Fed finalizes stress test reforms, takes comment on scenarios

• Key insight: Federal Reserve Vice Chair for Supervision Michelle Bowman has delivered one of the banking industry's most sought-after regulatory reforms: making stress tests more transparent and less volatile. 
• Expert quote: "The stress test is an essential component of our regulatory capital framework. Today's changes preserve its resilience by ensuring that it is transparent, granular, and risk-sensitive. The public will now have greater assurance that the risks banks take will be reflected appropriately in their stress test losses and their capital requirements." —Federal Reserve Vice Chair for Supervision Michelle Bowman
• Forward look: The Fed will publish stress scenarios for public comment in January and finalize them in February. 

The Federal Reserve finalized its reforms to its annual stress testing regime for large banks on Wednesday morning. 

The changes, aimed at making the yearly exercise more transparent and less volatile, come after years of advocacy by the banking lobby as well as a lawsuit filed by industry groups against the central bank in late 2024. 

Fed Vice Chair for Supervision Michelle Bowman, who has made stress testing reform a pillar of her tenure as the Fed's top regulator, said the new framework will enable stress tests to remain a central part of large bank oversight.

"The stress test is an essential component of our regulatory capital framework," Bowman said in a statement released alongside the finalized rule. "Today's changes preserve its resilience by ensuring that it is transparent, granular, and risk-sensitive. The public will now have greater assurance that the risks banks take will be reflected appropriately in their stress test losses and their capital requirements." 

The new framework will see stress scenarios and models published annually and opened to public comment. The Fed will subject banks to two separate stress scenarios each year and average results over a two-year period to reduce volatility. As part of its reform effort, the Fed will also use exploratory stress tests as well as internal bank stress tests to shape supervisory priorities. 

The Bank Policy Institute and the American Bankers Association lauded the framework as a needed upgrade to the program.

"Transparency and public input have produced a better stress testing framework that should improve accuracy and allow more thoughtful capital planning at covered banks, with economic benefits to the country," the trade groups wrote in a joint statement.

The changes are not universally supported, however. Critics say publicizing stress scenarios and opening them up to public comment will result in exams that are less scrupulous while enabling banks to, effectively, game the test.

"Disclosure of the stress test models and annual public comment processes on model changes and scenarios will make the stress tests less responsive to emerging risks," Fed Gov. Michael Barr said in a statement released alongside the rule. "Calcified models will also allow banks to optimize their balance sheets to the test, rather than focusing on underlying risk."

Barr — who has been skeptical of the Fed's stress testing reform effort — was the lone vote against finalizing the proposal, which was approved 6-1 by the Fed Board of Governors. 

Better Markets, a consumer advocacy group, lambasted the new framework, arguing that it would result in testing models that are too predictable and limit the Fed's ability to respond to emerging threats.

"This is the predictable consequence of regulators prioritizing industry complaints over protecting Americans from the devastating consequences of large bank failures," Christopher Appel, Better Market's director of banking policy, said. "That approach is misguided and risks leaving taxpayers to bear the brunt of the next crisis."

Bowman has characterized the changes, particularly the publication of scenarios, as a necessary shift to keep the regime in compliance with the Administrative Procedure Act. In their lawsuit against the Fed, banks and banking groups argued that because the tests result in capital changes, they must be put through formal notice and comment processes. 

In a speech earlier this month, Bowman said the reform effort is addressing "fundamental flaws" in the Fed's approach to stress testing and bolstering it against litigation by ensuring it "complies with U.S. administrative procedure laws."

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"In an effort to address legal challenges and make overall improvements to this framework, the Federal Reserve has incorporated lessons learned from the outset of this program," she said. "Some of these have been difficult lessons, especially for an institution like the Federal Reserve Board."

Annual stress testing was a key component of the Dodd-Frank Act of 2010, the legislative response to the subprime mortgage crisis and ensuing financial crisis. In its early days, the annual stress test was a high drama moment for the nation's largest banks, some of which failed to maintain sufficient capital under the stress scenarios.

Dynamics have changed in recent years. The last time banks even came close to failing the test was in 2019, when Credit Suisse's capital plan was given a "conditional non-objection" while Capital One and JPMorganChase had to resubmit their capital plans. Yet, even as banks increasingly meet the minimum capital requirements in the test, the exam has remained a critical supervisory moment for banks. A bank can still see its stress capital buffer increased even if it maintains well above the post-stress minimum if its projected losses increase relative to the previous year. 

Because of this volatility and the fact that banks had little insight into the factors that caused their capital requirements to increase year after year, banks grew frustrated with the regime. 

"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," the Bank Policy Institute said in a statement following the release of the 2024 stress 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."

One of the concerns about the Fed's new approach to stress testing is that the effort to increase transparency will undermine the effectiveness and credibility of the exams. Skeptics say banks can simply orient their holdings ahead of exam windows in such a way that they get the most favorable outcome possible. Reform proponents say this view overstates how much a bank can change its balance sheet for a moment in time snapshot. 

Still, to mitigate the risk of gaming or "window dressing," the new framework calls for banks to be subject to two different stress scenarios, with the more adverse scenario for each bank being factored into the calculation of its stress capital buffer. 

Barr, who served as vice chair for supervision under President Joe Biden, said he was "encouraged" by the inclusion of multiple scenarios. He also cheered the policy shift that will see exploratory stress tests used to inform bank supervision, noting that such a change was something he had "long advocated."

Still, he said changes to stress testing, some of which were implemented on a preliminary basis earlier this year, have led to the creation of models that are "less conservative." He expressed concern that the new framework could lead to the test being continually "watered down" over time.

"In sum, the final rule will significantly weaken the stress test and consequently, bank resilience," Barr said. "I have deep concerns that these changes will result in reliance on a stress test that lacks credibility and can no longer effectively assess the capital adequacy of the largest banks, thus putting our financial system and economy at risk."

Fed Gov. Lisa Cook, in a statement of her own, said she was "optimistic" that the new framework will enable the Fed to "administer a trustworthy, effective stress testing regime," highlighting the two-scenario approach as an effective defense against gaming. She also noted that the central bank has "other tools" to address "unusual or anomalous stress test results."

Still, Cook said she would be attentive to the results produced by the new stress testing framework and she would be open to further revisions if the regime's credibility wanes.

"Market confidence in the stress tests comes from the fact that the scenarios are indeed stressful. Thus, we must remain vigilant that the scenarios continue to be sufficiently rigorous to continue to warrant that market confidence," she said. "Should stress tests become less severe or overly predictable over time, we may need to contemplate other options to maintain resilience."

The new stress testing framework will go into effect on Dec. 31. The Fed will publish its next set of stress test scenarios for public comment on Jan. 10, 2027, and finalize them on Feb. 28. The deadline for banks to submit their capital plans and company-run stress tests will be April 30, and the final models for the Fed's exam will be released on May 15.

Results of the test will be disclosed on June 30, along with preliminary stress capital buffer requirements. Final stress capital buffers will be set by Sept. 30 and will be effective on Jan. 1, 2028.

Along with the finalized framework, the Fed also issued a new request for proposal to better understand how noninterest income models can be better factored into the annual exams. The public has 60 days to submit comments on that topic.