BPInsights: May 3, 2025

Stress Testing and Bank Capital: The Fed Asserts Broad New Powers

On April 29, the Federal Reserve filed a brief in litigation challenging the legality of its stress testing framework. The brief asserts that the assumptions and models that compose the stress test and produce a binding capital charges are not subject to the Administrative Procedure Act or any form of judicial review, and that Federal Reserve staff generally have the absolute and unreviewable authority to set bank capital requirements at any level they choose. The filing contradicts the Federal Reserve's earlier statements to the public and the Congress that it intended to revise its stress testing framework and make its stress test models public "[due] to [an] evolving legal landscape [and] changes in the framework of administrative law."

• The Federal Reserve's brief asserts that the 1983 International Lending Supervision Act grants it unfettered discretion, unreviewable by any court, to set capital requirements for banks on a case-by-case basis. The brief argues that, as a result, the stress capital buffer requirements that it imposes on banks - which collectively require banks to hold hundreds of billions in capital - may be determined using any process it chooses, for any reason it chooses, and without providing banks or the public with any information about how it does so.
• The Federal Reserve's brief claims, for the first time, that the stress capital charge that it imposes on banks is determined not by regulation but instead through case by case "adjudications" in which the Federal Reserve may establish, change, or ignore the scenarios, models and other standards its uses however it chooses. This claim is inconsistent with both the text of the Federal Reserve's stress testing rules and policy statements and its past statements that the scenarios, models, assumptions and other key elements used to calculate stress capital charges are forward-looking and consistent, comparable and uniform across banks.
• The Federal Reserve's legal theories are not limited to stress testing. The Federal Reserve's brief asserts it has the power to impose any type of capital requirements without judicial review or administrative procedure, so long as the Board purports to apply those requirements to individual banks through individualized "adjudications." According to that theory, the Federal Reserve could thus also impose the rules it proposed in 2023 to implement Basel III capital standards in any form it might choose without notice and comment simply by adopting those rules in secret, through the examination process, rather than proposing them publicly and allowing interested parties to comment.
• Taken as a whole, the Federal Reserve's brief lays the legal groundwork for moving the United States to the so-called "Pillar 2" approach, as employed by European regulators, where regardless of the requirements determined under applicable regulations and through stress testing (itself immune from legal process), the Federal Reserve can direct any bank to hold any level of capital it deems appropriate, without public notice and subject to no administrative process or judicial appeal. This is the approach previously advocated by Governor, then-Vice Chair, Barr.

Five Key Things

1. Warsh Calls for Narrowing Fed's 'Outsized Role'

Kevin Warsh, Shepard Family Distinguished Visiting Fellow in Economics at the Hoover Institution and a former Federal Reserve governor, decried the Fed's expanded role in recent years, called for returning the central bank to its original purpose and attributed errors in monetary policy to mission creep. "The Fed has acted more as a general-purpose agency of government than a narrow central bank," Warsh said in remarks at the IMF spring meeting on April 25. "Institutional drift has coincided with the Fed's failure to satisfy an essential part of its statutory remit, price stability. It has also contributed to an explosion of federal spending. And the Fed's outsized role and underperformance have weakened the important and worthy case for monetary policy independence."

• Imprinting: Warsh described how each Fed intervention precipitates further expansion, expressing concern that quantitative easing has become entrenched. "Immunologists describe a phenomenon where the immune system's response to a virus may impede the response to a subsequent variant. They call it immunological imprinting," he said. "I proffer a theory of economic imprinting whereby the policy choices of prior periods make the economy more vulnerable to shocks and less able to adjust organically." He also said: "Each time the Fed jumps into action, the more it expands its size and scope, encroaching further on other macroeconomic domains. More debt is accumulated…more capital is misallocated…more institutional lines are crossed… risks of future shocks are magnified…and the Fed is compelled to act even more aggressively the next time. "
• Bank regulation: The case for monetary policy independence does not extend to bank regulation and supervision. "I do not believe the Fed is owed any particular deference in bank regulatory and supervisory policy," he said. "Fed claims of independence in bank matters undermine the case for independence in the conduct of monetary policy." He expressed support for the principle of monetary policy independence while calling for accountability when the Fed errs: "I strongly believe in the operational independence of monetary policy as a wise political economy decision. And I believe that Fed independence is chiefly up to the Fed. That does not mean central bankers should treated as pampered princes. When the monetary outcomes are poor, the Fed should be subjected to serious questioning, strong oversight, and, when they err, opprobrium."
• Political distractions: Warsh critiqued the Fed's recent engagement on issues like climate change and inclusivity in employment, saying central banks should avoid extraneous political matters. "The more the Fed opines on matters outside of its remit, the more it jeopardizes its ability to ensure stable prices and full employment. And the more vulnerable it becomes to the body politic."
• Conclusion: In concluding remarks, Warsh called for a reset in the Fed's approach: "The Fed's current wounds are largely self-inflicted, and its plot armor is showing its wear. A strategic reset is necessary to mitigate losses of credibility, changes in standing, and most important - worse economic outcomes for our fellow citizens. Central bankers are trained to be careful with our critiques, lest the daylight reveal the magic. A bigger risk, however, is that of the sorcerer's apprentice: the misuse of magical powers producing trouble."

