Fed Governor Recommends Alternative to Proposed Stress Test Changes

Federal Reserve Governor Michael S. Barr argued that current proposals to alter the stress testing framework would weaken it as a tool for supervision over large banks. He offered an alternative path, recommending that stress test results be decoupled from binding capital requirements. 

In a speech before the Peterson Institute for International Economics, Mr. Barr argued that stress tests are central to evaluating bank resilience. He credited the process with motivating large banks’ to more than double their equity capital ratios and strengthening the ability of banks to measure, monitor, and manage risks. He emphasized that the credibility of the framework rests on severe, but plausible scenarios, independent Fed modeling, disclosure of results, and supervisory assessments of banks’ capital planning. He added that the Fed increasingly uses multiple scenarios—such as stagflation and large nonbank failures—to capture evolving risks.

To address allegations by banking associations that the tests were opaque and unpredictable, Mr. Barr said the Fed proposed altering the stress testing framework by (i) subjecting models to public comment and (ii) averaging results over multiple years. However, he warned that these steps might ossify assumptions, invite gaming by banks, and reduce incentives for strong risk management. He cautioned that full transparency of models would be like "handing out ... the test in advance," undermining the rigor of the test. He also warned that such changes could blur early warning signals and erode the credibility of the tests as indicators of systemic resilience.

Mr. Barr offered an alternative path, urging that stress test results be decoupled from binding capital requirements. He argued that treating stress tests primarily as a supervisory tool would preserve their rigor and flexibility, while capital levels could be set through regulation. He proposed retaining authority to impose individualized capital requirements in exceptional cases, similar to the United Kingdom’s Pillar II-B framework. He suggested this approach would maintain the dynamism of stress testing and ensure banks remain adequately capitalized to withstand future shocks.