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The Federal Reserve is weighing “significant changes” to its annual stress tests for large US banks that would reduce volatility of tests’ results and make the process more transparent.
The Fed did not provide a detailed account of the changes but said they could amend models that calculate hypothetical losses for banks, averaging results over two years to lessen the risk of large year-on-year swings, and allow the public to comment on hypothetical scenarios each year before they are finalised.
The Fed said the goal of the changes was not to “materially affect overall capital levels”.
“The framework of administrative law has changed significantly in recent years,” the Fed said in a statement. “The board analysed 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 Fed said the revamp was in response to recent changes in the framework of administrative law, which was upended earlier this year by the US Supreme Court decision to overturn what was known as “Chevron deference”. The ruling reined in federal agencies’ latitude to craft rules and regulations.
The test’s transparency and uneven outcomes have been areas of frustration for the banking industry. The Bank Policy Institute, an industry lobby group, welcomed the Fed announcement as a step towards “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 requirement 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, in recent years it has lost much of its drama with banks typically easily emerging from the hypothetical scenarios with sufficient capital. Bank executives have also criticised the tests for being too opaque and producing results that are too volatile.
Earlier this year, Goldman became the first US bank to successfully challenge the Fed over its stress tests and win a cut to its capital requirements as a result.
The changes to the stress test could end up being another victory for the banking industry, which is already hoping for a less onerous implementation of so-called Basel III endgame capital rules in a second Trump administration.
The initial plan for the Basel reforms was announced last year by Fed vice-chair Michael Barr, but it was scaled back in response to banking industry resistance. Its ultimate outcome will be influenced by the incoming Trump administration.
