withstand the stress and keep lending to customers.
customers.
A fourth aspect of the ESCAP and
subsequent stress tests was the public
disclosure of the scenario, the basic
testing methodology, and most
importantly, firm specific results.
And lastly, in addition to the balance
sheet data and other numbers related to
the stress test, the Federal Reserve
produced a qualitative supervisory
assessment of the bank's capital
planning decisions and processes.
One essential element of that first test
is that the supervisors reviewed and
assessed the data and modeling
assumptions used by the banks which
helped to provide credibility for the
loss estimates. The result of the SCCAP
was that 10 of the 19 tested
institutions were required to raise
capital sufficient to keep them above
regulatory minimums if the scenario were
to materialize, a total of $75 billion.
The 10 were given six months to develop
capital plans to meet their stress test
minimums. The ESCAP was remarkably
successful. There was skepticism that
the test would be sufficiently severe or
transparent to be credible and bank
stock prices were volatile due to
speculation about what the stress test
results would reveal. But bank stocks
recovered after the results were
announced in May. Most banks that had
been struggling to raise capital were
able to do so with nine of the 10 able
to find private sector sources of
funding by the six-month deadline.
Credit default swaps for large banks
returned to levels seen before the acute
stage of the crisis. Bank lending was
slower to recover, but stabilizing the
banks helped stop the crisis and the US
economy started the long process of
recovery that July.
I have compared the ESCAP to a
battlefield campaign. And while the
financial crisis certainly felt like
combat at the time, my point is to
emphasize the unique challenge of making
financial regulatory policy in an
emergency. The goal was to restore
public trust in banks that were under
fire. And as the job shifted to
preserving that trust, it was apparent
that there should be an ongoing role for
stress testing in peace time as well.
Starting with the yearly stress test
established in 2010 with the DoddFrank
Act and continuing with the integration
of stress testing into the Federal
Reserve's annual comprehensive capital
analysis and review or SECAR. The
peacetime approach focused on
institutionalizing bank resilience and
risk management practices. The Federal
Reserve conducted the first SECAR
exercise in 2011.
CCAR was an overall assessment of the
capital planning process of banks which
included quantitative and qualitative
components. Either of those components
could form the basis for an objection by
the Fed to firm plans to distribute
capital to shareholders. Distribution
which would reduce the capital available
that the firm could use to buffer its losses.
losses.
The quantitative evaluation of a firm's
capital adequacy was driven by the
results of the DoddFrank Act stress test
or DEFAST. It departed from the ESCAP in
at least two important ways. First,
rather than making the severe scenario
just a more negative version of the
current consensus forecast, the failed
build a process to develop thematic
forward-looking scenarios using
macroeconomic models calibrated to
historical data. Some parts of the
scenario design framework are
purposefully countercyclical under
normal conditions. For instance, the
minimum peak unemployment rate is set at 10%.
10%.
The counter cyclicality of stress test
scenarios is an attempt to lean against
the proylic effects that can make
borrowers appear overly resilient in
good times. Something which could cause
the model to significantly understate
the magnitude of borrower defaults when
the economy turns.
The second way that the DoddFrank stress
test departed from SECAR is that most
lost under that test are projected by
applying models developed and operated
by the Federal Reserve based on data
provided by the banks. Using Fed
developed and validated models provides
for independent risk assessment. The
granular data provided by banks has been
valuable in ensuring that the stress
tests are truly risksensitive and in
understanding broader trends and
interconnections in the financial system.
system.
In addition to this quantitative test,
SECAR assesses the ability of banks to
determine their capital needs in the
future. Supplementing the DEFAST model
administered by the Fed, each bank
projects its income over the stress
scenario using internal models,
providing supervisors with a view of
governance and risk management of the
bank's capital planning process. If a
bank did not pass either the qualitative
or quantitative evaluation, the board of
governors was able to object to the
capital plan and restrict the firm
shareholder distributions.
Over time, several criticisms of SECAR's
approach emerged. The first that with
SECAR was wholly separate from the
process used to set a bank a bank's
basic risk-based capital requirements.
Large banks also criticized SECAR for a
lack of transparency and predictability
that resulted in them precommitting to
lower capital distributions and higher
levels of capital.
In 2020, the Federal Reserve Board
addressed these bank criticisms by
creating the stress capital buffer or
SCB. I know there's a lot of acronyms.
