Federal Reserve Warns of Banking Risks: Stress Tests, Cyber Threats, and Climate Challenges

Federal Reserve Warns of Banking Risks: Stress Tests, Cyber Threats, and Climate Challenges

Federal Reserve Warns of Banking Risks: Stress Tests, Cyber Threats, and Climate Challenges

The Federal Reserve emphasizes the need to maintain credible stress tests, strengthen cyber resilience, and monitor risks from nonbanks and climate change. It warns against reducing capital requirements and stresses the importance of proactive supervision. Responsible innovation and regulatory vigilance are key to ensuring financial stability.

 

CONTENTS:

Federal Reserve Warns of Banking Risks: Stress Tests, Cyber Threats, and Climate Challenges
Federal Reserve Warns of Banking Risks: Stress Tests, Cyber Threats, and Climate Challenges

Federal Reserve Warns of Banking Risks: Stress Tests, Cyber Threats, and Climate Challenges

Banks play a crucial role in a stable economy, allowing households to secure loans, save for the future, and manage financial fluctuations. They also provide businesses with credit to sustain operations, expand, and create jobs. Additionally, banks facilitate financial transactions while relying on deposits from households and businesses. Given their significance, it is essential to ensure their resilience so they remain a stabilizing force during both economic growth and financial downturns.

While banks operate as businesses, balancing profit motives with risk management, they do not fully absorb the societal costs of failure. Therefore, regulation and supervision are necessary to prevent excessive risk-taking that could negatively impact individuals and businesses.

History has shown that bank failures are a recurring issue. The Great Depression underscored this reality, prompting the establishment of deposit insurance and emergency lending programs. However, to counteract the risks associated with government support, a regulatory framework was created to ensure banks take responsibility for the risks they introduce to the financial system.

Financial systems continually evolve, which has led to multiple banking crises, including those of the 1980s and the Global Financial Crisis of 2008. The latter exposed significant regulatory weaknesses, resulting in widespread economic turmoil, business closures, job losses, and government bailouts. In response, the Dodd-Frank Act and other regulatory reforms were enacted to reinforce oversight and prevent reckless risk-taking. The public message was clear: banking practices must be responsible and aligned with economic stability.

However, financial risks will continue to evolve, requiring ongoing regulatory adaptation. As Vice Chair for Supervision, I have acknowledged that no regulator can foresee every potential risk or predict financial shocks with complete accuracy. Our financial system is interconnected and constantly shifting, making it difficult to anticipate how vulnerabilities might amplify risks.

When I assumed my role in July 2022, the Global Financial Crisis was more than a decade behind us, and regulatory reforms had strengthened the system. Yet, in March 2023, the collapse of Silicon Valley Bank—one of the largest bank failures in history—triggered further financial stress, leading to the failures of Signature Bank and First Republic Bank. The situation required emergency measures, including systemic risk exemptions and an emergency lending program. While steps have been taken to address the regulatory gaps that contributed to these failures, ongoing risks and challenges remain.

Earlier this year, I announced my decision to step down as Vice Chair for Supervision while continuing to serve as a member of the Board of Governors. I believe I can be more effective in this role, contributing to monetary policy decisions and oversight efforts. Although this decision was difficult, I made it in the best interest of the institution and the public. It is essential to preserve the Federal Reserve’s independence and avoid distractions that could compromise its mission.

 

Before concluding my tenure as Vice Chair, I want to highlight seven key risks that will continue to shape the future of bank regulation and supervision:

  1. Completing post-financial crisis reforms – Ensuring that regulatory improvements remain intact and are fully implemented.
  2. Maintaining the credibility of stress tests – Strengthening stress-testing practices to accurately assess bank resilience.
  3. Ensuring consistent and effective supervision – Upholding high standards in regulatory oversight.
  4. Supporting responsible financial innovation – Encouraging advancements in banking while managing associated risks.
  5. Addressing cyber and third-party risks – Strengthening protections against cyber threats and vulnerabilities from third-party services.
  6. Monitoring risks in the nonbank sector – Assessing potential threats from financial entities outside traditional banking.
  7. Managing climate-related financial risks – Understanding and mitigating the financial sector’s exposure to climate-related risks.

 

These challenges will require continued diligence to safeguard economic stability and maintain public trust in the financial system.

 

Completing Post-Financial Crisis Reforms

Financial regulation often faces resistance, even after major crises. While helping to draft the Dodd-Frank Act in response to the Global Financial Crisis, I encountered pushback. The same has been true in recent years as we’ve worked to finalize post-crisis reforms and address emerging risks. Striking the right balance is essential, but it’s equally important to advocate for the American public.

Regulators must complete the implementation of key financial reforms without undoing the resilience banks have built. While efficiency improvements should be pursued where possible, maintaining strong capital requirements remains crucial. Capital buffers enable banks to absorb losses and continue operating during financial stress. The Basel III reforms enhance how we measure risks in credit, trading, operations, and derivatives, learning from past crises. Most major financial jurisdictions have already implemented these changes, leaving the U.S. as an outlier.