2. BPI's Sarah Flowers: Renew Tailoring, Refocus Supervision, Adjust for Economic Reality

Sarah Flowers, BPI Senior Vice President and Senior Associate General Counsel, testified this week at a House Subcommittee on Financial Institutions hearing on regulatory overreach. The hearing focused on regulatory tailoring and bank supervision. In her testimony, Flowers called for regulators to adjust key regulatory thresholds to reflect economic growth and inflation; to apply regulatory tailoring to bank supervision as well as regulation; and to refocus supervision on material risks. Flowers' testimony emphasized a fundamental disconnect: regulatory tailoring is law, but it's not reality.

• Evolving thresholds: The thresholds for regulatory requirements should be adjusted as the economy expands, Flowers said. "[R]egulations need to reflect economic reality rather than being frozen in time. There is an urgent need to index regulatory tailoring thresholds for all banks for economic growth and inflation. Regulation that fails to evolve with the macroeconomic environment constrains growth without offering an offsetting benefit. … Annually and automatically adjusting the tailoring category thresholds would prevent banks from facing more stringent regulations solely due to natural economic expansion."
• Supervision reform: Flowers called to align the CAMELS rating framework, and supervision more broadly, with the most material risks to a bank's financial soundness. "The CAMELS framework should be a framework that assesses financial condition and integrity of an institution, focusing it away on subjective measures of risk, including the minutiae that allow examiners to be at best in sort of a management consulting practice and at worst … politicizing risks, takes away from their focus on core issues of safety and soundness," she said.
• The costs of subjective supervision: Flowers and fellow witness Meg Tahyar of Davis Polk called to restore objectivity in the supervision. In her written testimony, Flowers cited an academic paper showing that "CAMELS ratings can be predicted by examiner identities and past experiences, holding bank fundamentals constant." This subjective examiner discretion is costly for banks, and therefore for the economy: "…an exogenous one-point increase in ratings due to examiner discretion causes a 24% increase in a bank's capitalization," the paper said. "Disagreement in ratings across examiners can be attributed to high average weight (50%) assigned to subjective assessment of banks' management quality, as well as heterogeneity in weights attached to more objective issues such as capital adequacy."
• Tailored vs. one-size-fits-all: Flowers stressed the need to apply tailoring principles to closed-door supervision as well as regulation. The law stipulates that regional banks should not be subject to the same requirements as the largest, most complex, globally active banks, but examiners nonetheless apply similar standards to regionals in "horizontal reviews," Flowers said.
• Other notable themes: To read more key takeaways from the hearing, click here.

3. At Bloomberg, The Cure is Worse than the (Misdiagnosed) Disease

An April 29 Bloomberg editorial claims that reform of the supplementary leverage ratio would be "irresponsible" and weaken banks by exposing them to greater Treasury risk. Leverage ratios ignore the risk of assets in assessing banks' capital adequacy and therefore strongly disincentivize the holding of relatively low-risk (and thus low-yielding) assets - a key need for banks that intermediate in capital markets, and the Treasury market in particular. Those low-risk assets include Treasury securities, and regulators and the Treasury Department are rightly concerned that market depth has not kept up with issuance and trading volume in that market. Reform to the leverage ratio would make it less likely to bind under stress conditions, and therefore make banks more willing to intermediate when markets are unstable and their services are most valuable. Read more here.

4. Fed's Financial Stability Report Highlights Treasury Market Strains

The Federal Reserve late last week released its most recent Financial Stability Report. The report highlights various risks to the stability of the financial system, from big-picture factors like geopolitical risk and inflation to strains in specific sectors or markets. As in previous recent reports, the Fed noted that the banking sector holds ample capital and liquidity and remains resilient. The Fed expressed concerns about stablecoin run risk and leverage in the nonbank sector. Other risks flagged in the report included cyberattacks, potential slowdowns in economic growth and trade policy uncertainty. The top potential shocks flagged in a survey included trade risks, policy uncertainty, U.S. fiscal debt sustainability, persistent inflation and monetary tightening and risk asset/valuations correction. Several of the same factors appeared in the same survey in fall 2024.

