An inability to effectively assess the resilience of the largest banks, as well as a lack of credibility – both putting the financial system and economy at risk – would be the result of changes to stress tests the central bank is now considering, one of its governors said Thursday.
Michael S. Barr, a governor of the Federal Reserve Board, said in remarks to the Peterson Institute for International Economics in Washington, D.C., said that “it is critical to maintain the dynamism and rigor of stress testing so that supervisors, banks, and the public understand the underlying vulnerabilities in the banking system and at the largest banks and understand that these firms are holding sufficient capital to address these vulnerabilities.”
He said he had “deep concerns” over changes to the stress test system, now being considered by the central bank board.
Barr contended that lawsuits brought against the current stress test regime by bank trade groups late last year spurred the Fed to consider changes. The Fed, he said, has announced that it would disclose and seek public comment on all the models that determine the hypothetical losses and revenue of banks under stress, as well as the annual stress scenarios. The agency also proposed, he said, to change its rules to average stress testing results over two years to reduce the year-over-year volatility in the capital requirements that result from annual stress testing.
“These proposed changes represent a policy choice to respond to the litigation by enhancing transparency and promoting public participation, and they are not intended to materially affect overall capital requirements. But in my judgment, they are a mistake that will make stress testing less rigorous and nimble,” Barr said.
Barr criticized the changes specifically. He said subjecting the test models to notice and comment “could lead them to ossify, and their dynamism and effectiveness may fade.” He added that the comment process “may have an uneven effect, since banks have an incentive to object to aspects of the models that result in higher capital requirements and not to highlight the areas in which the models underestimate downside risk. Responding to these comments could create a one-way ratchet that successively weakens capital requirements.”
He also contended that knowledge of stress tests in advance “will also increase the likelihood that banks are able to game the results to lower their capital requirements.” He said full transparency in the stress testing regime can increase systemic risks because risk is underestimated and capital is too low.
“The stress tests could lose their credibility. A loss in credibility is bad for the banks, the banking system, financial stability and, ultimately, American families and businesses,” Barr said.
Preserving the Dynamism and Credibility of Stress Testing
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