Risk & Compliance

Bankers Question Legality of Fed’s Stress Tests

Financial industry leaders say the tests may violate a law requiring transparency in government rulemaking.
Matthew HellerSeptember 19, 2016

The U.S. Federal Reserve’s stress tests for the largest U.S. bank holding companies may violate the law that requires transparency and accountability in government rulemaking, according to a group of financial industry leaders.

In a paper released Thursday, the Committee on Capital Markets Regulation said the public notice and comment requirements of the Administrative Procedure Act should apply to the tests that the Fed uses to measure whether banks would maintain sufficient capital in a future crisis.

The tests were mandated under the post-financial crisis Dodd-Frank law and the Fed has so far conducted six rounds of testing.

“The Federal Reserve has likely not complied with the APA’s procedural requirements in adopting key aspects of its Comprehensive Capital Analysis and Review stress tests,” the committee said, noting that if a bank fails a test, the Fed “can prevent the bank from returning cash to shareholders through dividends or stock buybacks.”

“Therefore, the Fed’s stress tests act as a de facto binding capital constraint on banks,” the paper said.

According to The Wall Street Journal, the paper could be a preview of a potential legal challenge by the banking industry to the tests. “Even if banks ultimately decide against action, serious contemplation of such a challenge is somewhat extraordinary,” the WSJ said. “It shows growing frustration among big financial firms with the tests, which have become even more of a burden with superlow interest rates weighing on profits.”

Before conducting a round of tests, the Fed adopts assumptions about stressful economic and financial market conditions banks may encounter and develops a model for how a hypothetical crisis would affect banks’ capital levels.

The committee said both the assumptions and models should be subject to the APA because they are part of a rule-making process, rather than an adjudication. “Public participation would result in better policy outcomes, because the public is likely to provide valuable information and insights to the agencies,” it said.

The paper rejected concerns that transparency could lead to banks “gaming” the tests, arguing that the Fed could use tools such as a good faith or anti-circumvention rule to prevent gaming.