The Federal Reserve Board will seek public comment on changes to improve the transparency of its bank stress tests and reduce the volatility of capital buffer requirements.
The stress tests evaluate the resilience of large banks by estimating their losses, revenue, and capital levels under a hypothetical recession scenario. The capital requirements serve as a cushion to absorb losses and allows banks to continue lending to households and businesses even during a recession.
Since the stress tests were created 15 years ago, large banks have more than doubled their capital levels, an increase of more than $1 trillion.
The proposed changes seek to do several things. One is to seek public comment on all of the models that determine the hypothetical losses and revenue of banks under stress. Another is to average results over two years to reduce the year-over-year changes in the capital requirements that result from the stress test. The third is to ensure that the public can comment on the hypothetical scenarios used annually for the test, before the scenarios are finalized.
However the proposed changes are not designed to materially affect overall capital requirements.
The Fed analyzed the current stress test in view of the evolving legal landscape and determined to modify the test in important respects to improve its resiliency.
For the 2025 stress test, the Fed plans to take immediate steps to reduce the volatility of the results and begin to improve model transparency. Further, it intends to begin the public comment process on its comprehensive changes to the stress test during the early part of 2025.
The proposed changes are being challenged by a group of financial organizations, including the Bank Policy Institute, the American Bankers Association, the U.S. Chamber of Commerce, the Ohio Bankers League, and the Ohio Chamber of Commerce.
The groups are filing litigation against the Federal Reserve, challenging what they call the opaque aspects of the stress testing framework.
While stress testing is an important risk management tool for banks and supervisors, the lawsuit seeks to resolve legal violations by subjecting the stress test process to public input as required by federal law.
“For years, we have highlighted serious concerns about the stress testing framework and the need for reform,” Greg Baer, president and CEO of the Bank Policy Institute, said. “The current opaque regime, combined with the lack of clear standards for the global market shock and the operational risk charge, continues to produce capital charges that are inaccurate, volatile and excessive, resulting in reduced lending and economic growth. We appreciate the Board’s announcement as a first step towards transparency and accountability, but believe it is necessary to file this suit to preserve our legal rights.”
Without the legally required transparency that applies to other federal regulations, the stress tests amount to an illegal intervention into the cost of capital, the groups contend. In addition, although this legal action targets the stress test, its goal is not to eliminate it — only to subject its key components to the benefits of public transparency.
“While we support stress testing as an important risk management tool, ABA has long advocated for the Federal Reserve to increase the transparency of its stress testing program, which shields key components like supervisory models from public view,” Rob Nichols, President and CEO of the ABA, said. “The opaque nature of these tests undermines their value for providing meaningful insights into bank resilience. To meet federal law, the Fed should publish the supervisory models and stress scenarios and invite public comment, which would enable banks and the public to better understand and prepare for regulatory expectations, reducing uncertainty and promoting a fairer, more predictable regulatory environment. We remain hopeful the Fed will address long-standing issues with the stress tests, but this litigation preserves our ability to seek legal remedies if the Fed falls short.”