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Identifying At-Risk Banks

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## High-Inflation Stress Test: Identifying At-Risk Banks

U.S. government bank regulators are being urged to conduct a new “high-inflation” stress test by Minneapolis Federal Reserve President Neel Kashkari. The purpose of this test would be to identify banks that are at risk and provide a better understanding of their capital shortfalls.

According to Kashkari, the potential losses that banks face due to interest rate risk seem to be more specific to certain cases rather than being a widespread issue. Therefore, implementing a high-inflation stress test would assist banks in preparing for a scenario that is worse than expected.

During a panel discussion on bank stability hosted by the Minneapolis Fed, Kashkari emphasized that the outlook for regional banks largely depends on the future of inflation. If inflation continues to decline, as predicted by the market, it could lead to an increase in asset prices and ease the pressure on bank balance sheets.

However, if inflation turns out to be more persistent than anticipated, and the Federal Reserve is compelled to further raise its benchmark interest rate, it could result in a decrease in asset prices and put additional strain on banks.

In such a situation, policymakers would have to make a choice between aggressively combating inflation or prioritizing banking stability, according to Kashkari.

To mitigate this potential dilemma, Kashkari suggests that increasing bank capital now could prove beneficial.

It is imperative for government bank regulators to conduct a high-inflation stress test to identify vulnerable banks and gain insight into their capital deficiencies. By doing so, the banking industry can be better prepared for any adverse economic scenario that may arise in the future.

# Banks Facing Challenges Amidst the Pandemic

In the midst of the pandemic, banks experienced a surge in deposits due to government stimulus payments provided to households and businesses. To make use of these funds, banks opted to invest in Treasury securities that carried low interest rates.

However, this strategy went awry as the Federal Reserve swiftly increased its benchmark interest rate over the past year in order to combat rising inflation following the pandemic.

One notable consequence of this situation was the downfall of Silicon Valley Bank in March, which can be attributed, at least in part, to their decision to not hedge their interest rate risks.

Although the turbulence in the banking sector has subsided to some extent, many banks across the country continue to grapple with underwater assets on their balance sheets. A recent study revealed that the U.S. banking system encountered substantial mark-to-market losses amounting to $480 billion, equivalent to 23% of the system’s tangible equity capital.

Neel Kashkari, a prominent figure in the banking industry, emphasizes the necessity of ensuring that banks possess sufficient tangible capital to absorb these mark-to-market losses effectively. Doing so would provide depositors with the reassurance that their money is secure.

However, Kashkari believes that banks are unlikely to proactively bolster their capital reserves in a timely manner without external intervention.

Fortunately, concerns regarding high inflation have somewhat diminished following the government’s report of a significant cooling in consumer inflation during June.

Read: U.S. inflation slows again in June

As a result, stocks, such as DJIA (+0.83%) and SPX (+1.06%), experienced upward movement. Meanwhile, the yield on the 10-year Treasury note (TMUBMUSD10Y) dropped to 3.90%.

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