The American Bankers Association, Bank Policy Institute and other trade groups sued the Federal Reserve last week over what they call a “lack of transparency” in the central bank’s stress testing process.
“Adopted in secret,” stress test models “[produce] vacillating and unexplained requirements and restrictions on bank capital,” the groups wrote in a lawsuit filed Dec. 24 in the U.S. District Court for the Southern District of Ohio.
The “significant and unexplained volatility” resulting from stress tests “impairs the ability of banks to efficiently deploy capital, including making loans to small businesses,” the trade groups wrote. “When banks are forced to hold excess capital — not to protect against the risk of loss, but instead to guard against the volatility of the [Fed’s] undisclosed and ever-changing criteria — it reduces credit availability, hinders economic growth and harms the American consumer.”
The lawsuit came a day after the Fed announced it aims to address two of the issues the lawsuit highlights: stress-test transparency and capital-buffer volatility. The Fed board on Dec. 23 said it intends to propose that it disclose and seek public comment on the models and hypothetical scenarios it uses for stress tests before they’re finalized. The central bank is also considering averaging test results over two years to reduce the year-over-year changes in capital requirements, it said. Further, the Fed said it wants to “begin the public comment process” in early 2025.
The Bank Policy Institute initially called the Fed’s announcement “a first step toward transparency and accountability,” adding that it is “reviewing it closely and considering additional options to ensure timely reforms that are both good law and good policy.”
A day later, the group was one of five plaintiffs suing the central bank.
A Fed spokesperson declined to comment on the lawsuit.
The plaintiffs said they sued to preserve their legal rights, adding that a statute of limitations for court challenges to some of the stress-test procedures expires in February.
“Plaintiffs cannot be certain at this time that the [Fed’s] recently announced reforms will provide a timely remedy to the harms arising under the current system,” the groups wrote Dec. 24.
The lawsuit also urges the court to declare the models and scenarios the Fed used in the 2024, 2025 and 2026 stress tests unlawful.
The think tank Better Markets, meanwhile, took issue with the Fed’s announcement on principle, saying the proposed changes would give banks a cheat code of sorts.
“The Fed all but stated it intends to give the Wall Street banks the keys to the stress tests, almost certainly making them largely predictable, highly gameable, and very favorable,” Better Markets CEO Dennis Kelleher said in a statement. “The announcement leaves little doubt that process will be a charade, and that the outcome is preordained.”
Kelleher also blasted the timing of the Fed’s stress-test announcement.
“Showing disrespect if not disdain for the public, the Federal Reserve’s announcement today at 4PM on the day before Christmas and Hanukkah eve should be beneath the dignity of the Fed,” Kelleher wrote. “Unfortunately, this stunt of trying to bury important news by releasing it late on Fridays or holidays is standard operating procedure for the Fed seeking to minimize media coverage and public awareness when engaging in questionable conduct that might not withstand the scrutiny of the light of day.”
Plaintiffs, in the lawsuit, noted their support for a capital buffer “and the appropriate use of stress-test results to determine it,” adding that they do not “seek to upend banks’ capital requirements or to disrupt the Board’s application of the stress tests.”
In a statement, ABA CEO Rob Nichols called stress testing an “important risk management tool.”
However, “the opaque nature of these tests undermines their value for providing meaningful insights into bank resilience,” he said. “We remain hopeful the Fed will address long-standing issues with the stress tests, but this litigation preserves our ability to seek legal remedies if the Fed falls short.”
Greg Baer, BPI’s CEO, was more pointed in his criticism, saying the “lack of clear standards for the global market shock and the operational risk charge” associated with the Fed’s stress test “continues to produce capital charges that are inaccurate, volatile and excessive.”
The U.S. Chamber of Commerce, the Ohio Chamber of Commerce and Ohio Bankers League are the other plaintiffs.
In its announcement Dec. 23, the Fed said it would continue the “exploratory analysis” element initially pitched as climate scenario readiness. That would stay separate from stress tests, and the results would be disclosed in aggregate and would not affect capital requirements, the Fed said.
The central bank said its proposed changes to stress testing transparency come “in view of the evolving legal landscape.”
That is likely a reference to the Supreme Court’s decision in June to strike down the Chevron doctrine. Judges were instructed, under that precedent, to defer to regulatory agencies’ interpretations when rules were seen as unclear.
The trade groups’ lawsuit, meanwhile, is based on the Administrative Procedures Act.
Stress-test transparency, or perceived lack thereof, spurred backlash from at least one prominent lawmaker last year.
“Instead of running stress tests in an open and accountable manner, subject to public scrutiny, the Federal Reserve cloaks the stress tests under a veil of secrecy,” Rep. Andy Barr, R-KY, said at a June hearing of the House Financial Services Committee, according to American Banker. “This is no legal basis for this secrecy, and the perceived benefits of secrecy are illusory at best.”
A Fed governor, too – Republican Michelle Bowman – in a September speech, cited the importance of “feedback from banks and other members of the public to ensure that stress testing is fair, transparent and more useful going forward.”
In recent years, it’s become exceedingly rare that any large bank would fail a Fed stress test. In August, Goldman Sachs became the first bank – since such disputes were allowed – to successfully argue for a lower capital buffer than the central bank initially prescribed as a result of stress testing.
