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The Federal Reserve is considering introducing “major changes” to the annual stress tests it conducts for major US banks, which would reduce the volatility of the test results and make the process more transparent.
The Fed did not provide a detailed accounting of the changes, but said it could adjust models that calculate banks' default losses, averaging results over two years to reduce the risk of large year-over-year fluctuations, and allow the public to comment on default expectations. Scenarios every year before finalizing them.
The Fed said the goal of the changes is not to “materially impact overall capital levels.”
“The administrative law framework has changed significantly in recent years,” the Fed said in a statement. “The Board analyzed the current stress test in light of the evolving legal landscape and decided to modify the test in important aspects to improve its flexibility.”
The Fed said the renewal came in response to recent changes to the administrative law framework, which was upended earlier this year by the US Supreme Court's decision to strike down what was known as “Chevron deference.” This ruling curbed the freedom of federal agencies to formulate rules and regulations.
The transparency of the test and its uneven results were areas of frustration for the banking industry. The Banking Policy Institute, an industry lobby group, welcomed the Fed's announcement as a step toward “transparency and accountability.”
The stress test is an annual exercise for the largest US banks, including JPMorgan Chase and Goldman Sachs. Their businesses are put through a series of doomsday scenarios to calculate the appropriate capital requirements for each lender. Capital is used to absorb potential losses.
The test was vital in restoring confidence in the banking sector following the 2008 financial crisis. However, much of the drama has been lost in recent years, as banks have easily emerged from hypothetical scenarios with sufficient capital. Bank executives also criticized the tests for being too vague and producing highly volatile results.
Earlier this year, Goldman became the first US bank to do so challenge successfully Fed on stress tests and winning capital requirement reductions as a result.
The changes to the stress test could be another victory for the banking industry, which is already hoping for a less onerous application of the so-called End of Basel III Capital rules in the second Trump administration.
The initial plan for Basel reforms was announced last year by Fed Vice Chairman Michael Barr, but was scaled back in response to resistance from the banking industry. Its final outcome will be affected by the incoming Trump administration.
