Governor Bowman Calls for Changes to Bank Stress Testing

Federal Reserve Board Governor Michelle W. Bowman called for a "fundamental rethink" of the Fed's stress testing framework and the Stress Capital Buffer ("SCB") requirements for large banks.

Speaking at a meeting of the Executive Council of the Banking Law Section of the Federal Bar Association, Governor Bowman emphasized the need to reevaluate key aspects of the stress testing program, given the increasing complexity of large financial institutions. She identified four primary areas of concern: (i) excessive volatility in year-to-year stress test results, (ii) a lack of transparency around the models used in testing, (iii) the short compliance window for adjusting to new capital requirements and (iv) overlap with other regulatory frameworks such as Basel III.

• Volatility in Stress Test Results. Governor Bowman noted that significant year-over-year volatility in stress test outcomes complicates banks' capital planning and long-term risk management. While some variability is expected as economic conditions and business models shift, she warned that excessive unpredictability in results leads banks to hold unnecessarily high capital buffers, driving up costs and distorting decision-making. She suggested reforms such as averaging stress test results over multiple years or constraining annual scenario variability to reduce this volatility.
• Lack of Transparency in Stress Testing Models. Governor Bowman criticized the opacity of the stress testing models, which frustrates banks' efforts to anticipate outcomes and manage their capital efficiently. She called for greater disclosure of the underlying models used in the stress tests, arguing that this would enable banks to better allocate capital and manage risk. She pushed back against the argument that transparency would lead to "gaming" of the system, emphasizing that regulatory oversight and dynamic adjustments would prevent this from undermining the tests.
• Short Compliance Time Frame for Capital Adjustments. Governor Bowman highlighted the practical difficulties caused by the brief window that banks are given to comply with new capital requirements once stress test results are released. She argued that longer compliance timelines would help banks adjust without having to disrupt their long-term capital planning processes. The current short compliance period, she suggested, exacerbates the impact of year-to-year volatility in stress test results.
• Regulatory Overlap with Basel III. Governor Bowman pointed to overlapping regulatory frameworks—specifically, the interaction between stress testing requirements and the Basel III market risk rules—as another area in need of reform. She warned that such overlaps risk over-calibrating capital requirements, particularly in areas like market-making and trading activities, potentially stifling the role of US capital markets in the global economy.

Governor Bowman acknowledged the importance of stress testing as a supervisory tool but urged regulators to address these deficiencies to enhance the resilience and efficiency of the banking sector.