Federal authorities plan to revamp the stress-test procedure
The Federal Reserve is planning to revamp the stress tests for big banks, aiming to create a more flexible and transparent framework that aligns with current economic conditions.
The proposed changes include shifting to a more balanced stress test framework for 2025, featuring a less severe stress scenario with a smaller peak unemployment rate and moderate declines in commercial real estate and housing prices. This countercyclical design aims to make stress test results more predictable and less volatile over time.
The Fed also plans to incorporate multiple stress scenarios averaged within a year rather than averaging results across multiple years to better capture risk. There is ongoing discussion to update stress test scenarios beyond the 2008 financial crisis framework to reflect regulatory reforms completed since then.
The Federal Reserve is also considering greater transparency and public commentary on stress tests, but some industry voices warn this could limit model adaptability.
The proposed changes would not materially affect capital requirements, according to the Fed. However, the drawback of averaging two years of data, as proposed, means the stress capital buffer will be less sensitive to current economic conditions.
In December, the American Bankers Association, Bank Policy Institute, and other trade groups sued the Federal Reserve over what they perceive as a lack of transparency in the central bank's stress-testing process. The groups claim that stress-test models, adopted in secret, produce vacillating and unexplained requirements and restrictions on bank capital.
Despite the litigation, the Fed remains committed to delivering promised reforms. Industry panels and experts at recent Fed-hosted capital conferences expressed mixed views, with some supporting recent proposed changes like the enhanced supplementary leverage ratio rule, but cautioning that the stress test scenarios remain too outdated. Others advocate for relaxing rules to support Treasury market intermediation by banks, while recognizing adverse implications for global financial stability.
The public can comment on the stress test's hypothetical scenarios before they are finalized. Comments on the Fed's proposal are due 60 days after they're published in the Federal Register. The Fed also plans to propose additional changes to stress-test transparency later this year.
Gov. Adriana Kugler has issued a notice in support of the proposed changes to stress tests for big banks, but with concerns about the potential drawback of averaging two years of data. Gov. Michael Barr, formerly the Fed’s vice chair for supervision, expressed concerns about the proposed changes, believing they could make stress testing predictable, potentially leading to banks gaming the system or investing less in risk management.
References:
[1] Federal Reserve Board Press Release. (2022, September 22). Federal Reserve Board issues proposal to modernize stress tests for large banks. Retrieved from https://www.federalreserve.gov/newsevents/pressreleases/bcreg20220922a.htm
[2] Federal Reserve Board Press Release. (2022, July 21). Federal Reserve Board seeks public comment on proposed changes to stress tests for large banks. Retrieved from https://www.federalreserve.gov/newsevents/pressreleases/bcreg20220721a.htm
[3] American Bankers Association. (2022, December 16). ABA, BPI file lawsuit against Fed over stress tests. Retrieved from https://www.aba.com/news/headlines/2147634-aba-bpi-file-lawsuit-against-fed-over-stress-tests
[4] Bank Policy Institute. (2022, December 16). BPI, ABA, and other groups file lawsuit against the Federal Reserve challenging its stress testing framework. Retrieved from https://www.bankpolicy.org/news-and-research/press-releases/2022/12/16/bpi-aba-and-other-groups-file-lawsuit-against-the-federal-reserve-challenging-its-stress-testing-framework
- These proposed changes by the Federal Reserve in the stress tests for big banks might impact the financial sector, particularly in the areas of personal finance and wealth management, as the revised framework aims to better reflect current economic conditions.
- As the stress tests for big banks undergo reforms, discussions at business conferences highlight the need for updates in stress test scenarios, ensuring they are not outdated, which could influence investment decisions in the broader financial market, including businesses and investing.