To address the criticism that SECAR was
additive and wasn't integrated into
capital planning, the SCB combined the
basic capital requirement for banks with
one equal to a bank's projected capital
ratio decline during the stress period
plus a year's worth of planned
dividends. linking components of the
Capro framework
to address the claim that CCAR lacked
transparency and predictability. The SCB
requirement set for each participating
bank at a level that reflected its
losses in the stress test and provided
banks with flexibility to change their
dividends in real time.
Another bank criticism was that SECAR's
use of its qualitative assessment was
subjective. The SCB dropped the
qualitative objection and moved that
assessment of capital planning practices
into the traditional supervisory process.
process.
By more directly integrating stress
testing into capital regulation, the SCB
increasingly moves stress testing away
from supervision and toward the
regulatory arena, a consequential decision.
decision.
While this change was intended to
promote consistency and predictability,
in retrospect, it may have reduced some
of the value of the exercise in that it
reduced the range of facts and
circumstances the board would take into
account when evaluating an individual
firm's capital adequacy.
As a result, the board's flexibility to
adjust capital adequacy determinations
based on the unique features of
different firms, including different
business models and risk profiles, was constrained.
constrained.
When I became vice chair for supervision
in 2022, we continued the process of
evolving the stress test. In particular,
the Fed conducted multiple scenarios not
directly connected to setting banks
capital requirements. Using additional
scenarios has helped us to understand
how a broader range of risks might
affect the banking system. For example,
we've explored a stagflation scenario
and looked at the failures of large
non-bank counterparties. Using multiple
scenarios has helped keep our risk
assessments dynamic.
Before turning to the legal challenges
to the current stress test framework, I
would be remiss not to emphasize the
value of the framework we have. The
stress test has been a critical element
that led to strengthening both the
quantity of capital in the banking
system and the riskmanagement
capabilities of large banks. Since the
global financial crisis, large banks
have more than doubled their riskbased
common equity capital ratios from
roughly 5% to 12% or more. At the same
time, they have made meaningful
improvements in their ability to
measure, monitor, and manage their own
risks. The stress test has directly
contributed to both. Despite this
success, some have argued for what they
term full transparency of the test. But
the criticism can be misleading because
two important points are often omitted.
First, the Federal Reserve already
provides substantial information about
the design of the test and has expanded
these disclosures over time. Banks are
far from uninformed. They receive
substantial information about the models
in annual model methodology disclosures
and any material model changes are
phased in over two years with full explanation.
explanation.
Second, what critics call transparency
is not disclosure of basic information
about the rigor and methodology of the
test essential for its credibility.
Instead, it is the equivalent of handing
out the questions to the test in advance.
advance.
that would fundamentally undermine the
rigor of the test which is intended to
assess resilience under conditions not
fully known in advance just as in a
financial crisis.
In short, the framework strikes a
deliberate balance providing banks with
enough from information about scenarios
and models to ensure fairness and
accountability but preserving the rigor
that makes this trust test an effective safeguard.
safeguard.
In December 2024, bank trade
associations brought suit against the
board of governors, challenging the role
of stress testing in setting SCB
requirements for large firms. The trade
associations have challenged what they
contend is the opacity of certain
elements of the stress testing process
and have argued that the models and
scenarios should be released in proposed
form to promote transparency and
facilitate public comment.
In anticipation of and in response to
this litigation, the board announced
that it would disclose and seek public
comment on all the models that determine
the hypothetical losses and revenue of
banks under stress as well as the annual
stress scenarios. The board also
proposed to change its rules to average
stress testing results over two years to
reduce the year-over-year volatility in
the capital requirements that result
from annual stress testing.
These proposed changes represent a
policy choice to respond to the
litigation by enhancing transparency and
promoting public participation. And they
are not intended to materially affect
overall capital requirements.
But in my judgment, they are a mistake
that will make stress testing less
rigorous and nimble.
Subjecting the stress testing models to
the notice and comment process could
lead them to oify and their dynism and
effectiveness may fade. Stress testing
models are inherently complex and
require adjustments to maintain accuracy
and relevance to appropriately account
for quickly developing risks. Changes in
the model would require new notice and
solicitation of comment and the time lag
and burden in making changes would be
significantly extended.
We saw this type of oification play out
before the global financial crisis when
supervisory stress testing of Fanny May
and Freddy Mack became formulaic and
failed to capture escalating risks with
dire consequences.
An additional problem is that the common
process may have an uneven effect since
banks have an incentive to object to
aspects of the models that result in
higher capital requirements and not to
highlight the areas in which the models
underestimate downside risk. Responding
to these comments could create a one-way
ratchet that successively weakens
capital requirements.
