Get Ready For the Biggest Stress-Test of Them All

For several weeks now, my e-mail box has been peppered with messages from banks disclosing how they fared on this year’s Dodd-Frank stress tests. Almost all announce that their balance sheets would survive even the “severely adverse scenario” that the Federal Reserve proposed this year.

That severely adverse scenario was indeed pretty scary: oil back to $110 per barrel; unemployment soaring back to 10 percent and staying there well into 2016; a 4.5 percent contraction in GDP growth; home prices down 25 percent, equity market down 60 percent; sharp recessions in the United Kingdom and Japan; sluggish growth elsewhere in the world.

So it’s good news to hear that even under those circumstances, most banks have modeled their risks that they can emerge battered, yes, but unbailed out. That was a key goal of the Dodd-Frank Act five years ago, and corporate compliance and risk managers have been grinding away to manage these stress tests ever since.

The only problem is that the severely adverse scenarios looming around the world economy right now aren’t at all what the Federal Reserve anticipated. Which means the banking sector’s risk management systems are about to get a real-world stress test quite unlike what we’ve been planning for.

The obvious example is Greece, and we should all brace for what’s to come this week out of Athens and Brussels. (My prediction: a default and exile out of the Eurozone currency.) But remember that Greece is only one of several systemic risks that the world’s financial system is facing right now. We have a recession of some kind gurgling to the surface in China, and the specter of interest rate hikes from the Federal Reserve sometime later this year because the U.S. economy is allegedly so strong. You won’t find any of those dynamics showing up in the Fed’s stress tests.

Plenty of people will say that the banking world has already de-risked away from Greece, since the country has done its debt-addled pas de duex with European Union creditors for five years. Let’s hope they are right. Greece is a small economy, after all, and its significant international trade is mostly shipping and tourism. If risk managers at big banks have done their jobs well, the worst pain from Greece crashing out the euro should be confined to Greece.

A much bigger risk is China. Its stock markets are convulsing. Its economic growth is slowing. The central bank has cut interest rates four times in less than a year, and telegraphed the message to banks that they should keep the lending spigot open. With all that cheap money, people and businesses have been taking on more debt to invest in that over-heated stock market rather than in growth plans. State-owned enterprises are simply falsifying their revenue and profit numbers, rather than improving efficiency and finding growth.

In short, China is a macro-economic mess, and Beijing’s efforts to wallpaper over the ugly side of economic life there are finally starting to fail. (Pithy lesson compliance officers can take to boards and middle managers: corruption always catches up to you.) The question is whether China will endure a recession akin to what the United States experienced in 1990-91 or 2002-03—or a financial crisis like what we suffered in 2008. Given that China’s banking system is clogged with bad loans, my gut tells me it will be more like the latter. Have your risk models accounted for that?

The last systemic risk on my mind right now is the one closest to home: that the Fed might raise interest rates. Even if you put aside the argument that large parts of America still aren’t enjoying good economic growth (an argument that still has lots of evidence, by the way) and agree that the Fed kinda sorta maybe perhaps should raise rates just a teeny-weeny bit (which is all commitment Fed governors are willing to make right now), the question remains: does anyone on Wall Street still remember how to make money when rates are rising?

That’s not a glib question. One recent study noted that 30 percent of traders working on Wall Street today have never seen the Fed raising interest rates. Clearly, lots of people working on Wall Street during the last rate-hike cycle in the mid-2000s didn’t know how to handle it either, since their bad bets led to the financial crisis. If the stock market really is over-valued these days thanks to low interest rates for so long, a rate hike is like a pin tapping against a balloon: the higher the rate, the stronger the tap. We all know what happens to the balloon eventually. 

So congratulations to all those banks that survived those Dodd-Frank stress-tests. Now let’s see how we do in the real world. 

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