Fed Stress Tests Prove Case for Barn Door Economics

Wonder of wonders, miracle of miracles, the banking system is safe and secure – from the Great Recession of 2008-09.

That is more or less the Federal Reserve Board’s assessment after the latest round of stress tests were completed earlier this year. The central bank announced the results in late June and was clearly in a celebratory mood.

“Today’s results confirm that the banking system remains strong and resilient,” said Fed vice chair for supervision Michael Barr, in a media release. Barr was quick to add the stress tests – created after the near-collapse of the global financial system a decade and a half ago as a way to move beyond the “too big to fail” regulatory response of that financial crisis.

The annual exercise tests the resiliency of large banks in a hypothetical recession and shock to the financial markets based on the individual institutions’ books at the end of last year.

In the 2023 test, the banks faced a “severe global recession” with a 40% decline in commercial real estate prices, a surge in office vacancy rates and a nearly 40% drop in housing prices. In addition, the test included a spike in the unemployment rate to double digits.

While not exactly the same scenario financial services organizations faced in 2008-09, the test parameters are close enough overall to see where the Fed got its inspiration from when creating the test. And therein lies the problem.

It is certainly reassuring to know the largest banks are on solid financial footing to withstand the kind of economic turmoil that led to the Great Recession. While more recent economic shocks may have dimmed the memory of those years, the financial meltdown was a rude awakening for many who imagined the information technology revolution had created a new economy that was able to withstand monetary shocks with nimble focus and minimal harm.

Alas, that bubble burst even faster than the housing market and reset an entire generation’s ideas about work, life and the American Dream.

But in this post-pandemic economy, people want to find some sense of normality, even if it hearkens back to darker economic times. While the economic factors that led to the Great Recession were dire, they are understandable. It is clear how the financial system, propped up by toxic mortgage-backed securities fueled by cheap money and lax lending standards, imploded. And the success of this year’s stress tests confirm that policymakers and regulators learned the lessons of the era.

But that false sense of security offers no more protection than closing the barn door after the horses run off. While there will always be some eternal economic truths, there are likely no perpetual financial solutions to panics, recessions or depressions.

And even if we remember the past, we still may be doomed to repeat it.