Risk & Compliance

Fed Proposes Additional Stress Test Disclosures

Regulators are seeking to give banks more information about the testing process without enabling them to game the system.
Matthew HellerDecember 11, 2017

In a major concession to large banks, the Federal Reserve has proposed changes to its annual “stress tests” that would make the process more transparent to lenders.

The stress tests were mandated by the post-crisis Dodd-Frank financial reforms but as Reuters reports, banks have “for years complained that the Fed’s stress testing process is too opaque, leaving them in the dark over whether they will pass or fail.”

The proposed changes announced last week would, the central bank said, “further enhance the public’s understanding of the supervisory stress test models without undermining the effectiveness of the stress test as a supervisory tool.”

Among other things, more detailed disclosures would provide the public with “information on the fundamental soundness of the models and their alignment with best modeling practices” and help financial institutions to “understand the capital implications of changes to their business activities, such as acquiring or selling a portfolio of assets.”

The stress tests examine how banks with more than $50 billion in assets would perform under hypothetical future scenarios of varying degrees of economic stress. If banks fail to maintain a minimum capital level throughout each of the scenarios, they can be penalized by blocking their payments of dividends.

Under the existing process, American Banker said, the Fed makes “certain aspects of its modeling process known in an appendix to the released results, but those disclosures are limited to the basic structure of the model.”

“The proposed enhanced model description would include certain important equations that characterize aspects of the model,” the Fed’s proposal said.

The central bank acknowledged that making the testing process too transparent might enable banks to game the system.

“One implication of releasing all details of the models is that firms could conceivably use them to make modifications to their businesses that change the results of the stress test without changing the risks they face,” the Fed said. “In the presence of such behavior, the stress test could give a misleading picture of the actual vulnerabilities faced by firms.”