The Federal Reserve played a vital role in shaping these international standards, and following through on them is essential for maintaining credibility. If the U.S. fails to implement Basel III, concerns over competitive fairness may push other jurisdictions to enforce stricter rules on U.S. banks operating abroad. This could weaken U.S. banks’ global competitiveness and encourage regulatory easing elsewhere, which increases systemic risk.

The March 2023 banking turmoil, sparked by the collapse of Silicon Valley Bank (SVB), revealed how quickly financial instability can escalate. Historically, major bank failures unfolded over weeks, but SVB’s downfall happened in less than a day, causing widespread stress. Since then, the Federal Reserve has worked with banks to improve their readiness for accessing emergency liquidity. This has led to a significant increase in collateral pledged to the system, enhancing financial stability. However, some institutions remain unprepared for crisis conditions, and without mandatory requirements, there’s a risk that progress could backslide.

The crisis also underscored that financial vulnerabilities in any segment of the system—not just global systemically important banks (G-SIBs)—can have widespread consequences. While regulatory efforts have strengthened the resilience of these institutions, further measures are needed. Large banks must align their capital levels with their actual risk exposure, and unrealized losses on available-for-sale securities should be factored into capital requirements. This would encourage better management of interest rate risks before they become severe.

Additionally, banks must ensure they can quickly convert assets into cash to meet liquidity needs during periods of stress. Current regulations may underestimate how certain deposits, particularly those from high-net-worth individuals and venture capital firms, behave in crises. Refining liquidity requirements to better reflect real-world deposit outflows is necessary.

Reciprocal deposit arrangements—where deposits are spread across multiple banks—have become more common as a way to mitigate risks tied to uninsured funds. However, these arrangements remain largely untested under severe financial stress. It’s crucial to assess how they might function in a crisis, as well as the operational risks involved.

Finally, improving the resolution process for banks in distress is critical. Requiring all large banks—not just G-SIBs—to issue long-term debt could provide greater stability and aid in orderly resolutions. Regulators have proposed rules on long-term debt, and after reviewing public feedback, adjustments have been made. Moving forward with these updated requirements will strengthen financial resilience.

Alongside Basel III revisions, enhanced liquidity and long-term debt standards will help close existing gaps in the regulatory framework. Additionally, banks must remain alert to ongoing risks, particularly in commercial real estate—where refinancing challenges persist—and interest rate risks, especially for institutions with high levels of uninsured deposits.

Completing these reforms will ensure a more stable and resilient financial system, better equipped to withstand future shocks.

 

Upholding the Integrity of Stress Tests

The Federal Reserve’s annual stress tests remain crucial in maintaining confidence in the financial sector. These tests played a key role in stabilizing banks after the Global Financial Crisis and continue to be an essential tool in assessing vulnerabilities and ensuring banks maintain adequate capital reserves to withstand financial shocks.

In December, the Board announced major changes to stress tests, aiming to enhance transparency while reducing capital volatility in response to legal developments. While increasing transparency is necessary, it must be carefully managed to avoid unintended consequences.

First, regulators must prevent stress test modifications from leading to lower capital requirements. During the Basel III process, banks frequently challenged elements that raised capital requirements while downplaying those that underestimated risks. Their feedback should be considered, but adjustments must avoid underestimating systemic risks.

Second, greater transparency may allow banks to manipulate their portfolios to optimize test outcomes without actually reducing risk. If institutions exploit the disclosed models to minimize required capital levels, the effectiveness of stress testing as a risk management tool will diminish.

Third, complete transparency could discourage banks from investing in independent risk assessment while increasing system-wide concentration in assets deemed favorable under stress test models. Additionally, banks might reduce capital buffers beyond the minimum requirement, increasing vulnerability during crises.

Finally, maintaining a dynamic and relevant stress test framework is crucial. Given the evolving financial landscape, stress test models and scenarios must be regularly updated. However, an overly rigid rulemaking process may hinder necessary adjustments, reducing the stress tests’ effectiveness. To address this, the Fed has incorporated exploratory scenarios, which were first introduced during the pandemic and are now a regular part of testing. Though not binding, these scenarios provide valuable insight into potential risks.

To further enhance capital resilience, the Fed should retain its authority to impose firm-specific capital requirements based on supervisory discretion, similar to the Basel “Pillar 2” approach used internationally. As stress test adjustments move forward, maintaining robust oversight will be essential.

Strengthening Supervision for Financial Stability

Maintaining effective supervision is another critical aspect of financial stability. While efforts to streamline regulatory processes are worthwhile, they must not compromise the ability of supervisors to act decisively when risks emerge.

A proactive approach to supervision helps address vulnerabilities early, reducing the likelihood of crises that could threaten financial stability. Efforts to improve efficiency should focus on better prioritization of risks rather than restricting examiners’ ability to identify and escalate concerns.

The collapse of SVB serves as a cautionary tale. The Federal Reserve’s Office of Inspector General found that inadequate examiner resources and expertise contributed to supervisory failures. While some issues were identified, examiners lacked the ability to enforce corrective actions in time. The Fed has since taken steps to strengthen its oversight, but further investments in examiner capacity and support are needed to ensure swift and effective intervention when risks arise.