Knowing the details of the stress test
in advance will also increase the
likelihood that banks are able to game
the results to lower their capital
requirements. We've seen examples of how
firms have been able to gain stress
tests in the past. For instance, some
firms started to use so-called macro
hedges. Many of these macro hedges were
hedges against a deep recession, similar
to a stress test scenario. And these
short-term hedges were cheap because
investors assumed these scenarios as
extremely unlikely. They were far out of
the money in option terms. The hedges
project reduced projected capital losses
in the stress test by billions of
dollars for some banks, but they weren't
really credible protection from the
effects of a recession because
maintaining these hedges would become
prohibitively expensive as the economy
moved into an actual downturn. This is
just one example of attempts to game the
stress tests that were eventually
addressed through the supervisory
process. But this example underscores
how full disclosure of the Fed's stress
test models and scenarios would enable
banks to optimize stress test results
by, among other things, adjusting their
balance sheets based on their knowledge
of where the models underpric risk in
order to reduce their capital
requirements without materially reducing
their actual risks.
Banks are likely to change their
behavior in other ways that increase
risks. Banks may invest less in their
own riskmanagement framework if the test
becomes too predictable. Full disclosure
of the board's models may encourage
concentration across the banking system
in assets that receive comparably
lighter treatment in the test, which
could create risk to financial stability.
stability.
and banks are likely to reduce their
management buffers, making it more
likely that they would breach their
required buffers and minimums in the
event of stress.
The upshot is that a so-called full
transparency stress test can increase
systemic risks because risk is
underestimated and capital is too low.
The stress tests could lose their
credibility. A loss in credibility is
bad for the banks, bad for the banking
system, bad for financial stability, and
ultimately bad for American families and businesses.
businesses.
As an alternative path to these proposed
changes, I would favor prioritizing the
rigor of the stress testing framework by
separating stress testing from binding
regulatory capital requirements, which
would instead be increased commensurately.
commensurately.
The DoddFrank Act requires that the
board conduct stress tests on large
banks to evaluate whether such companies
have the capital on a total consolidated
basis necessary to absorb losses as a
result of adverse economic conditions.
While these results can and should still
play a role in informing supervisory and
managerial assessments of the
appropriate capital level for particular
banking organizations, decoupling the
stress test results from the preliminary
SCB would enable the board to preserve
essential aspects of stress testing,
including the generation of credible and
detailed information on the risk
exposures of banks and how their capital
levels would be affected by a stress
event. Such information would be
valuable in the supervision of banks in
the uh normal times and especially
important for banks and the financial
system if they are again threatened by crisis.
crisis.
If the stress tests are no longer used
to inform the calculation of a firm's
preliminary SCB requirement, the legal
justification for publishing the models
and scenarios for comment would be
eliminated and have already discussed
the policy grounds for not publishing
them. So the board could abandon the
notice and comment proposal.
The board could instead approach these
statutoily required tests primarily as a
supervisory exercise and could thereby
retain flexibility to design and adjust
the models and scenarios as appropriate
to ensure their rigor and robustness.
Moreover, as authorized by the DoddFrank
Act, the board could run multiple
scenarios to provide greater dimension
to the assessment of risk. As history
teaches us, shocks and crises can
manifest through a range of channels.
And testing a large bank's unique
profile under a range of risks is more
likely to yield high value information
about a bank's likely resilience to
potential stress events. The net result
of these changes would be to increase
the nimleness, dynamism, and
effectiveness of our current stress
testing framework. The board's continued
publication of firm specific results but
promote transparency and market discipline
discipline
so that this change does not reduce
overall capital in the system. SCBs
could instead be set entirely by
regulation. For most non-GIBs subject to
the SCB requirement, the current 2.5%
buffer floor likely remains an
appropriate level. For Gibbs with a lot
of trading, past stress tests have
routinely indicated that SEB should
likely be set higher than the 2.5% floor
and any regulatory capital measure
designed to replace the current SCB
framework would need to account for this gap.
gap.
While further analytical work is
required, the shortfall generated by
decoupling the stress tests from the SCB
may be largely addressed by a regulatory
capital requirement baked like linked to
the risks in the trading book with
perhaps some other adjustments as
required to maintain appropriate capital
levels. If over time stress testing
results indicate that this replacement
regulatory capital measure routinely
exceeds or falls short of the capital
levels required to provide adequate
resilience to stress conditions. The
board could revise the regulatory
measure through a notice and comment
process informed by data gathered in the
stress testing process.
