Stress Tests Create ‘False Sense of Security’: Fed’s George

It's not every day that a bank regulator argues that financial regulations and monetary policy contributed to the near collapse of the financial system.

The Federal Reserve headquarters in Washington, DC.
The Federal Reserve headquarters in Washington, DC.

But that was the heart of the speech delivered in New York City Wednesday by Kansas City Fed President Ester George.

Low interest rates sent investors on a "search for yield," George said. Banks increased the risks they were willing to take in a hunt for higher returns, she said.

George also said that financial regulations contributed to the financial crisis by creating incentives for banks to accumulate mortgage related assets. In particular, she cited Basel capital regulations that allowed banks to hold less capital against mortgage-backed securities as a source of the financial crisis. These led banks to hold very similar baskets of assets, magnifying the crisis.

The regulatory risk weights regulators assigned to mortgage-backed securitieswere too low, George argued. They "bore little relation to the losses banks took on such securities during the crisis," she said.

She warned that regulators run the risk of once again misaligning incentives and "creating standards that give institutions incentives to adopt more concentrated risk exposures."

Stress tests and sophisticated risk modeling should not replace onsite bank examinations, George said.

"The breakdown of risk models and risk-management practices during the crisis also tells me that we must not view stress tests, other forms of quantitative analysis and models used by macroprudential supervisors as being a substitute or replacement for examiners and onsite supervision," George said.

She went on to warn that stress tests could create a "false sense of security" about the financial system.

Also included in George's catalog of regulatory sources of the financial crisis were implicit guarantees of Fannie Mae, Freddie Mac and "too big to fail" financial institutions.

George said she supports Volcker Rule restrictions on trading activity by banks, saying that investment banking-like business models had made financial institutions increasingly complex and difficult to monitor.

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