imagine a scenario in which government deficit spending pushes the economy to its breaking point. As deficits balloon, the bond market could react with a “bond market revolt,” resulting in a significant spike in Treasury yields. In this situation, the Federal Reserve may find itself in a bind. Moving too slowly on quantitative tightening, the Fed’s future efforts at quantitative easing (QE) could become inflationary and ineffective.
This type of crisis scenario would force the government into making tough choices: deep cuts in spending, scaling back on social programs, and increasing taxes. How would banks fare in a world where Treasury yields climb sharply, inflation accelerates, and government austerity measures reshape the economy? Would bank balance sheets withstand the strain, or would we face something reminiscent of the stagflationary period of the early 1980s?
The Role of Risk Management in Preparing for the Unpredictable
The essence of risk management is preparing for the unknown. While we may never be able to fully predict every potential risk, it’s crucial for the industry to focus on scenarios that reflect today’s unique economic environment. Shouldn’t banks be stress testing for potential systemic risks related to the federal deficit and bond market stability? Such testing could provide valuable insights for banks to shore up their resilience in the face of economic shocks stemming from government fiscal policy.
In the end, the point isn’t to have all the answers but to ensure we’re asking the right questions. If we are truly in the business of managing risk, we should be looking beyond the last crisis and preparing for the risks that today’s conditions present. The banking industry may well benefit from exploring broader stress testing scenarios that incorporate systemic risks in our government’s fiscal policies.
For banks aiming to proactively manage these emerging risks, we’re here to help. Reach out to Patti Casaleggio (pcasaleggio@invictusgrp.com) to schedule a consultation on how Invictus can support your bank's risk management strategy and prepare for the challenges outlined here.