Summary:

Situation Overview: The Federal Reserve Board is considering significant changes to bank stress tests

What: The Federal Reserve Board will seek public comment on significant changes to improve the transparency of its bank stress tests and to reduce the volatility of capital buffer requirements

Who: Banks subject to Federal Reserve Supervisory Stress Tests.

In Depth

In December 2024, the Federal Reserve Board (the “Board”) announced that they will be seeking public comment on “significant changes to improve the transparency of its bank stress tests and to reduce the volatility of resulting capital buffer requirements.”

The announcement signals that the Federal Reserve is considering changes to address recurring industry feedback, and anticipates legal arguments made in a recent lawsuit filed by industry groups. Importantly, the announcement indicated that the proposed changes are not designed to materially affect overall capital requirements.

This post summarizes these potential changes, and implications for Bank management.

Increased Stress Test Transparency

The Board’s stress tests evaluate the resilience of large banks by estimating their losses, revenue, and capital levels under a hypothetical scenario that changes each year.  The Board’s forecasts rely on (i) Board-designed scenarios, as well as (ii) Board-developed models.

i. Board-designed scenarios: The Board intends to propose that the public can comment on the hypothetical scenarios used annually for the test, before the scenarios are finalized.

Historically, the “Supervisory Severely Adverse” scenario was developed as required by the Scenario Design Policy statement, which required a severe recession. The Scenario Design Policy requires a 3 to 5 percentage point increase in unemployment, or an unemployment rate of at least 10 percent (whichever is greater). All other variables were calibrated based on that unemployment rate path, with falling interest rates.

Essentially, since its adoption, the Supervisory Severely Adverse scenario has been a Global Financial Crisis-like scenario, and it has missed opportunities to test banks’ emerging risks, such as exposure to rising interest rates.

The Board’s announcement does not explicitly mention the Market Shock component of the scenarios. Assuming the Board provides the public with the opportunity to comment on both the macroeconomic and market shock scenarios, the industry will have the opportunity to comment on the consistency (or lack thereof) between the two.

ii. Board-developed Models: The Board intends to seek public comment on all of the models used to determine the hypothetical losses and revenues of banks under stress and indicated that they will take immediate action to improve model transparency for the 2025 stress test.

This is welcome news for the industry, which has long struggled to understand stress test results, based on the limited model disclosures provided by the Board. Firms have observed material differences between their own forecasts vs. the Board’s for key components, such as Pre-Provision Net Revenue (PPNR), and been challenged by their own stakeholders to explain those differences.  Additionally, the lack of transparency creates significant capital planning and capital management challenges, with firms speculating about which business activities are more or less capital intensive than others.

Reduced Volatility

The Board intends to average their stress test results over two years to reduce the year-over-year changes in the capital requirements that result from the stress test. This “averaging” could reduce the overall volatility in Stress Capital Buffers, which can aid firms with longer term capital planning. The Board also indicated that they will continue to use exploratory analyses (e.g., additional scenarios, such as the 2024 liquidity funding stresses and alternative market shocks) to inform bank supervision and financial stability assessments.

What Firms Should Do

Firms should prepare to advocate for these changes. The proposed improvements in model transparency will provide firms with an opportunity to both understand the Board’s methodology, and to advocate for modeling enhancements/modifications which could more effectively reflect the true risk of portfolios.  Firm’s model development and validation resources should be prepared to engage in the review of any additional transparency the Board provides.

Additionally, firms should be prepared to run multiple stress scenarios. The Board’s continued use of exploratory scenarios indicates that they will continue to explore multiple risks in each stress testing cycle.

Put Patomak’s Expertise to Work

As regulatory expectations continue to evolve, Patomak is ideally situated to advise firms on driving enhancements to stress testing capabilities. Our deep expertise enables us to help you navigate complexities and mitigate risks. Wherever you are in your safety and soundness journey – from advance preparation to stay ahead of the curve, or verifying the adequacy of existing capabilities – Patomak’s suite of services can provide the support you need to succeed. If you would like to learn more about how Patomak can partner with you, please reach out to Diane Daley at ddaley@patomak.com or Heather Espinosa at hespinosa@patomak.com.