When Federal Reserve Chairman Jerome Powell faces lawmakers this week, one big question will almost certainly be: Is the central bank playing favorites among the big banks?

Sens. Elizabeth Warren, D-Mass., and Sherrod Brown, D-Ohio, ranking member on the Banking Committee, criticized the agency for its latest round of stress test results earlier this month after the Fed agreed to give Goldman Sachs and Morgan Stanley a “conditional non-objection” on the quantitative portion of their exams, despite a capital shortfall. In doing so, the Fed permitted the investment banks to maintain their capital distributions at recent levels, rather than cutting them, and to avert what The Wall Street Journal has termed the “black eye of failure.”

The lawmakers raised questions about the decision in a July 10 letter to the Fed, calling the decision “a gift to the banks.”

Jerome Powell
Powell will testify before Congress about the Fed's activities, including its recent stress tests. Bloomberg News

The Fed for its part has said that the move was tied to one-time changes in the tax overhaul passed late last year, which put the banks at a capital disadvantage before the tests were even conducted. On a June call with reporters regarding the exam results, senior Fed officials stressed that the banks faced the same consequences as those that had failed the quantitative portion of the test in the past — namely that they would have to abide by prior levels of buybacks and dividends. A spokesman for the central bank declined to comment further.

Yet given that all 35 banks tested faced changes from the recent tax law, “it’s unclear why Goldman Sachs and Morgan Stanley deserve special treatment,” Brown and Warren said in their letter.

It’s a question Democrats are likely to ask repeatedly at Powell’s back-to-back hearings in the Senate and House on Tuesday and Wednesday, particularly as the Fed weighs a number of changes to how stress tests will be conducted in the future.

Of course, this one decision is extremely unlikely to pose any real threat to the economy in the short term — the financial system is much stronger than it was in 2009 when the tests were first developed. Nor do the exams play the same role that they did in the wake of the crash, when they were used as a key tool to shore up public confidence. It’s understandable that policymakers may be rethinking how the stress tests should be conducted going forward — and the part they play in the supervisory framework — almost a decade after the crisis.

“Stress tests are a key part of the regulatory arsenal, but they’re now confirming what appears to be the case — that the system is in pretty good shape,” said Phil Swagel, a professor of international economic policy at the University of Maryland.

But that doesn’t mean the use of bright lines doesn’t have its advantages, particularly when it comes to results that are released to the public.

This is an issue the Fed is likely to face again as it contemplates moving away from a black and white “pass/fail” framework for the quantitative portion of the test altogether. The central bank has proposed replacing that model with a more complex “stress capital buffer” — a customized capital standard that banks would have to maintain throughout the following year. That buffer would be published in place of the strict pass/fail results.

And yet it’s clear that offering Goldman and Morgan Stanley the “conditional non-objection” label has muddied the waters for the central bank before a new regime has even been finalized.

Creating even the appearance of favoritism to certain financial institutions is dangerous for the Fed, which continues to face attacks on its independence, including from those in Congress. As much as officials might emphasize that the tax changes amount to a one-time effect, there’s no telling what atypical blip might affect the test results in the years to come — or how the agency might react. It suggests a willingness to be flexible with the country’s largest banks that hasn’t been seen before when it comes to the exams, and so it’s a decision with potentially lasting consequences.

“The important thing is that the Fed be transparent about whatever it did,” said Michael Barr, a professor of law at Michigan University.

Powell will have his chance soon enough.

Bankshot is American Banker’s column for real-time analysis of today's news.

Victoria Finkle

Victoria Finkle

Victoria Finkle is deputy Washington bureau chief and editor of American Banker's op-ed blog, BankThink.

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