Federal Reserve Bank of Boston President Eric Rosengren said regular “stress tests” may help financial institutions prepare for unexpected risks, such as fallout from a sovereign debt crisis or a disruption to the U.S. economy from state and local governments.
“We need to do a much better job of using so-called stress tests to challenge commonly held views, so that boards of directors and regulators of firms better understand the fundamental drivers of risks in organizations and in the financial system,” Rosengren said today in prepared remarks for a speech in Boston.
The Fed has ordered the 19 largest U.S. banks to test their capital levels against a scenario of renewed recession. Such stress-testing is mandated by the Dodd-Frank Act, signed into law by President Barack Obama in July, overhauling regulation of the financial system with the goal of reducing the risks of future financial crises.
Banks’ risk managers, chief financial officers, boards of directors, and regulators all have a role to play in ensuring “regular, thoughtful stress testing,” Rosengren said.
“Regulators should be able to compare and contrast the quality of stress tests across organizations and hold accountable those organizations that are not keeping up with their peers,” Rosengren said.
He didn’t discuss his views on the economic outlook or monetary policy in the speech.
Under the Fed’s review, the largest U.S. banks stress-tested the performance of their loans, securities, earnings, and capital against at least three possible economic outcomes as part of a broader capital-planning exercise.
The central bank’s adverse economic scenario included a 1.5 percent decline in gross domestic product from the fourth quarter of last year through the end of 2011 and has unemployment peaking at more than 11 percent by the first quarter of 2012. The Fed will finish its review in March.
Responding to an audience question about what the Fed is doing to reduce risks from banks deemed “too big to fail,” Rosengren said: “We are looking at higher capital requirements, and I think we will get higher capital requirements.”
Also today, Federal Reserve Bank of New York President William Dudley said the “considerably brighter” economic outlook isn’t yet reason to withdraw record monetary stimulus.
“We provided additional monetary policy stimulus via the asset purchase program in order to help ensure the recovery did regain momentum,” Dudley said in a speech in New York. “A stronger recovery with more rapid progress toward our dual mandate objectives is what we have been seeking. This is welcome and not a reason to reverse course.”
The Fed announced a plan in November to buy $600 billion of Treasuries through June in a second round of so-called quantitative easing aimed at combating too-low inflation, stimulating economic growth and creating jobs. The Fed has a congressional mandate to ensure maximum employment and low and stable inflation.
Rosengren’s speech focused on the difficulty of debunking “financial myths” that can cause bank risk models to fail. One such myth was the belief before the crisis that home prices were unlikely to fall across the country, he said.
Widely Held Beliefs
“Debunking a myth requires individuals to go against strongly and widely held beliefs,” said Rosengren. “For this to happen we may need significant changes in the governance of risk management at banks and other parties in the financial system.”
Rosengren mentioned two potential risks — spillover from a sovereign debt crisis and the strained budgets of local and state governments in the U.S. While he said it’s likely both situations will be resolved, participants should be prepared for more “disruptive” outcomes.
Rosengren, 53, joined the Boston Fed as an economist in 1985, and became the bank’s president in 2007. Fed presidents rotate voting on monetary policy, with Rosengren next voting in 2013.
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