Banks and Business Groups File Legal Challenge Against Federal Reserve Over Flawed Stress Testing Framework

BPI, along with the American Bankers Association, the U.S. Chamber of Commerce, the Ohio Bankers League and the Ohio Chamber of Commerce on Dec. 24 announced the?filing of litigation?against the Federal Reserve, challenging the opaque aspects of the stress testing framework. While stress testing is an important risk management tool for banks and supervisors that helps?ensure that banks have sufficient capital to withstand a severe economic shock,?the?lawsuit seeks to resolve longstanding legal violations by subjecting the stress test process to public input as required by federal law. Stress testing has direct implications on banks’ ability to support American households and businesses and harms the U.S. economy by slowing job growth, hindering capital markets intermediation and raising the cost of credit. Why now: The current Federal Reserve’s stress testing framework is in violation of the law, as detailed in the complaint filed in court on Dec. 24. BPI and the co-plaintiffs have for years petitioned for improvements to the stress testing framework that would bring it into compliance with the law and make it a better tool for assessing risk. While the Federal Reserve has now acknowledged the problems with the framework and the need to bring it in compliance with the law, the co-plaintiffs could possibly forfeit the ability to challenge the stress test framework due to a statute of limitations date fast approaching in February of 2025. Since the statute of limitations on several of the agency actions establishing the framework for the stress tests expires in February 2025, BPI and its partners had no choice but to file this lawsuit in order to preserve their legal rights. So while the recent announcement is an important first step, filing preserves legal options going forward. To access a copy of the complaint, please click here.

• Commentary: Randal Quarles, former vice chair for supervision at the Fed, noted in a CNBC interview that the Fed had flagged flaws in stress testing during his tenure, but did not fully address those. He said the Fed is likely to take action on addressing such problems. “I think this gets?resolved relatively?straightforward,” Quarles said.?“The banks are pushing on an?open door at the Fed, but I?think bringing the lawsuit is a?useful framing mechanism for?ensuring all of those solutions?are reached.”?
• Additional commentary:?On CNBC yesterday, former Fed Governor Dan Tarullo argued that publicly releasing stress test models and scenarios for comment would undermine their effectiveness in assessing banks' resilience to an unexpected stress scenario. While stress tests are now integrated into ongoing capital requirements to provide risk sensitivity to the U.S. capital framework, this serves a different purpose from the original stress tests. Banks already conduct multiple stress tests using various scenarios as part of their risk management.
• Process concerns: “My clients are not opposed to?stress tests,” outside counsel Gene Scalia said in a CNBC interview.?“They conduct their own?internally.?What they are concerned about?is both the process?by which stress tests are?applied by the Fed right now?and the results, which are?random, arbitrary, and?ultimately bad for the U.S.?economy as a whole …?What we want to see is a new?rulemaking process where the?tests are vetted, where the?public can see the stress?tests, comment on the models?that are used, and we can be?more confident going forward.”
• Open and useful: Transparency in stress tests is a feature, not a bug, the Wall Street Journal opined in a recent editorial on the lawsuit. “If the Fed is truly worried about herd behavior, it could revisit its risk-weighted capital rules,” the editorial said. The stress tests are redundant given the Fed’s other capital requirements, and they may encourage moral hazard. But if Congress won’t eliminate them, the least the Fed can do is make them more open and useful.”

1. 0 for 16: More Evidence of a Broken Supervision System

A recent analysis highlighted a number that reveals further evidence of a broken bank supervisory regime, specifically regarding the supervisory appeals process: “In total, banks and their holding companies went a combined 0-for-16 in the final appeal decisions published so far this year.” Banks sanctioned by supervisors can appeal those decisions, but the appeals process is riddled with bias, information asymmetry and a lack of transparency, as BPI has previously noted. The 2024 appeals reviewed in this analysis involved a range of issues, from liquidity ratings to anti-money laundering. But in the backdrop of all of them is the flawed appeals system, which allocates too much discretion to examiners and little due process to banks. In recognition of the serious shortcomings of the existing appeals process, efforts were made at the FDIC in 2020 to reform the system, but those reforms were nullified once leadership changed in 2022.

• The troublesome ‘M’: One of the appeals involved a bank challenging the FDIC’s downgrade of the bank’s Management rating in the CAMELS rating system. This “M” component of CAMELS is often weaponized by bank examiners and its subjectivity exploited to constrain a bank’s growth and other activity, effectively acting as a multi-year financial penalty. Read more here.

2. BPI’s Baer Talks Basel Endgame on Marketplace

BPI CEO Greg Baer joined a recent episode of Marketplace to discuss the future of bank regulation, including the Basel Endgame proposal and stress testing. The Basel proposal has garnered opposition from “quite a strange group of bedfellows,” from climate groups to community lending advocates, host Nova Safo said in the interview.

• Show your work: “I don’t think the banking industry has any objection in principle to the Basel Accord,” Baer said. “The U.S. proposal, however, was significantly different from what was agreed to on an international basis at Basel, and some of the international standard is uniquely punitive to U.S. banks. So what we were asking, and I think what the Fed heard, is that they need to repropose that, they need to do the analysis, they need to show the data and explain why they are establishing the requirements that they are.”

3. Treasury Hit by China Hack

The U.S. Department of the Treasury this week disclosed a hack by a Chinese state-sponsored actor. The intrusion’s full impact is still being assessed, according to the Washington Post, but the attack occurred via a third-party vendor and targeted Treasury’s Office of Foreign Assets Control, the Office of the Treasury Secretary and the Office of Financial Research. OFAC handles U.S. financial sanctions, and targeting this office would suggest an interest in future sanctions designations. The documents accessed in the hack were unclassified but could still contain insights into sensitive matters like sanctions deliberations, according to the article. Treasury was alerted to the breach by its software contractor, BeyondTrust. China has denied involvement in the incident.

To read this entire edition of BPInsights, click here.

To receive BPInsights in your inbox every Saturday morning, click here.