- Key insight: The Federal Reserve will establish a day for freezing bank balance sheets for purposes of stress test analysis and will subject banks to two different global market shock scenarios. It will also incorporate stress test results into supervision.
- Expert quote: "The rationale for these changes is straightforward. A risk-sensitive stress testing framework ensures that [stress capital buffer] requirements align with risk-taking behavior." — Federal Reserve Vice Chair for Supervision Michelle Bowman
- Forward Look: Bowman said the Fed expects to finalize its new stress testing framework within the coming weeks. It will then look to cement changes to the GSIB surcharge and the Basel III capital framework before the end of the year.
The Federal Reserve's top regulator previewed a pair of additional changes to the central bank's stress testing regime ahead of the new framework's forthcoming finalization.
In a speech delivered on Friday morning, Fed Vice Chair for Supervision Michelle Bowman said the central bank is making two additional changes to its large bank stress testing program to address "risk sensitivity" and "risk capture."
The first reform will result in the Fed setting a date for freezing bank balance sheets for stress testing purposes. This will happen shortly before the scenarios in the test are released, Bowman said. The second will see banks subject to two global market shock scenarios, with the worse of the two results being incorporated into the firm's stress capital buffer calculation, or SCB.
"The rationale for these changes is straightforward. A risk-sensitive stress testing framework ensures that SCB requirements align with risk-taking behavior," Bowman said. "If firms take additional risks, they should expect those risks to be reflected in greater losses in the stress test, which in turn would lead to higher capital requirements. The reverse is also true."
These amendments build upon the Fed's proposal from last October, which aims to improve the exam's transparency and reduce its volatility.
It does so by committing the Fed to opening the scenarios for the test to public comment and
The Fed's stress testing protocol was one of several regulatory reforms called for by the Dodd-Frank Act of 2010, the legislative response to the global financial crisis. In its early years, the annual assessments regularly unveiled weaknesses in some of the nation's largest banks, but more recently its findings have been less jarring for the industry.
Still, the lack of transparency around the test's design and the fact that year-to-year fluctuations led to increased capital requirements even for banks that passed the test were perennial gripes from the industry for years. Executives and trade groups have become increasingly critical of the program over time, a sentiment that culminated in
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The Fed instituted some immediate changes — including
"This framework creates a legally sound regulatory process for setting capital requirements and enhancing supervision," Bowman said Friday.
In her speech, Bowman also outlined changes to bank supervision based on stress test results, noting that examiners will begin using findings from each year's exam to hone their oversight around specific areas of weakness in those banks and throughout the banking system.
"Just as banks rely on stress testing to manage their own risk, the Fed's stress tests should do more for our supervisors than calculate a single capital requirement," she said. "Fed stress tests should also identify a firm's vulnerability to various material financial and nonfinancial risks before those risks emerge. That information, in turn, will help inform how best to focus our supervisory attention across our large bank portfolios."
Bowman said the incorporation of stress testing into supervision could serve as a "forward-looking tool for early identification of idiosyncratic and emerging risks."
She also said supervisors will do more to incorporate banks' own findings from internal stress tests to improve their oversight, a nod to a critique levied by some large banks that their own stress-testing methods were more precise and insightful than the Fed's.
"Large banks design and assess, in some cases on a daily basis, the most severe scenarios they may face," Bowman said. "Supervisors will engage to understand their vulnerability to risks uncovered by the banks' analyses and contrast them with our stress test analyses of the same banks."
Unlike the broader changes to the Fed's own stress testing program — which appear to be subject to notice-and-comment requirements under the APA because they impact bank capital obligations — these supervisory changes will not be subject to a formal rulemaking process and findings will not be disclosed publicly.
Bowman said she expects the Fed's stress testing rule to be finalized within the coming weeks, adding that other capital rules, including those implementing the Basel III standards and changes to the global systemically important bank, or GSIB, surcharge, are likely to follow later this year.