This proposed approach of decoupling the
stress test from regulatory capital and
increasing regulatory capital to make up
the shortfall in the SCB appears to me
to be the best way to retain the value
of stress testing as a supervisory
exercise while maintaining appropriate
levels of capital in the system.
However, replacing the current framework
of individualized SCBs informed by firm
specific stress test results with
broadly applicable formulaic regulatory
capital requirements would result in a
dimmunition of the risk sensitivity
reflected in the SCB requirements.
That is capital levels for firms that
are subject to the stress tests would be
relatively less tailored than they
currently are and less reflective of the
unique business models, exposures, and
risk profiles of a particular firm.
To address this loss in risk
sensitivity, I would propose that in
exceptional circumstances, the board
could use its capital directive
authority to impose individualized
capital requirements on specific firms
to account for a firm's particular
circumstances, including its capital
structure, riskiness, complexity,
financial activities, and other
appropriate riskrelated factors. This
would be similar to the United Kingdom's
Pillar 2B requirements and those of
other jurisdictions. While these
requirements could be informed by the
stress test results in part, they would
also take into account qualitative
factors and supervisory judgment.
Because these individualized
requirements would consider the specific
risks of a firm, they would be adjusted
to reflect a firm's specific risk
profile. While I don't believe it would
be advisable for this type of exercise
to become the default manner for setting
capital requirements, in exceptional
cases, it would preserve some of the
tailoring benefits of the current SCB
regime in a manner that comports with
the changes I have discussed.
Furthermore, it would preserve the
ability for banks to address stress
results that demonstrate significant
deficiencies in capital adequacy under a
stress scenario when the firms are
otherwise in compliance with regulatory
capital requirements.
With these changes, stress testing could
maintain its flexibility and
adaptability and therefore could retain
its value as an effective tool for
identifying idiosyncratic risk in a
major bank and ensuring that capital is
sufficient to address that risk. Among
the benefits would be the space this
approach would allow for continued
innovation in stress testing. Such
innovation is vital as finance evolves
and banks continue to seek ways to
reduce supervisory and regulatory
requirements. This approach could allow
for scenario design and modeling
advancements unencumbered by the
limitations I've spoken of imposed by
the notice and comment process.
In conclusion, I believe it is
critically important to maintain the
dynism and rigor of stress testing so
that supervisors, banks and the public
understand the underlying
vulnerabilities in the banking system
and at the largest banks and understand
that these firms are holding sufficient
capital to address these vulnerabilities.
vulnerabilities.
I have deep concerns that the set of
changes the board is now considering
risk resilience on a risk reliance on a
stress test that can no longer
effectively assess the resilience of the
largest banks and lacks credibility,
thus putting our financial system and
the economy at risk. Thank you very much.
much. [Applause]
>> Well, uh, that was not uplifting, at
least at the end. And uh so I want to go
straight into asking you what do you
think is the chance of your recommendation
recommendation
gathering uh support and maybe even
gathering support sufficient to uh you
know to become for the board to turn
back from where they were and for other
voices to join in and argue for uh more
flexibility. I have also to confess that
having first dealt with or learned about
supervision and regulation when I was at
the Bank of England where supervisory
rather than regulatory approach was very
much uh in the way of doing things. Um
it does seem attractive to me to think
of holding the flexibility and relying
more on supervisory challenges on
supervisory oversight. But of course
that does raise the question of are the
supervisors up to the task.
>> So first question is
is this is your approach uh have a chance?
chance?
>> I think there's I think there's time for
the board to think about it. We haven't
had a formal proposal yet before the
board. Um there's time for the board to
assess that. There'll be time if the
board moves forward with this first
stage of the notice and comment process
for us to receive comments from the
public uh and to take those comments
into account and my experience has been
in serving on the board and as an
observer of it for many decades now that
the board is open to different ways of
thinking about thing and is things and
is not locked into any predetermined
strategy. So the reason for giving these
remarks and for encouraging the public
to engage in this process is that I hope
that the board will be open to an
alternative way of getting out of the
box that we're that we're currently in.
I was uh in a discussion with another
supervisor just recently who was
commenting that as far as money is
concerned there's nothing new under the
sun and but as far as it with the
developments in information technology
uh IT people come up with ideas and they
don't understand about money people
don't understand about it do you see
that as a problem in in this issue of
stress testing that there are all sorts
of clever ways for the IT people to
figure out new models and so on and uh
we know that fundamentally
there are cycles and bad loans are made
in good times and during the good times
there's tremendous pressure to release
you've written about this or spoken
about this to relieve u pressure on
capital and then in the bad times times
the government might
>> it's not there.