5. BPI Announces Heather Hogsett as New Head of BITS

The Bank Policy Institute announced this week that Heather Hogsett has been promoted to Executive Vice President and Head of BITS. Heather will assume the responsibilities of the outgoing Head of BITS, Chris Feeney, who - after 10 years - is transitioning to a new advisory role as senior fellow.

BPI President and CEO Greg Baer stated:

Heather Hogsett is a talented and trusted leader who is deeply respected among her colleagues at BPI and across the industry. Cybersecurity, fraud and scam prevention and other operational challenges remain crucial problems for our industry, and Heather's expertise will allow us to work with members and policymakers to find innovative solutions to these difficult challenges.

We're also deeply grateful to Chris Feeney for 10 years of exceptional leadership and service at BPI and other key industry initiatives, such as the Financial Services Sector Coordinating Council, fTLD and the Cyber Risk Institute. As the industry looks for innovative ways to defend against cyber attacks and fraud, Chris's keen business and operational knowledge will continue to be a major asset for BPI, BITS and our industry.

BITS is the technology policy division of BPI made up of a team of cybersecurity, fraud and technology experts. It serves as a forum for C-Suite executives, including CEOs, CIOs, CISOs and other senior leadership to advance policies and practices that maintain the safety and resiliency of the U.S. financial system.

Hogsett has been with the organization for nearly a decade and previously served as senior vice president and deputy head of BITS. She currently serves as co-chair of the policy committee for the FSSCC and as a board member for fTLD Registry Services. Before joining the organization, she served as staff director for federal relations at the National Governors Association where she was responsible for leading the NGA's federal legislative agenda. Before her time at NGA, Hogsett worked for the U.S. House Committee on Homeland Security and the U.S. Senate Committee on Homeland Security and Governmental Affairs.

Along with the announcement, BPI announced several additional staffing changes:

• Jeremy Newell will become BPI's new Head of Strategy.
• Paige Pidano Paridon was promoted to Executive Vice President.
• Tabitha Edgens was promoted to Executive Vice President
• Tonny Welling will become BPI's Chief Administrative Officer, in addition to his CFO duties.

In Case You Missed It

Op-Ed: The Private Sector, Not Government, Should Be the Driving Force in the Mortgage Market

Government-sponsored enterprises Fannie Mae and Freddie Mac were supposed to be reformed after the Global Financial Crisis, but instead stand in the way of a revitalized mortgage market led by the private sector, according to a Wall Street Journal op-ed by the Hoover Institution's John Cochrane and Amit Seru. The authors point to the dominance of Fannie and Freddie in the mortgage securitization market crowding out private lenders as well as the role of bank regulation: "Tighter bank regulation such as Dodd-Frank's ability-to-repay rule, and scrutiny by the Consumer Financial Protection Bureau, moved more business to the GSEs," Cochrane and Seru wrote. "Strict capital and liability-risk regulations-such as Basel III capital requirements and Dodd-Frank's risk-retention rules-clobbered the private securitization market." A mortgage market led by the private sector would "offer more dynamic mortgage structures-adjustable-rate options, shared-equity models, or fixed-rate loans with built-in flexibility," the op-ed argues, positing that the government takeover of mortgage finance "severely limits innovation." The authors call on the Trump administration to enact long-needed reform in housing finance.

CFPB Drops Defense in UDAAP Lawsuit

The CFPB agreed with industry group plaintiffs to abandon its appeal of a district court decision finding unlawful changes the CFPB made to its UDAAP exam manual. The changes to the manual on Unfair, Deceptive and Abusive Acts and Practices, a legal category setting out prohibited behaviors among financial firms, were challenged by the Chamber of Commerce, American Bankers Association and other groups on the grounds that they unlawfully expanded the statutory definition of "unfairness" to encompass discrimination. A federal judge granted summary judgment to the plaintiffs in 2023, and the CFPB had appealed the ruling. The joint stipulation filed by the CFPB and the plaintiffs in the appeal means that the parties agreed to terminate the case.

Traversing the Pond: What's New in International Banking Policy

Here's the latest in global bank regulation and policy.