Promoting Responsible Financial Innovation

Innovation in financial technology has the potential to enhance efficiency and accessibility. Blockchain technology, for example, could revolutionize banking by reducing costs and improving transaction speed. However, such advancements also introduce new risks that must be managed responsibly.

Crypto-assets, in particular, present unique challenges due to the lack of traditional investor protections. Regulatory safeguards are essential to address risks such as mismanagement of client funds, misinformation, fraud, and misleading claims regarding deposit insurance. Additionally, the pseudonymous nature of crypto transactions makes them attractive for illicit activities, including money laundering and terrorist financing. While industry-led efforts to mitigate these risks are promising, regulatory oversight remains necessary.

To support responsible innovation, the Federal Reserve has established the Novel Activities Supervision Program, which helps banks navigate technological advancements while ensuring risk management remains a priority. This balanced approach will be key to harnessing the benefits of financial innovation without compromising stability.

 

Addressing Cyber and Third-Party Risk

Cyber threats from both nation-states and independent actors have become a significant concern for the banking sector, necessitating stringent oversight by regulators. Last summer’s disruption caused by a third-party security provider underscored the vulnerabilities inherent in outsourced security systems. A failure in one of these critical services can impair a bank’s ability to perform essential functions, jeopardizing both individual institutions and the broader financial system.

Given the concentration of the IT industry, operational failures within a single entity can have widespread repercussions, regardless of the root cause. Moreover, advancements in artificial intelligence present both risks and opportunities—bad actors can leverage AI for cyberattacks, while financial institutions can employ it to bolster their security measures. Both banks and the Federal Reserve must continue investing in cyber resilience to safeguard financial stability.

 

Risks in the Nonbank Sector

The growing role of nonbank financial entities—including hedge funds, private credit firms, and insurance companies—poses emerging risks to the financial system.

Starting with hedge funds, banks’ exposure to these entities has increased significantly, while hedge fund leverage remains near historic highs. The collapse of Archegos highlighted the risks associated with hedge funds and their deep interconnectedness with banks. Recent stress test analyses indicate that banks have substantial exposure to hedge funds under certain market conditions, with counterparty risk varying depending on specific financial shocks.

One notable trend is the expansion of the Treasury cash-futures basis trade, which enhances liquidity and price discovery under normal conditions. However, this practice involves high leverage, making it susceptible to rapid unwinding and market instability, as observed in early 2020. While margining practices and risk management should theoretically mitigate these risks, individual firms do not fully account for the broader market impact of their actions. Regulatory intervention, such as mandating central clearing for Treasury trades, is crucial in ensuring market resilience. Additionally, efforts should focus on closing loopholes in margin collection and refining banks’ credit risk management strategies with hedge fund counterparties.

The private credit sector has also expanded rapidly, now comparable in scale to the high-yield bond and leveraged loan markets. Traditionally, private credit operates with limited leverage and long-term funding, reducing its susceptibility to sudden deleveraging. However, the sector’s opacity and rapid growth introduce new risks, particularly as connections between banks and private credit firms deepen. The accessibility of private credit to retail investors through mutual and exchange-traded funds raises concerns about liquidity mismatches, which have historically contributed to financial instability.

The insurance industry presents additional systemic risks. Many households rely on life insurance companies for retirement security, making these firms critical to long-term financial planning. While insurers are designed to be patient investors, they may be tempted to take on excessive risk, sometimes beyond what policyholders and regulators anticipate. A significant shift is occurring as private equity firms increasingly acquire life insurance companies, leading to greater reliance on nontraditional liabilities that may prove unstable in times of financial stress. Unexpected losses in the insurance sector could exacerbate a credit crunch during economic downturns, warranting close regulatory monitoring.

 

Climate Risk

Financial regulators must continue addressing the risks posed by climate change. The Federal Reserve is responsible for identifying emerging threats to financial stability, including those stemming from natural disasters.

The recent California wildfires serve as a stark reminder of the challenges facing insurance markets in an era of more frequent and severe climate events. These disasters have caused devastating loss of life and economic hardship, with financial losses ranking among the most severe on record. Similarly, the flooding caused by Hurricane Helene exposed significant gaps in flood insurance coverage.

The regulatory framework governing insurance markets often prevents proper risk pricing, limiting market signals that could encourage climate adaptation and mitigation strategies.

There is also uncertainty about whether private capital will be sufficient to absorb the rising costs of natural disasters. The Federal Reserve’s role in climate risk management is specific but vital—it must assess the potential impacts of climate change on bank stability and overall financial resilience. The pilot climate scenario analysis conducted by the Fed was a key step in evaluating how the largest banks could withstand climate-related shocks.

Moving forward, clear guidance for major financial institutions will remain essential in promoting sound risk management practices tailored to evolving climate threats.

 

Conclusion

The United States benefits from a strong and dynamic economy, the world’s most liquid markets, and the global prominence of the U.S. dollar. The Federal Reserve plays a critical role in sustaining this strength by ensuring a stable and resilient financial system.

Predicting financial shocks and their impact is inherently challenging. Therefore, robust regulation and supervision act as necessary safeguards to protect households and businesses from systemic risks.

 

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