>> So how do you see the uh that interplay
of the development of uh of new
technologies and the work that is in one
sense the same as it's been for decades
of trying to make banks make account?
>> Well there you know there are kind of
three elements in the questions that
you've raised. one is this uh cycle of
history that we see and that you
referred to I gave remarks on um not
that long ago. We we do see these cycles
repeat over time and in periods where
the economy seems to be doing well and
memories of the last financial crisis
have faded.
There's this tendency to reduce regulation
regulation
or not to keep up with the changes by
making sure regulation keeps a pace. And
that failure to keep pace or to even
reverse regulation that is there in good
times ends up feeding the next financial
crisis. And as you said, oftentimes it's
the case first of all that that
financial crisis cause causes enormous
harm to families and to businesses. We
certainly saw that in the global
financial crisis
uh in spades. Um and then the second
thing that often happens is the
government then has to step in and
support the financial sector so that the
financial sector can once again support
the economy. And the whole point of
getting regulation right in advance was
that you make it less likely that firms
will get themselves into such trouble
that they harm the real economy and
government is required to step in. And I
I do worry that we're in the beginning
of one of these uh deregulatory
processes, deregulatory cycles now. you
can see it in lots of different areas,
stress testing, supervision, capital,
um, uh, to name a few. Uh, the second,
you know, theme you raised is this
question about regulation versus
supervision. And I think both are really
important. It's good to have strong uh
regulation that goes through the notice
and comment rule making process that
everybody can rely on and see as a base
level of resilience in the system. And
then it's also really important to have
supervisors who are poking and
proddding. Stress testing is a great
tool for poking and proddding when it's
done right. And that brings me to your
third theme which is you know this
question of technology and can the
regulator keep up? And that's one of the
reasons that I'm really worried about
the path we're on on stress testing,
making it subject to this notice and
comment process because
technology will keep going and banks
modeling processes will keep going and
people will invent new ways to take on
risk that the stress tests don't pick up
and it will become harder and harder for
the stress test to keep up. I really
worry that the gears of the system will
slow down and that friction will uh make
it harder for the stress test to stay
dynamic and innovative. This is not
through any fault of anybody at the Fed.
I'm sure that the PE teams who are
working on stress testing are going to
do their utmost to keep the stress test
dynamic and relevant and uh accurate.
But they're going to be having this push
against them of the bank lobby and the
notice and comment rulemaking process
that the bank lobby uses and that will
make it hard for them to to stay
dynamic. And that's that's the worry
that I have that will end up with a
stress testing process that sort of
blesses the banking system as being safe
when it's not
>> right. So it's interesting that there's
an arc of the US inventing stress
testing essentially after the global
financial crisis and
in a sense banks
submitting to it maybe not always
happily but also they wanted and and
non-banks became banks in order to be
kind of embraced
>> by the system and embraced by the safety net
net >> um
>> um
then it becomes more and more annoying
for the banks to uh to have this safety
net which they feel is uh unnecessary
and so on. when you as I was listening
to you, I was thinking it's like a kind
of cat and mouse game
>> between the banking firms that want to
take on risk in order to make profits
and the uh regulators who are trying who
are looking at it from a systemic point
of view and want to limit that risk. And
is there a is that just the nature of
the beast that it will always be this
cat and mouse game with uh periodic
crises necessary to I don't know uh
knock some cents into the risktakers but
at the at a big economic cost. So how do
you see that?
>> No I I I do worry about that. I mean
there is this there is this cat and
mouse aspect of the game. I mean uh
banks respond to a set of incentives in
the world and uh regulation attempts to
uh adjust those set of incentives and
then banks respond to the regulatory
um incentives themselves and drawing
those lines is super difficult. We don't
want as you said in your introduction we
don't want a banking system without
risk. We want banks to take on risk.
That's their function in society. They
take on a set of risks that help our
economy grow.
uh but we want them to manage those
risks and we want them to have enough
capital against those risks so that if
they get into trouble they bear the
economic consequence not taxpayers not
society at large we want them in
economic terms to internalize um those
costs and that's what the battle is
about in in capital regulation banks
never like capital they would prefer to
hold as little capital as the market
would let them get away with. Uh, and
the reason we have bank regulation is so
that banks have sufficient capital to
take society's costs into account in
thinking about their risk management.
And stress testing is part of that
conversation, if you will, about what
the appropriate way to manage risk is.
