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U.S. government bank regulators should run a new “high-inflation” stress test to identify at-risk banks and be able to better gauge their capital shortfalls, said Minneapolis Federal Reserve President Neel Kashkari on Wednesday.
“The potential losses banks face today from interest rate risk appear to be more idiosyncratic than systemwide, and this high-inflation stress test would help banks prepare for a worse-than-expected scenario,” Kashkari said, in a blog post and a subsequent panel discussion on bank stability hosted by his regional Fed bank.
In his essay, Kashkari said the outlook for some regional banks depends “largely” on what happens to inflation.
If inflation continues to cool, as the market expects, asset prices could climb, and bank balance sheet pressures would likely ease.
But if inflation is more entrenched than expected and the Fed has to raise its benchmark interest rate further, this could reduce asset prices and put pressure on banks.
“In this scenario, policymakers could be forced to choose between aggressively fighting inflation or supporting banking stability,” Kashkari said.
Increasing bank capital now might help avoid this dilemma, he said.
During the pandemic, banks took in new deposits as households and businesses received government stimulus payments. Banks used the funds to purchase Treasury securities with low interest rates.
These securities have lost value as the Fed raised its benchmark interest rate quickly in the past year to combat a burst of inflation in the wake of the pandemic.
The collapse of Silicon Valley Bank in March was tied, in part, to their decision not to hedge their interest rate risks.
While the turmoil in the sector has eased, banks across the country still have underwater assets on their balance sheets. A recent study found that the U.S. banking system faced $480 billion of mark-to-market losses, representing 23% of the system’s tangible equity capital.
“Ensuring that banks have enough tangible capital to absorb mark-to-market losses would help to reassure depositors that their money is safe,” Kashkari said.
He said banks were unlikely to choose to build capital quickly on their own.
Concern over high inflation eased Wednesday after the government reported that consumer inflation cooled sharply in June.
Read: U.S. inflation slows again in June
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