• Simplifying ECB supervision: A group of European Central Bank officials is urging a newly formed task force on "simplifying" EU bank rules to consider changing criteria that determine if a bank merits supervision from the ECB rather than its country-specific regulator, according to Bloomberg. Such a change would likely decrease the number of banks directly overseen by the ECB. A meaningful reduction of that nature would "mark the biggest curb of the supervisory arm since it was created over a decade ago," Bloomberg reported. The considerations, and the formation of the simplification task force, come as Europe grapples with concerns about competition and economic growth amid its multiple layers of regulation.
• PRA climate consultation: Meanwhile, the UK's Prudential Regulation Authority has published a consultation proposing updates to a 2019 supervisory statement on financial firms' management of climate risks. The PRA is aiming to consolidate regulatory feedback on climate risk management and to align expectations with international standards. The effort comes as climate rules are increasingly fragmented across the global economy. The consultation was accompanied by a speech from Bank of England official David Bailey, who said the proposed revisions will "bring our guidance up to date by adding detail to those areas where our understanding of best practice has matured," such as scenario analysis, which he said will receive greater emphasis under the revised expectations.

Financial Associations Recommend Action to Remove Barriers to Digital Assets Innovation

A coalition of financial services trade associations urged the President's Working Group on Digital Asset Markets to support efforts to remove barriers to financial institutions engaging in digital asset activities. The associations include the Bank Policy Institute, American Bankers Association, American Fintech Council, Americas Focus Committee of the Association of Global Custodians, Financial Services Forum, Securities Industry and Financial Markets Association and The Clearing House Association.

In a joint letter, the associations acknowledge the meaningful progress the Federal Reserve, the FDIC and the OCC have made in rescinding policies and guidance that have hindered banks' ability to engage in digital asset activities. The associations recommend additional steps that the banking agencies can take to advance bank innovation further.

"The U.S. will not be able to achieve a leadership position in digital assets and financial technology under the status quo," the letter states. "Banks are an essential component of the financial and payments systems and are governed by a comprehensive regulatory framework carefully crafted to mitigate the risks inherent to financial activities. It is therefore critical that the federal banking agencies take further steps to facilitate banks' ability to engage in digital asset activities."

The associations made three key recommendations in the letter:

1. Create consistent rules across agencies. The federal banking agencies should coordinate to issue joint rules and guidance when possible. If joint guidance isn't possible, the agencies should at least align their policies to avoid conflicting requirements.
2. Regulate the activity, not the technology. The agencies should affirm that banks may engage in permissible banking activities regardless of the technology used. A tokenized asset is no different from the traditional form of that asset; therefore, the regulatory framework should be technology-neutral.
3. Set clear risk-management expectations. Rather than requiring individual institutions to obtain permission from their regulator prior to engaging in digital asset activities, the agencies should issue uniform expectations for how institutions should manage the risks of those activities, including anti-money laundering, capital and liquidity risks.

The associations' recommendations are aligned with the objectives outlined in the President's Executive Order on digital asset markets and build on their February 20, 2025, letter to the PWG. While the banking agencies have addressed many of the recommendations, the associations continue to urge the Federal Reserve to revise its Policy Statement on Section 9(13) of the Federal Reserve Act and to rescind SR 23-7, "Creation of a Novel Activities Supervision Program."

To access a copy of the letter, please click here.

Basis Trades, Leverage Ratios: How April 9 Changed the Treasury Market

A recent episode of Bloomberg's Odd Lots podcast explores implications for the Treasury market from the volatile events of April 9, 2025, when the 10-year Treasury yield hit a peak. Bloomberg Intelligence Chief Global Interest Rate Strategist Ira Jersey analyzed the market ructions in discussion with co-hosts Tracy Alloway and Joe Weisenthal. Jersey highlighted various aspects of recent bond market tensions, such as the role of the basis trade, influences on demand for U.S. Treasuries, geopolitical uncertainty and structural changes in the market. One factor mentioned in the interview - the supplementary leverage ratio, a crucial limiting factor in banks' capacity to make markets in Treasuries. The episode not only examines short-term dynamics such as those in early April but also long-term implications for this critical bond market.

The Crypto Ledger

Here's the latest in crypto.

• UK crypto rules: The UK plans to exempt foreign stablecoin issuers from its new crypto rules as the country seeks to align with the U.S. in digital asset regulation, the Financial Times reported. The proposed rules represent the UK's first attempt to regulate the sector. UK Chancellor Rachel Reeves has discussed the prospect of closer technology cooperation with the U.S. with Treasury Secretary Scott Bessent.
• SEC closes PayPal stablecoin probe: The Securities and Exchange Commission has dropped a probe into PayPal's stablecoin, according to Law360. PayPal reported the end of the inquiry in an investor disclosure recently. The probe was launched in November 2023, when the SEC began investigating PayPal's PYUSD token.