And I worry that the path that we're on
will result in less of that balance. And
if things get out of whack and banks
start taking on more risk for which they
have inadequately capitalized
themselves, then that's when farmers get
hurt and small businesses get hurt and
families lose their home and people
can't find a job. That's that's what
that's about. And so getting that
balance right, I think, is crucially
important for the American economy. And
that's why I care so deeply about what
we're talking about today.
>> Yes. And I think that's that's really
well said and I liked your the way that
you were talking about stress testing is
a way to poke at at uh risks and poke at
and reveal risks that may not be
captured by a system that of regulation
is necessarily a slower one. I want to
ask about the edges of regulation in two
different ways. one as I referred to SVP
and of course that to SVB um when
Silicon Valley Bank got into trouble uh
the common refrain was well they weren't
you know there had been a mistaken
lowering of for a while of the
regulatory boundary within the US um or
within the banking system and then
separately there are the non-banks um we
were talking earlier about private
credit, private equity, uh all of these
uh mechanisms of um providing financing
to the real economy through institutions
or mechanisms that don't involve the
banking system.
>> Uh is that a problem or is the fact that
they're outside the banking system kind
of fine because at least uh regular
depositors are not going to be affected?
How do you see those two issues? Well,
there's always this problem uh you know,
I've taught financial regulation for
many years and one of the the key themes
of the classes that I've taught are this
question of the regulatory perimeter.
Who's in regulation, who's not in
regulation, who's covered, who's not
covered. There's no way to get away from
that problem completely. But I will say
on on SVB, you know, one of the one of
the problems that happened with SVB was
that uh there was legislation that was
um passed by Congress to lower the
burden on uh banks that were large banks
but not super large banks. and SVB was
omitted then from uh supervision as a
large bank and they were taken out of
the stress testing program and there
were other changes to its capital and
liquidity requirements and they were
sort of treated like a large community
bank for quite a while as they were
growing fast and that led examiners to
miss some of the key growing risks in
the uh in the bank. Um, you know, I I
testified on this bill back before it
passed, saying that one of the risks
that you have is that if you let a
series of these institutions
that are large but not super large get
out of this regulatory perimeter, they
might all behave in a similar way that
we wouldn't know and then they could
create stress in the financial system.
And that's basically what happened in 2023.
2023.
uh you know now when you look at the
broader issues that you raised about
the non-bank sector the the United
States has a very vibrant very dynamic
uh financial system some of which
involves banks and some of which
involves lots of different kinds of
other entities and not all those
entities should be regulated like banks
we have different kinds of regulation
for different kinds of institutions but
there is this risk that
uh risk will float from one part of the
system to another without people
understanding what that risk is and
without being able to measure and manage
that risk and that's what you want to
look out for. So we you know at the Fed
we have a process we use to try and look
across the financial system not just at
the banking sector and say where are the
other potential sources of risk. How do
we manage its intersection with the
banking system? what could happen if
that set of problems, you know, blew up.
You know, at at various times, we've
looked at things like the role of hedge
funds in the treasury market and uh what
do we think about the rise of private
credit and what's the structure of
non-bank mortgage origination and
servicing? There are lots of these kinds
of topics we're looking at all the time
to try and say okay do we have our
handle on the risk for the system as a
whole not just in the banking sector
>> and do you feel that that's
or which are the areas out just on the
edges or the other side that worry you
the most if you are happy to ready to
talk about that. Well, I'm I'm you know,
I guess I by disposition I'm always
worried about
>> everything risk in the system.
>> That's your job.
>> You and I have spent enough time
together to know you know, you never
know, we were talking about this just
now over lunch. You never know where the
shock is going to come from.
>> People who were in in the wake of the
global financial crisis, one of the
things that people did, very smart
people did was to build um agent-based
models to understand the transmission of
risk in finance. and agent-based models
people know come out of epidemiology.
That's sort of where where it's, you
know, commonly used and then it was
brought into the financial sector
analytic toolbox. But nobody doing
agent-based modeling and using these
advanced sophisticated techniques
thought, well, what happens if we have a
once in a hundred years global pandemic?
What would that do to the financial
system? So you you just don't know where
the shock is going to come from. So you
have to focus on resilience in the
system as a whole. And that's why
capital is so important and that's why
stress testing is so important. You just
don't know where the shock is going to
come from. You want there to be
sufficient resilience that the system
can withstand those kinds of shocks.
>> So it's interesting that you mentioned
the pandemic because of course that was
a massive crisis shock and all the rest
of it that did not lead to a sustained
financial crisis. I mean there were
moments of of extreme stress. So what
was it that went right?
