The Federal Reserve’s annual stress tests are under scrutiny as major banks claim the central bank’s lack of transparency into the test’s process and criteria violates the Administration Procedure Act.
The Federal Reserve’s Annual Bank Stress Tests Come Under Stress
A group of major banks have taken issue with how the Federal Reserve conducts its annual stress tests, alleging that the central bank’s lack of transparency into the test’s process and criteria violates the Administration Procedure Act.
The Purpose and Process of Stress Tests
The Federal Reserve conducts a stress test on about 30 U.S. banks every year to evaluate their ability to withstand economic crises. This is done by using hypothetical scenarios such as when the unemployment rate rises to 10 percent and housing prices drop 40 percent. Banks are asked to submit detailed data about their liquidity levels, loan and deposit, and asset holdings.
The Plaintiffs’ Concerns
The Bank Policy Institute, a trade organization representing major banks like JPMorgan Chase, Citigroup, and Goldman Sachs, has filed a lawsuit against the Fed jointly with several other organizations. The plaintiffs argue that the Fed should publicly disclose any changes to its stress tests and solicit public input before making those changes.
They also claim that the current process is opaque and allows for regulatory manipulation. For example, under U.S. accounting rules, banks report HTM securities at their principal value rather than the market value. This can lead to a situation where a bank needs to cash out these securities when their market value is significantly lower, rendering them unable to raise sufficient funds.
The Impact on Banking Regulation
The lawsuit comes after the Supreme Court repealed the “Chevron doctrine” in June 2024, which curtailed federal agencies’ ability to use reasonable discretion to interpret ambiguous U.S. law to write regulations. This has led to a renewed focus on transparency and public input in banking regulation.
In response to the plaintiffs’ concerns, the Fed announced that it would seek public comment on significant changes to improve the transparency of its bank stress tests. While the plaintiffs do not oppose stress testing or capital requirements, they welcome this move as a step towards greater transparency and accountability.
The Need for Reform
The collapse of Silicon Valley Bank in March 2023 highlighted the need for reform in banking regulation. A post-mortem report by the Fed noted that it must strengthen its supervision and regulation, specifically pointing to the treatment of HTM securities in standardized liquidity rules and internal liquidity stress tests.
Experts like Kim Schoenholtz, former Citigroup global chief economist, argue that banks should be required to mark-to-market for regulatory purposes. This would help regulators identify at-risk banks more effectively and prevent similar collapses in the future.
