Fed finalizes changes to bank stress tests

PROVIDENCE – The Federal Reserve board recently finalized changes to stress tests for the nation’s largest and most complex banks that it said will increase “transparency,” while a public interest group questioned whether the changes will make it easier for banks to pass the tests.

The changes will disclose more information to financial firms about how their portfolios would perform under economic shocks. The information would include hypothetical economic scenarios used for testing, including hypothetical unemployment rates and housing prices.

The 2019 tests will include factoring an increase in the unemployment rate to 10 percent from the current 4 percent national rate, as well as elevated stress in corporate loan and commercial real estate markets in the most severe scenario.

The Fed said the changes are intended to “improve public understanding of the program while maintaining its ability to independently test large banks’ resilience.” The transparency changes, first proposed in 2017 and finalized Feb. 5, come amid long-standing complaints from banks that the testing is cumbersome and not transparent.

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“The Fed’s rigorous and independent stress tests have been one of the most important and successful post-crash tools used by U.S. regulators. In sharp contrast, Europe has used weak, bank-friendly stress tests that all the banks pass but remain systemic threats and unable to support economic growth,” said Dennis Kelleher, president and CEO of Better Markets, a Washington, D.C.-based nonprofit promoting “the public interest” in the financial markets.

“By giving Wall Street’s biggest banks more information about the tests under the guise of ‘transparency,’ the Fed risks following the failed path of Europe and snatching defeat from the jaws of victory,” Kelleher said.

The first change, which will begin in this year’s stress-test cycle and expand in following years, will provide significantly more information about stress-testing models. Using the added information, the Fed said, a bank would be better able to evaluate the risks in its own portfolio or compare the losses from its own models to losses from the Fed’s models.

In addition, the Fed also finalized a policy statement to describe its approach to model development, implementation and validation. The statement also describes seven principles that guide stress-test modeling.

“While transparency is generally good, it will be incredibly counter-productive if it allows the banks to game the tests,” Kelleher said. “The Fed must be vigilant to ensure that this critical tool does not become ‘no-stress’ stress tests.”

Scott Blake is a PBN staff writer. Email him at Blake@PBN.com.