Well, there was there was massive
government intervention to prevent the
pandemic from becoming an economic and
financial catastrophe. And in the
absence of that government intervention,
things would have been terrible. Uh
there was huge intervention to save
money market mutual funds. There was a
lot of uh support for the corporate bond
market. There was support for municipal
bonds. There was support for the housing
market. There was economic aid that went
to communities. There was economic aid
that went to individuals and all of that
worked together in both the financial
sector and the economic sector to keep
the economy from plummeting and actually
to help it recover much more quickly
than countries in other parts of the world.
world.
>> Of course, all of that support together
with the uh you know once in a lifetime
or uh once once in every three
generation shock to our economy from the
pandemic. plus Russia's assault on
Ukraine, a series of supply shocks
hitting the economy, plus the support
for demand, Fed inflation that we're now
continuing to work on addressing.
>> So, let me turn I mean, I think all of
that is interesting, especially because
there's a question about whether
the financial sector actually learned
that risk didn't matter so much because
it was rescued. So, that's always the
balance. It's always the worry,
>> right? Um, but you mentioned inflation.
Let's turn, of course, um, you know, as
a Fed governor, you also have to worry
about interest rates and we've had, as I
mentioned, a series of uh, Fed policy
makers talking about how they see the
economy. We don't have that much time
left but um before I see if there are
questions from audience I really would
like to hear your view on this balance
of risks or maybe the risks are not
balanced but rather intentionally
>> well you know let's just take a step
back and remember we had you know
inflation uh rise up extremely steeply
and since that time it's come down
gradually uh and we're now at a point
where uh inflation is running under 3%.
And it had been doing this long kind of
gradual reduction in um in inflation
while the labor market remained solid uh
and the economy was growing at a good
rate. And that that's a very unusual
um set of circumstances to have
experienced without a significant
recession. And now we're looking at uh
the situ a situation where inflation is
starting to rise again slowly and that
is largely uh because of tariffs. So
we're seeing services inflation and
housing inflation continue with a bumpy
path but continue to come down. But
goods inflation is moving from negative
which is its normal state in the world
um to positive and growing. And the
question is uh what's going to happen to
inflation over time as it moves away
from our target.
We need to watch that and be careful
about it because it is largely related
to tariffs. A reasonable base case is
that it will continue to rise over time
through 2026
but then will stop rising and will go
back to its normal path. That's a
reasonable base case, but there's a risk
that those price increases could be more
embedded in the way we think about
prices and then inflation could spread
to the services sector to to other parts
of the economy. And we have to guard
against that risk vigilantly to be sure
that tariff increases in prices don't
become embedded in the economy and that
we return towards our towards our
target. On the labor side of our
mandate, we have a dual mandate to care
about inflation and maximum employment.
On the labor side of the mandate,
many indicators suggest that the labor
market um is doing okay. So, if you look
at uh the unemployment rate, it's held
quite steady in a narrow band for a
while. uh the vacancy to unemployment
rate, the the quits rate, the um new
claims rate, you can think of as all
showing positive signs. But there are
heightened risks now on the employment
side of the mandate. So one, you know,
important example is if you look at the
payroll data and you make certain
adjustments to it, you can think of it
as basically being in a band around zero
growth um in payroll for the last
several months. Now part of that is
labor supply has shrunk a lot because
immigration is no longer providing uh
new workers to the to the labor force,
but labor supply has also labor demand
has also come down. And so whenever
you're operating in an economy with zero
effectively zero net job growth, a
negative shock could
cause a more significant decline in the
labor market. So we have to be attentive
to that. And that's I think why you saw
us I'll just speak for myself. I
thought, you know, our our move to
reduce rates by 25 basis points at our
last meeting was an appropriate
riskmanagement acknowledgement of that
increased risk to the employment side of
the mandate. So, we have to take both
these things in mind, their intention.
The inflation side of our mandate would
suggest that we hold still or raise
rates. The employment side of our mandate suggests that we would lower
mandate suggests that we would lower rates as a riskmanagement exercise. So,
rates as a riskmanagement exercise. So, we have to be careful as we're moving
we have to be careful as we're moving forward. We're making adjustments to
forward. We're making adjustments to make sure that the employment side of
make sure that the employment side of the mandate is doing okay. That we also
the mandate is doing okay. That we also are keeping a watchful eye on inflation.
are keeping a watchful eye on inflation. And that's I think what you're going to
And that's I think what you're going to see us trying to weigh in the coming
see us trying to weigh in the coming months.
months. >> And is that well I I'll turn to uh to
>> And is that well I I'll turn to uh to the audience in case there are
the audience in case there are questions. Yes. Thank you. Please uh say
questions. Yes. Thank you. Please uh say who you are and ask your question.
who you are and ask your question. >> Good. Is this okay? Great. Um, thank you
>> Good. Is this okay? Great. Um, thank you very much for that presentation. I agree
very much for that presentation. I agree that you can't distribute the test. Uh,
that you can't distribute the test. Uh, >> sorry. Can you just tell us who you are?
