The Federal Reserve is taking a two-track approach to stress testing reform — proposing changes to the process while also arguing in court that it is not obligated to do so.
Last week, the central bank responded to the banking industry's lawsuit over its annual stress test for large banks. The Fed argued that it is not legally required to disclose the models it uses ahead of tests, nor does it have to open those models up to public comment.
The Fed's motion came less than two weeks after it
The Fed's contradictory approaches have frustrated both the banking industry and advocates for higher capital standards.
"At the very least, it makes the Fed seem very disorganized. It looks like the Fed's right hand doesn't know or doesn't care what the left hand is doing," said Jeremy Kress, a former Fed lawyer and professor at the University of Michigan's Ross School of Business. "It's making a much different argument in court than it is making in the court of public opinion — the public affairs office is doing something much different than the legal division."
Meanwhile, bankers and their allies see the Fed's filing as not only a
"The Federal Reserve's legal theories are not limited to stress testing," wrote Bank Policy Institute spokesperson Tara Payne in a recent newsletter. "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.'"
The filing, made in the U.S. District Court for the Southern District of Ohio, was made in response to
The industry groups have argued that the Fed's current practices violate the Administrative Procedures Act and that changes made to the program in 2019 and 2020 were "arbitrary and capricious." In March, they
In the filing, the Fed points to two statutes — the International Lending Supervision Act of 1983 and the Home Owners' Loan Act of 1933 — as authorizing it to issue firm-specific capital requirements on a supervisory basis. It argues that the stress tests and resulting stress capital buffers applied to large banks do not have to go through an APA rulemaking process.
Payne argued in her BPI blog post that the Fed's stance cuts against current rules and policies related to stress tests. She also pointed to past statements from the central bank about the scenarios, models, assumptions and other elements of the exams being used to calculate capital charges on a forward-looking, consistent, comparable and uniform basis.
At the heart of this debate is a question of whether the current stress testing regime amounts to a rulemaking or an adjudication, said David Zaring, a law professor at the University of Pennsylvania's Wharton School of Business.
Zaring equates rulemakings to legislation, in that they apply to a wide group of entities — in this case, banks — in a standardized way. Adjudications, meanwhile, have agencies acting more like courts, determining if individual entities have done something wrong.
The current stress testing regime seems to straddle the line between the two classifications, Zaring said. On the one hand, it is a single test applied to a group of banks. On the other hand, the resulting capital charge is set on a bank-by-bank basis. It remains to be seen how the court will make sense of this, he said, but noted that one potential outcome is the Fed shifting its practices to be more squarely supervisory to be more firmly in the adjudication lane.
"The worst case for banks that could come out of this is if the Fed moves the stress test into its supervisory portfolio, making it less uniform and less transparent," he said. "That would be the opposite of what they've been arguing for."
Graham Steele, a former Treasury official under the Biden Administration, said the Fed's argument is legally sound and fits within the long-running understanding of the institution's regulatory and supervisory authorities.
But, Steele added, recent court rulings and executive orders have raised questions about many of those authorities and made their viability in court less certain. Because of this, he said, the Fed's dual strategy makes sense.
"If they're worried about losing the substantive legal case in this new world with a hostile judge that would then weaken their powers for the longer term, it could be worth conceding on this rule in the short term in order to preserve their powers over the longer term," he said. "There are certainly counterarguments that doing so would amount to something like unilateral disarmament, but to the extent that the Fed is an institution based on long-term thinking and stability, you can see the long game that they're playing."
