Big Banks' Stress Tests Are Still Flawed

By some metrics, the US financial system is in great shape. All 31 banks that underwent the Federal Reserve’s stress tests this year maintained adequate capital even in a “severe” economic scenario. Yet that’s not as reassuring as it sounds: The tests are flawed, banks still have a poor understanding of their own risks, and regulators may yet succumb to a dangerous complacency.

As critics have been pointing out for years, such tests are an inadequate gauge of resilience. The scenarios they test don’t always capture the full spectrum of plausible risks that the system may face — such as how a sharp rise in interest rates would take down some banks, as it did Silicon Valley Bank and others early last year. They also don’t account for the ripple effects that amplify financial distress. A severe drop in stocks, for instance, might lead to a rush into Treasuries that upends the repo market.