>> sorry. Can you just tell us who you are? >> Excuse me. Sorry. I think I probably did
>> Excuse me. Sorry. I think I probably did that while it was off. I'm Colin
that while it was off. I'm Colin Hendricks. I'm with the institute. I do
Hendricks. I'm with the institute. I do hope that you get your wish. Um, but I
hope that you get your wish. Um, but I I'm I want to make sure I understand
I'm I want to make sure I understand this correctly. If you're able to de to
this correctly. If you're able to de to separate these two processes and be able
separate these two processes and be able to devise the best possible stress suite
to devise the best possible stress suite of stress tests that you can imagine and
of stress tests that you can imagine and then that information is made public and
then that information is made public and then you have a disclosure of the
then you have a disclosure of the capital requirements that does not
capital requirements that does not directly correspond to what you have
directly correspond to what you have said is the best mousetrap for assessing
said is the best mousetrap for assessing this. How do you think markets or the
this. How do you think markets or the the public generally is going to respond
the public generally is going to respond to any discrepancies that might arise?
to any discrepancies that might arise? Thank you.
Thank you. >> It's a good question. I mean, I think
>> It's a good question. I mean, I think one of the reasons that I think it's
one of the reasons that I think it's quite important for the stress test to
quite important for the stress test to be made public and to have individual
be made public and to have individual results is that that market discipline
results is that that market discipline will matter. And if the markets view the
will matter. And if the markets view the stress test as credible, they will look
stress test as credible, they will look to the banks to make sure that they can
to the banks to make sure that they can withstand the stress of that stress
withstand the stress of that stress test. I think that's a totally
test. I think that's a totally appropriate thing.
appropriate thing. you
you uh are there other questions um from the
uh are there other questions um from the audience and I'm sorry for those online
audience and I'm sorry for those online that we we can't take questions online
that we we can't take questions online or we're not taking questions online at
or we're not taking questions online at the moment. I just want to uh finish off
the moment. I just want to uh finish off perhaps with another monetary policy
perhaps with another monetary policy question for you Michael which is
question for you Michael which is this balancing of the risks doesn't
this balancing of the risks doesn't sound like actually we're restarting an
sound like actually we're restarting an easing cycle. We know that's the way to
easing cycle. We know that's the way to go and we've done one 25 basis point and
go and we've done one 25 basis point and we expect as uh as the dot plot seem to
we expect as uh as the dot plot seem to suggest we we expect another couple in
suggest we we expect another couple in the next uh two three months and maybe
the next uh two three months and maybe even more in 2026. So
even more in 2026. So what's your view on that? I you know I I
what's your view on that? I you know I I do think that the most likely direction
do think that the most likely direction of travel the base case is that it will
of travel the base case is that it will be appropriate to reduce rates over
be appropriate to reduce rates over time. I just think we need to be
time. I just think we need to be cautious about how we do that. I think
cautious about how we do that. I think there's too much focus on what are we
there's too much focus on what are we going to do between now and December and
going to do between now and December and not enough looking over 2025 and 2026
not enough looking over 2025 and 2026 and thinking what is going to be the
and thinking what is going to be the sequence and timing of rate cuts over
sequence and timing of rate cuts over that longer period of time. And I I
that longer period of time. And I I think the direction of travel is towards
think the direction of travel is towards lower rates, but I think we need to be
lower rates, but I think we need to be cautious about it.
cautious about it. >> Okay. Well, on that uh note, thank you
>> Okay. Well, on that uh note, thank you very much. Thanks for the interesting
very much. Thanks for the interesting discussion about and thank you for
discussion about and thank you for coming here and putting out that view
coming here and putting out that view about let's think differently about
about let's think differently about stress tests because they were an
stress tests because they were an essential tool in helping the US economy
essential tool in helping the US economy to recover so quickly from the global
to recover so quickly from the global financial crisis and a tool that we want
financial crisis and a tool that we want to stay uh active and useful. So thank
to stay uh active and useful. So thank you all. Let's uh thank you Michael.
you all. Let's uh thank you Michael. Let's all join us.
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