Why Suing the Fed Over the Stress Tests Is a Dangerous Idea

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WASHINGTON — Big banks' flirtation with the idea of suing the Federal Reserve Board over its stress testing regime carries significant political risk and even if successful could yield at best a pyrrhic victory over the megabanks' primary regulator.

An academic white paper written by Harvard law professor Hal Scott and backed by a coalition of big banks and industry groups lays the legal groundwork for a lawsuit, arguing the stress tests violate the Administrative Procedure Act by not providing a public notice-and-comment period. It also contends that the Fed's internal Comprehensive Capital Analysis and Review models used in the test are opaque and not well understood by the institutions being tested.

But the current political and public relations landscape — particularly in light of the recent revelations related to Wells Fargo — makes any lawsuit a potentially dangerous move.

"For a group of the largest financial firms to sue the Fed in this political climate, particularly in light of the massive wrongdoing at Wells, is terrible optics and bad politics," said Camden Fine, an outspoken critic of big banks and the president of the Independent Community Bankers of America, which recently sued the federal government itself to block new business lending rules for credit unions.

That banks are even contemplating it speaks, however, to the frustrations institutions feel about stress tests specifically and the post-crisis regulatory regime in general.

Since the CCAR process began in 2011, banks have been aggravated by the secrecy surrounding the process. Institutions have no input on the hypothetical economic models used by the Fed, and feel the data they send the central bank vanishes into a black hole. The results of the test are hugely important, determining whether they can pay dividends and take other steps to deploy capital, and yet they have virtually no say on how it is conducted.

"On some level, I bet they all want to sue — and I think that's true on a number of issues, not just CCAR," said Mark Calabria, director of financial regulation studies at the libertarian-leaning Cato Institute.

Still, Scott's white paper, presented by the Committee on Capital Markets Regulation — whose members include JPMorgan Chase, Wells Fargo and the Clearing House Association — takes banker complaints one step further, providing a legal road map to suing the Fed.

It is even formatted like a legal brief, with citations to relevant case law and counterpoints to the Fed's potential legal defenses of the program — making the implied threat of litigation unmistakable.

Since failing the CCAR stress tests can keep a bank from issuing a dividend, the paper argues that it acts as a binding constraint on banks and is subject to APA requirements, including public notice and comment.

Yet it's notable that so far, banks are staying away from the paper. None of the major trade associations have embraced the paper publicly, and even Scott said the argument isn't intended to preview a lawsuit.

"This never had anything to do with any possible discussion of lawsuits," Scott said in an interview. "We were looking at this as a public policy issue. We're sort of saying there's a legal problem here. What I would like to see come out of this is for the Fed to revise its process."

The Fed declined to comment on the paper, but has repeatedly argued in the past that the CCAR process is designed to prevent "teaching to the test" — keeping banks from designing their capital plans just to pass CCAR rather than to be prepared for various contingencies.

The Wall Street Journal this month published a story saying that some banks were discussing a lawsuit behind the scenes that would challenge the stress tests using roughly the same arguments that the paper lays out, and Scott's publicist cited that article in an email previewing the publication of the paper earlier this week. But Scott maintained that whatever discussions may be happening among individual banks had nothing to do with his paper.

"I did not know about that, never discussed that possibility with any banks," Scott said. "If banks are thinking about litigating this issue, that's separate from anything the committee has done."

Neither the Clearing House Association, which is a member of the CCMR, nor the American Bankers Association, which is not, would comment publicly on the paper. Although the ICBA is a member of the CCMR, Fine said the group wanted no part in any potential future suit.

Some observers said the big banks have wiggle room to pursue a lawsuit even in the current political environment.

Karen Shaw Petrou, managing partner of Federal Financial Analytics, said she doesn't think the Wells scandal — in which thousands of employees were fired for opening phony accounts — plays into the question of challenging CCAR because the stress tests don't just affect the largest banks. The process covers all banks with more than $50 billion of assets, capturing regional banks that enjoy more political support.

"This is an area where there is a partisan divide on whether the big banks are right or not, in part because CCAR's burden on the midsize regional banks is so huge," Petrou said.

But there are other reasons big banks may not want to sue other than just the political climate, including that institutions get some benefit from the stress tests — namely the right to point to the annual results as proof that they are well capitalized and thus blunt any public concern about their safety and soundness. On Sept. 12, JPMorgan Chase CEO Jamie Dimon made exactly such an argument, saying he is "very much in favor of the stress tests" and that his firm can "bear the losses of all 31 SIFI banks" with its own capital.

Calabria said another drawback would occur if the banks were able to prevail.

"One reason I suspect banks might not sue is because they kind of have a negotiation process now with CCAR," Calabria said. "It is fair to say there is a back-and-forth between the bank and the regulators before [scenarios] get out. The Fed can do a rulemaking, can take notice and comment … but it's not as if only the banks can comment. The way the system is now, only the banks get to comment."

Calabria said he suspects "Professor Scott is right on the law here, but I don't see any of the banks pursuing this, because from their perspective it isn't a winning strategy."

Big banks could also choose to sue in other areas, however, a prospect alluded to in Scott's paper.

It notes that there are "several other instances where regulatory agencies may have failed to comply with the requirements of the APA … [including] the "living wills" process, the designation of certain non-banks as systemically important and banking regulators' deference to foreign regulatory bodies, including the Basel Committee on Banking Supervision and the Financial Stability Board." The committee said it intends to "further explore whether these regulatory actions or processes are consistent with the APA."

One banking industry source who asked not to be named said that part of the motivation for the white paper may be as a placeholder for future litigation pending the completion of a rule incorporating the Fed's capital surcharge for global systemically important banks into the CCAR framework.

Fed Govs. Jerome Powell and Daniel Tarullo said in June that the central bank would likely incorporate the entirety of the GSIB surcharge into those banks' final post-stress minimum capital requirements, but would include "offsets" to blunt the impact of that change. While no bank wants to sue its primary regulator, the source said, if a final rule effectively forces some of the larger banks to break up, all bets are off.

"These are folks that you have to live with. You're kind of stuck with them," the source said. "I do think, though, that part of it may depend on what the Fed does with its rulemaking in a few months. That may change the calculus."

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