How A Federal Reserve Practice Can Help Your Personal Finances

by Guest on July 28, 2013

federal reserveDriving along a wooded section of Florida highway, I noticed a haze of smoke among the trees and wasn’t sure what I was witnessing. A specific area of the forest had been burned, with care to preserve the trees but to destroy the undergrowth. I turned to my outdoorsy father-in-law in the passenger seat and asked him about the purpose of the intentionally set fires. He explained: “They help prevent bigger fires.”

In Florida, as well as in other dry parts of the country, wildfires happen regularly and sometimes spread uncontrollably. The additional fuel of the undergrowth not only extends their range, but also increases the temperature at which they burn, making them far more deadly for responders. By stress testing various tracts of woodlands for the potential of a fire, private landowners or Forestry Services can determine which, if any, preemptive measures should be taken to reduce the risk and frequency of wildfires.

In the banking world, the Fed is seeking to employ a similar strategy in order to prevent a recurrence of the 2008 “wildfire”. By observing historical data in order to measure relevant variables like the Probability of Default of a given financial institution, the Fed can perform stress tests in order to determine where and when to take minor actions (setting brush fires) so as to avoid major catastrophes. While those minor actions tend to be regulatory, and thus highly politicized and hotly debated, the model of stress testing is a practical one for application in our personal financial lives.

Just as stress testing can increase a forest’s ability to withstand the shock of a lightning bolt or severe drought, and help a banking institution endure the shock of popped financial bubbles, so too can it help an individual endure the shock of various circumstances that could be otherwise financially disastrous. The loss of a job, the death/injury of a friend or family member, or a bad investment are all realistic possibilities that it would be wise to test against.

Stress testing should take the form of examining a range of possible “what-ifs” and determining their likelihood, and then taking specific actions based on those conclusions. I’m not advocating for an increase in general anxiety, but rather pointing out that a personal or family plan will help keep burdens from being needlessly multiplied if and when adversity comes. Here are a few questions to ask for starters:

  • You are considering buying a house this year instead of next year by scraping together every last dime and utilizing all of your savings. What if your hot water heater broke or other expensive household item broke in the first month of ownership?
  • You own a mortgage and are considering a job change that would reduce your take home pay: would you be able to afford your mortgage payments with the change? Would you be able to sell your house if you needed to, and for a high enough amount to cover your remaining loan balance given current housing prices?
  • For those about to retire: do you have any outlets to find a job or additional income if the stock market tanks and the value of your portfolio decreases? If you have a longer life expectancy (genetically speaking), a little decline in your retirement payouts could make it difficult to afford essentials over a longer period of time.
  • For those currently financing kids’ college: what would happen to your child’s college funding in the event of a surprise medical cost? Would you make him or her sign up for a student loan? Transfer to a cheaper school? Preparing your children for these possibilities is a good idea, and it will teach them gratitude for any help you give them;
  • How much of your income is going to debt payments? Are you tapping into savings to afford paying back loans?;
  • What would happen if you lost your job? How long would you be able to pay bills before going broke or having to ask for help?

There are many other stress test questions you could and should ask of your personal financial situation, and on a regular basis. This exercise will help you clear the flammable brush of financial dangers, so to speak, and significantly reduce the risk of unmanageable financial wildfires in your future.

About The Author

Patrick writes for DepositAccounts.com, a website that monitors products and rates at more than 7,500 banks and credit unions and that pairs that information with comprehensive commentary, reviews, tools, and community forums to equip and guide depository banking consumers.

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