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The Federal Reserve is considering “significant changes” to its annual stress tests for large U.S. banks, reducing volatility in test results and making the process more transparent.
The Fed did not provide a detailed explanation of the change, but it revised the model that calculates a bank’s hypothetical losses by averaging two years of results to reduce the risk of large year-over-year fluctuations, and He said the public could be allowed to comment on the losses. Scenarios are created each year before they are finalized.
The Fed said the purpose of the changes was not to “materially impact overall capital levels.”
“The administrative law framework has changed significantly in recent years,” the Fed said in a statement. “The board has analyzed the current stress test in light of the evolving legal landscape and has decided to modify the test in important respects to improve its resiliency.”
The Fed said the review was in response to recent changes in its administrative law framework, which were overturned by a U.S. Supreme Court ruling earlier this year overturning so-called “Chevron compliance.” The ruling curbed the freedom of federal agencies to create rules and regulations.
Testing transparency and uneven results are a source of frustration for the banking industry. The Banking Policy Research Institute, an industry lobbying group, welcomed the Fed’s announcement as a step toward “transparency and accountability.”
Stress tests are conducted annually by America’s largest banks, including JPMorgan Chase and Goldman Sachs. Their business is exposed to a series of doomsday scenarios to calculate the appropriate capital requirements for each lender. Capital is used to absorb potential losses.
The test was crucial in restoring confidence in the banking sector after the 2008 financial crisis. But much of that drama has been lost in recent years, as banks can easily escape hypothetical scenarios if they have enough capital. Bank executives have also criticized the tests, saying they are too opaque and the results too unstable.
Earlier this year, Goldman became the first U.S. bank to challenge the Fed over stress tests and win lower capital requirements as a result.
Changes to stress tests could be another victory for the banking industry. The banking industry is already hoping for a less onerous implementation of so-called late Basel III capital requirements in the second Trump administration.
The original plan for Basel reform was announced by Fed Vice Chairman Michael Barr last year, but was scaled back after resistance from the banking industry. The final outcome will be influenced by the incoming Trump administration.
