WASHINGTON– One Federal Reserve Board governor is warning that the changes to bank stress tests the central bank is now considering will lead to an inability to effectively assess the resilience of the largest banks, as well as a lack of credibility, both of which he said would put the financial system and economy at risk.
In remarks to the Peterson Institute for International Economics, Federal Gov. Michael S. Barr said “it is critical to maintain the dynamism and rigor of stress testing so that supervisors, banks, and the public understand the underlying vulnerabilities in the banking system and at the largest banks and understand that these firms are holding sufficient capital to address these vulnerabilities.”
Barr told the event he has “deep concerns” over changes to the stress test system now being considered by the central bank board.
Lawsuits Played Role
Barr further suggested that lawsuits brought against the current stress test regime by bank trade groups late last year spurred the Fed to consider changes.
In response, Barr said the Fed plans to disclose and seek public comment on all the models that determine the hypothetical losses and revenue of banks under stress, as well as the annual stress scenarios. Moreover, Barr noted the Fed said it also plans to change its rules to average stress testing results over two years to reduce the year-over-year volatility in the capital requirements that result from annual stress testing.
“These proposed changes represent a policy choice to respond to the litigation by enhancing transparency and promoting public participation, and they are not intended to materially affect overall capital requirements,” Barr said. “But in my judgment, they are a mistake that will make stress testing less rigorous and nimble.”
Risk of Ossification
Barr specifically argued the test models subject to notice and comment “could lead them to ossify, and their dynamism and effectiveness may fade,” and further added that the comment process “may have an uneven effect, since banks have an incentive to object to aspects of the models that result in higher capital requirements and not to highlight the areas in which the models underestimate downside risk. Responding to these comments could create a one-way ratchet that successively weakens capital requirements.”
In addition, Barr contended that knowledge of stress tests in advance “will also increase the likelihood that banks are able to game the results to lower their capital requirements.”
He said full transparency in the stress testing regime can increase systemic risks because risk is underestimated and capital is too low.
