BPI’s Francisco Covas in Congressional Testimony: Stress Tests Need More Transparency

Washington, D.C. — Bank Policy Institute Head of Research Francisco Covas will testify today at a House Financial Services Committee subcommittee hearing on the Federal Reserve’s stress tests. The Fed’s stress test models and scenarios should undergo public notice and comment, Covas said in the testimony. The status quo — opaque models, uncertain inputs and volatile results – imposes costs on the economy: fewer loans available for small businesses and other customers, slower employment growth, less market liquidity and a less efficient allocation of capital by banks across the U.S. economy. 

“The lack of transparency in the Fed’s stress-testing regime imposes significant economic costs. These include reduced credit availability, slower employment growth and decreased market liquidity. By allowing public comment on scenarios and supervisory models, policymakers can mitigate uncertainty and promote a more effective financial system that better serves the needs of the U.S. economy.” – Francisco Covas, BPI Executive Vice President and Head of Research

Here’s the background: The Fed’s stress tests consistently demonstrate that large banks are well capitalized and able to support the economy through both good times and bad. The tests determine the stress capital buffer, part of large banks’ minimum capital requirements. Given its far-reaching economic implications, the stress testing regime deserves public transparency through the notice and comment process, a legal requirement the Fed currently does not meet.

  • How they work: Stress tests evaluate large banks’ resilience to hypothetical adverse scenarios, such as a severe recession. The Fed projects bank performance under these stress scenarios. The results of these tests are used to set bank capital requirements, which banks then use to allocate capital across different business lines and products, such as mortgages and providing debt and equity for U.S. corporations.
  • Uncertainty costs: If the performance of banks in the stress tests is too uncertain, banks may allocate capital in an overly conservative way to ensure they can meet their requirements no matter what – in other words, they hold “uncertainty buffers.” Those can deprive businesses and consumers of the lending and capital markets intermediation that fuels economic growth.

The stress testing framework faces several challenges that can be attributed to various factors:

  • Excessive volatility in the stress capital buffer. Makes it more difficult for banks to allocate capital efficiently across various business lines if their capital requirements swing back and forth each year.
  • Lack of transparency in the models used to forecast bank performance.
  • Inaccurate and counterintuitive results produced by Fed models in the stress tests, inconsistent with real-world experience and more granular bank models.
  • Flawed reconsideration process for banks to appeal their stress test results.
  • Overlaps between the stress tests and the risk-weighted assets framework.

Bottom line: The lack of transparency in the Federal Reserve’s stress-testing process has meaningful economic costs and impedes banks’ ability to plan for the future. By injecting transparency into stress testing, policymakers can promote a more efficient, effective banking system that serves the U.S. economy’s needs, helping it grow stronger.

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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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