BPI Statement on Stress Tests

Washington. D.C. – The Bank Policy Institute issued the following statement on the 2024 stress tests:

“Yesterday, it was widely noted that the nation’s largest banks had passed the Federal Reserve’s stress test. This reflects a continuing misunderstanding of that test, which is unsurprising, given its opacity and complexity.

Since 2020, the results of that test have not been a one-time pass-fail grade; instead, the stress losses are used to calculate an additional binding capital charge on the covered banks. The result of this year’s test is an increase in capital requirements for over half of the banks; about one-third of the banks see capital requirement increases of 70 basis points or more; five banks show capital requirement increases exceeding 200 basis points. And the rationale for these increases is very difficult to discern, given the secrecy of the Federal Reserve Board models used to calculate the charge.

A bank ‘passing’ the test simply means that it is not required to raise capital or shrink assets immediately, and in that sense, banks ‘passed’ the test.  But banks passed because they now all hold large excess capital as an uncertainty buffer given the randomness of each year’s test results. Note that for those banks that did not see capital increases, that buffer was held for no reason; that capital could have been allocated to fund a larger number of loans; presumably much of it will now be used for share repurchases.”

In addition, this year’s stress test results show why transparency is needed, a new BPI analysis explains.

Yesterday’s results reveal significant challenges that need to be remedied. These results demonstrate the necessity of transparency in stress test models and scenarios and the opportunity for public comment, a key theme of testimony at a House hearing this week by BPI’s Francisco Covas.

The challenges: A significant problem area is the Fed’s projection of net revenues, a major component of banks’ stress test performance. The Fed fails to disclose the details of its modeling methods and relies on aggregated models that assign disproportionate importance to recent bank performance. As these revenues fluctuate year over year, so do the Fed’s stress projections, creating large swings in banks’ capital requirements and making it hard for them to allocate capital efficiently. Ultimately, uncertainty in capital requirements reduces lending and banks’ participation in capital markets activities. Moreover, the substantial increases in capital requirements for subsidiaries of foreign banks operating in the U.S. raise questions about the consistency and fairness of the stress testing process across different types of banking institutions.

Public input: As noted in BPI’s testimony, allowing public comment on scenarios and supervisory models would enable extensive review by experts, academics and banks. This would make the scenarios more transparent, the models more accurate and ultimately, the financial system better equipped to serve the U.S. economy’s needs.


In case you missed it:

Here are some key highlights from Covas’ testimony this week.

  • Significant overlap: The stress tests already account for operational risk and market risk, two key risk areas covered by the Basel III Endgame capital proposal, Covas noted. The stress tests’ Global Market Shock covers market risk, he noted in response to Rep. Andy Barr (R-KY) at the hearing. The Basel proposal and the stress tests therefore account for some of the same risks. “They effectively are a double count in the sense that they are requiring banks to hold capital for exactly the same types of risks,” Covas said. He noted the need to “look holistically at the requirements” and to adjust the Global Market Shock.
  • The costs of uncertainty: In response to Rep. Bill Posey (R-FL), Covas explained how uncertainty in capital requirements from stress test volatility can lead to underinvestment in small businesses. “In the face of this uncertainty, the banks just decided to underinvest in activities … that are more cyclically sensitive, namely small businesses and lending to households with less-than-pristine credit scores,” Covas said. In a separate exchange, Covas said the stress-test uncertainty that drives banks to hold extra buffers of capital “will reduce credit availability and provision of capital to markets.”
  • Violating the law: Rep. John Rose (R-TN) asked if the failure to solicit public comment on stress test models and scenarios violates administrative law. The stress capital buffer is effectively a capital requirement, and therefore a rule that should be subject to the same notice and comment requirements as the Basel Endgame proposal, said Covas.
  • Lack of data: Covas also discussed ways to enhance the transparency and granularity of the Fed’s stress test models. “A lot of the issues are due to the lack of data that the Fed is using,” Covas said. “I think the banks have much more, better data and more experience, and there could be dialogue similar to Basel Endgame where the Fed receives comments from the industry and from subject matter experts that leads to improvement of the models.” In response to Rep. Roger Williams (R-TX), Covas observed that volatility in the stress test results can stem from the lack of granularity in the models. “Because they are based on data that’s not very granular, the results change significantly from one year to the next,” Covas said.
  • Due process: Banks have made eight requests for reconsideration since the stress capital buffer was put in place in 2020, Covas said, and the apparent denials of these requests suggest a lack of due process. “There’s no explanation of how those reconsideration requests are currently being addressed,” Covas said.

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About Bank Policy Institute.

The Bank Policy Institute is a nonpartisan public policy, research and advocacy group that represents universal banks, regional banks and the major foreign banks doing business in the United States. The Institute produces academic research and analysis on regulatory and monetary policy topics, analyzes and comments on proposed regulations, and represents the financial services industry with respect to cybersecurity, fraud, and other information security issues.

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