(Bloomberg) -- Two top former US economic policymakers sharply criticized the Federal Reserve’s 2022 stress tests of banks for failing to have probed potential vulnerabilities in the banking system to a sharp rise in interest rates.

“I don’t see how anybody last spring could have thought that the major risk was anything other than a spike in interest rates,” former Treasury Secretary Lawrence Summers said in a roundtable with Bloomberg Television’s “Wall Street Week” with David Westin. “So a process that didn’t consider it as a risk seems to me to be a profoundly problematic process.” 

While Fed officials have touted the annual stress tests as their key supervision method to evaluate the health and resilience of the country’s biggest banks, regulators didn’t model any jump in rates last year — despite the inflation surge of 2021.

Read More: Fed’s Bank Tests Overlooked Risk of Rapid Rise in Interest Rates

“You would think that interest rate-risk would have jumped to the top of the supervisory heap,” Dan Tarullo, a former Fed governor who oversaw financial regulation and supervision at the board, said in the roundtable. 

The duo also urged top US regulators to be clearer in their position on supporting uninsured depositors. Treasury Secretary Janet Yellen triggered a selloff in stocks on Wednesday when she said regulators weren’t unilaterally prepared to offer a blanket guarantee. On Thursday, she said regulators would be prepared for further steps to protect deposits if warranted.

Communication Vital

“I would be feeling my responsibility as the chair of the Financial Stability Oversight Council very strongly at a moment like this” if serving as Treasury chief, said Summers, who’s now a Harvard University professor and paid contributor to Bloomberg Television. “And I’d be thinking about making sure that, whatever I was saying and doing, I was adding to confidence rather than subtracting from confidence in the very short run.”

Tarullo, who served at the Fed from 2009 to 2017, said his conclusion was that Yellen and Fed Chair Jerome Powell have essentially communicated that regulators have the authority to insure previously uninsured deposits in failed banks.

“If that is indeed their position, if you think about it, it’s essentially the same as insuring uninsured deposits,” he said. “If that’s what you mean, why don’t you say it more clearly so that you will maximize the calming effect of whatever tool it is that you’re prepared to use?”

Summers highlighted the amplified risks of depositors being able to withdraw money via digital technology, particularly after the surge in interest rates that’s taken place.

Regulatory Overhaul

The new “high interest rate, super digital world” hasn’t been seen before, he said. “There’s a lot of reason to be open to a much wider range of possibilities about the risks associated with deposits.”

It may ultimately be appropriate to “fundamentally rethink the structure of our financial system,” Summers said, though the coming several weeks aren’t the time for that.

Read More: Citi’s Fraser Warns Mobile Money Is ‘Game Changer’ for Bank Runs

Tarullo said in the current environment, even the failure of a $2 billion bank — if uninsured depositors weren’t made whole — could “add fuel to the potential systemic fire.”

Stephanie Flanders, a senior executive editor at Bloomberg News, noted in the roundtable that some have argued the concerns about deposit flight bolster the case for a central bank digital currency. “Because then you can automatically have a claim on on the central bank for your deposits.” 

But that’s “a big leap from where we are now,” she said. “And it means a fundamental change to the model of banking that we’ve had.”

Last year’s supervisory oversight means that it wouldn’t have even made much difference if Silicon Valley Bank — which was too small to require a stress test — had been included, said Tarullo.

SVB collapsed earlier this month as depositors pulled their cash amid concern about the bank’s holdings of depreciated bonds.

“It seems almost like the supervisors were mailing it in,” Tarullo said. It was “a moment when monetary policy was turning in a dramatic way towards tightening and at a moment where the Fed had just retired the word transitory,” he said. “That’s a decision of the Board of Governors and so it rests with them.

--With assistance from Mackenzie Hawkins.

(Updates with comment from roundtable on a central bank digital currency, in fourth paragraph after ‘Regulatory Overhaul’ subheadline.)

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