Fed revamps its stress test rules after a lawsuit from major banking and business groups

The Federal Reserve announced a major overhaul of its annual bank stress tests after a legal challenge from multiple industry groups, according to a press release from the central bank on Friday.

The changes respond to complaints that the process used to determine how much capital large banks must hold was opaque, unpredictable, and costly for lenders. The Fed said the new approach is intended to increase transparency while keeping the test useful for evaluating how firms would handle severe economic downturns.

The Fed said it will disclose more detail about the scenarios and models used to run the tests and will allow public comment on them. The central bank also said the overall reduction in capital requirements will be minimal. It expects capital requirements to fall by only a “negligible” amount, reducing the workload for banks, especially the largest institutions that undergo the test each year.

The plaintiffs argued the stress tests lacked transparency and were unlawful. The groups that brought the lawsuit included the Bank Policy Institute, the American Bankers Association, the U.S. Chamber of Commerce, the Ohio Bankers League, and the Ohio Chamber of Commerce.

Large banking lobby groups the Financial Services Forum and the Bank Policy Institute, issued statements supporting the announcement, saying it addresses long-standing concerns about difficulty and lack of clarity in the testing system.

Federal Reserve outlines model and scenario changes

The Fed said banks will need to submit less documentation going forward. The average reduction will be about 10,000 pages of supporting materials per institution.

There was division within the central bank.

Michael Barr, a member of the Board of Governors, said he did not support the proposal. He said the plan would “make the stress test weaker and less credible” and could produce “overly optimistic projections,” opening the door for “gaming by banks.”

Michelle Bowman, who previously served as the vice-chair for supervision, supported the proposal and called it “excellent,” but said she regretted that the issues were only addressed “after a lawsuit became inevitable.”

The timing of the overhaul comes as regulators are evaluating several other rules for banks. The Trump administration has pushed officials to reduce regulatory burdens to encourage growth and investment across the financial sector.

Stress tests were put in place after the 2008 crisis, when the government introduced the comprehensive capital analysis and review process to ensure banks could survive severe shocks.

Future test conditions and legal challenge

The Fed said the stress test will continue to evaluate resilience under harsh economic conditions, like how they would perform if unemployment reached 10 percent, nominal home prices fell by about one-third, and commercial real estate prices dropped by 40 percent.

Douglas Elliott, a partner at the consulting firm Oliver Wyman, said the tests have been the strongest driver of capital requirements for large banks and that the new structure may ease that influence “to some extent.”

The estimated change to capital levels is small. The Fed said the modifications to models and scenarios would reduce required capital by roughly 0.25 percentage points on average compared to the previous two years.

Earlier in the year, the central bank suggested averaging stress test results over a two-year period to reduce swings in the amount of capital banks must hold from one year to the next.

Regulators require banks to hold enough capital to absorb losses during financial stress. Banks often prefer lower capital requirements because it can increase profitability relative to equity.

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