Questions raised on stress testing framework

A major case regarding the US Federal Reserve (US Fed) has reached the court. A group of US banks and business organizations have filed a lawsuit against the Fed over transparency and other legal issues in the stress testing framework. The issue was raised by organizations such as the American Bankers Association and the US Chamber of Commerce, which seek resolution of long-standing legal violations.

Why was the lawsuit filed against the US Fed?

The US Fed recently announced plans to change the annual stress testing framework. The move was aimed at making the process more transparent and stable.

Banks’ objection:

• The Bank Policy Institute (BPI), one of the plaintiff groups in the case, filed the suit in federal court in Ohio.
• “We applaud the Fed’s efforts for transparency and accountability, but this lawsuit is necessary to protect the industry’s legal rights,” said BPI President Greg Bayer.

US Fed’s plan:

The US Fed’s plan includes:

1. Disclosure of models for estimating banks’ losses and revenues.
2. Inviting public comments.
3. Determining capital requirements based on two-year average results of the stress test.
4. To implement the process by 2025.

What is stress test?

The stress test is an annual process that assesses how America’s largest banks—such as JPMorgan Chase, Goldman Sachs, and Bank of America—will fare in the face of various economic challenges.

How does this test work?

1. simulation:
   • The bank has to be prepared to face a situation like a 40% fall in commercial real estate prices and a 36% fall in house prices.
2. Calculation of Required Capital:
   • The Fed uses the results of these tests to decide how much capital reserves banks must maintain.
3. Importance:
   • These tests played an important role in restoring confidence in the banking sector after the 2008 financial crisis.

Controversy and criticism:

However, criticism of this process has increased in recent years:

• lack of transparency:
  • There has been year-to-year volatility in models and results.
• Oppose:
  • Banking groups are not opposing the stress testing process, but are demanding more transparency in it and improvements in forecasting models.

Banks’ demand in the lawsuit

1. Improve Transparency:
   The model used by the Fed must be publicly explained.
2. Ensuring Stability:
   Year-to-year variations in capital requirements and test results should be minimized.
3. Standardization of Process:
   • Banks say the current model is vague and needs reform.
   • They want the process to be clear and predictable.

US Fed response and plans

The Fed did not comment directly on the matter, but it has committed to implementing its new plan by 2025.

Key Steps:

• Process improvement by taking feedback from banks and public.
• Changes in the model to ensure greater transparency and consistency.