Fed to Propose "Significant Changes" to Bank Stress Tests, Trade Groups Sue
Commentary by Sebastian Souchet
The Federal Reserve Board said it will "seek public comment on significant changes to improve the transparency of its bank stress tests and to reduce the volatility of resulting capital buffer requirements." Following the announcement, bank trade groups sued the agency over a "lack of transparency" in the stress testing process.
In a press release, the FRB said that "the Board 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." The FRB intends to propose changes that include, "disclosing and seeking public comment on all of the models that determine the hypothetical losses and revenue of banks under stress; averaging results over two years to reduce the year-over-year changes in the capital requirements that result from the stress test; and ensuring that the public can comment on the hypothetical scenarios used annually for the test, before the scenarios are finalized." The FRB emphasized that the "proposed changes are not designed to materially affect overall capital requirements."
The FRB said it plans to (i) continue its exploratory analysis ("which assesses additional risks to the banking system in ways that are separate from the stress test"); (ii) take immediate steps to reduce the volatility of the results and begin to improve model transparency; and (iii) seek public comment during the early part of 2025.
The Bank Policy Institute, Ohio Chamber of Commerce, Ohio Bankers League, American Bankers Association and Chamber of Commerce sued the FRB over a "lack of transparency" in the stress testing process. The Complaint, filed in the US District Court for the Southern District of Ohio, alleged that the FRB's process for conducting bank stress tests violates the APA by failing to: (i) subject the scenarios and models to notice-and-comment rulemaking and (ii) publish the rules and methodologies, leaving regulated parties without fair notice of the standards applied. Additionally, the Associations claim that the process lacks transparency and imposes arbitrary capital requirements, causing significant financial and operational burdens.
Commentary
The Associations indicate that they filed the suit, in part, as a way to preserve their ability to challenge the FRB's stress test framework; the six-year statute of limitations to challenge the framework expires in February, 2025.
The opacity of the stress testing framework has been a longstanding issue. The FRB finally appears ready to address it. FRB Governor Michelle Bowman has repeatedly highlighted a number of policy concerns, including the volatility of year-to-year results and regulatory redundancy with other bank capital requirements. In seeking to reform the stress testing framework, policymakers at the FRB have the opportunity to consider not only the issues raised in the plaintiffs' Complaint, but the important policy concerns raised by Governor Bowman.
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Federal Reserve Board Governor Michelle W. Bowman called for a "fundamental rethink" of the Fed's stress testing framework and the Stress Capital Buffer requirements for large banks.