Fed urging banks to increase loan loss provisions, test discount window

The Federal Reserve is proactively working with banks to bolster their resilience in preparation for unexpected shocks to the financial system.

While US bank financial health is generally sound, the Fed is encouraging banks to implement risk management strategies as it monitors potential vulnerabilities in the financial system. This includes stress in commercial real estate (CRE) and the rapid growth of private credit, Fed Governor Lisa Cook said during a presentation at the Brookings Institution.

"The key is to check the shock absorbers on the car and make sure that it can make the drive," Cook said.

The Fed is specifically pushing banks to increase their loan loss provisions, Cook said. US bank credit provisions rose sharply in 2023 as banks predicted continued credit normalization and elevated risk. Still, many banks reported lower-than-expected provisions in the first quarter.

Having proper provisions is particularly important for banks with high CRE concentrations as work-from-home trends and reduced office usage have led to pressure in bank CRE portfolios in the wake of the pandemic.

The regulator said she views the CRE risk as sizable but manageable, and that the Fed will continue to monitor the sector in the short and medium term.

Additionally, the Fed is encouraging banks to pre-position collateral at the Fed discount window so they can quickly access liquidity when they need it, Cook said.

While banks have been hesitant to utilize the discount window due to the stigma that doing so is a sign of trouble, more banks did begin to following a string of bank failures in the spring of 2023. In recent months, regulators have floated ideas to reduce the stigma, such as adding discount window borrowing to banks' liquidity requirements or crediting them for discount window borrowing capacity in their liquidity coverage ratios.

The Fed is also looking out for emerging vulnerabilities in the financial system such as the rise of private credit, which could be a sign of weak underwriting or excessive risk appetite, Cook said. Private credit has quickly gained market share on banks in recent years. Therefore, the Fed will continue to monitor private credit's interconnectedness with the rest of the financial system, the regulator said.