Stress Testing: Why It Matters

The Federal Reserve's stress tests are an important risk management tool for both banks and regulators. They identify potential vulnerabilities and ensure that banks have sufficient capital to withstand severe shocks. Stress tests involve hypothetical scenarios, but they have real economic implications as the projected capital depletion determines one of the capital buffers that large banks must maintain.

• Issues with stress tests. Until recently, the stress testing regime was flawed. The results were often inconsistent with the banks' own models and market experience; while the public had no view into the calculations behind the Fed's models, the counterintuitive outcomes suggested poor modeling choices.

A well-designed stress test benefits consumers and the economy. Well-designed stress tests detect vulnerabilities in the banking system, ensure banks have sufficient capital and can reduce borrowing costs for customers.

• Under the prior framework, the volatility and opacity in stress test results from year to year made it challenging for banks to effectively engage in capital planning, leading them to hold "uncertainty" capital buffers. This dynamic resulted in higher borrowing costs for bank customers.
• The stress tests also failed to meet a legal requirement that regulators invite public comment and "show their work" when issuing binding regulations. These stress tests are binding rules that determine bank capital requirements and must therefore be subject to public feedback. BPI filed a legal challenge in 2024 to demand transparency and objectivity in the framework, and the Federal Reserve has made a good-faith effort to reform its process.

What's happening now? The Federal Reserve just finalized rules to enhance transparency and remedy flaws in the stress testing framework. It also re-proposed certain of its pre-provision net revenue models, which examine a bank's core earnings, revenues and expenses before accounting for loan loss provisions.

• The stress test is important because it is the only part of the U.S. capital regime that looks at a bank's balance sheet at a granular level and models the risks of those assets in a comprehensive manner. Unlike all other major countries, the U.S. will soon use only standardized approaches for assigning risk weights to assets and determining regulatory capital minimums. Standardized approaches put assets into broad categories that are not very risk-sensitive.
• As a consequence of public feedback, the Fed re-proposed certain of the PPNR models - a welcome step that demonstrates the value of public comment. The Fed appropriately concluded that these models could not be fully addressed in a single rulemaking and has instead proposed further refinements for public comment. There is a range of reasonable views on how best to model PPNR, including among industry participants.

Transparency aims to fulfill legal obligations, will reduce stress test volatility and ultimately benefits bank customers.

• Transparency around the stress test scenario design process and underlying models is legally required. Both the APA and the due process clause require the government to explain its regulations. Drivers are allowed to know the speed limit. Builders are allowed to know the building codes. Taxpayers are allowed to know the tax code.
• The examination process and supervisory framework prevent banks from "gaming" the stress test by altering their balance sheets prior to the annual stress test.
• Disclosure of the stress testing models will allow banks to better understand their marginal capital requirements for specific assets, which will reduce their need to maintain uncertainty buffers. This should result in lower borrowing costs for consumers.

Dispelling myths. There are several incorrect narratives that have led to confusion about the role and value of stress tests.

The value of transparency. Transparency in stress tests is not akin to giving a student the answer key to an exam for which there are correct answers, and there is value in capital requirements being rooted in objective modeling rather than supervisory discretion.

• Decoupling the stress tests from capital requirements and converting them into a closed-door supervisory process would replace precise, risk-sensitive models with opaque supervisory judgment.
• The tests are not a simple pass-fail exercise. Even if a bank "passes," the tests still play a critical role in identifying nuanced risks and vulnerabilities.
• Public input results in better tests - ensuring that models and scenarios actually capture risks and reflect the rapidly changing financial system.
• Transparent models enable banks to plan their capital allocation and reduce uncertainty buffers, resulting in lower borrowing costs for customers.

Diversity of scenarios. The new framework will still ensure that the stress test scenarios remain dynamic year to year. However, there are only a limited number of macroeconomic drivers of significant banking system losses.

• Similarity in stress tests year-to-year is unsurprising, since the key historical drivers of economic and banking system stress are: rising unemployment, falling real economic growth, declining housing prices, widening credit spreads and falling equity market values.

The stress test scenarios produced by the Federal Reserve over the past 15 years have been consistent with such economic dynamics with differences in severity of the shocks reflecting salient risks at that time.