Washington, D.C. — Bank Policy Institute Head of Research Francisco Covas will testify today at a House Financial Services Committee subcommittee hearing on the Federal Reserve’s stress tests. Covas emphasized in his testimony that the Fed’s stress test models and scenarios should undergo public notice and comment. He argued that the current opaque models, uncertain inputs, and volatile results impose economic costs, including fewer loans for small businesses, slower employment growth, less market liquidity, and inefficient capital allocation by banks.
“The lack of transparency in the Fed’s stress-testing regime imposes significant economic costs. These include reduced credit availability, slower employment growth and decreased market liquidity. By allowing public comment on scenarios and supervisory models, policymakers can mitigate uncertainty and promote a more effective financial system that better serves the needs of the U.S. economy,” said Francisco Covas.
The background provided highlights that the Fed’s stress tests consistently show large banks are well-capitalized to support the economy during both prosperous and challenging times. The tests determine the stress capital buffer, which is part of large banks’ minimum capital requirements. Given its broad economic implications, Covas argued that the stress testing regime deserves public transparency through a notice and comment process—a legal requirement not currently met by the Fed.
Stress tests evaluate large banks' resilience to hypothetical adverse scenarios such as severe recessions. The Fed projects bank performance under these scenarios to set capital requirements used by banks to allocate capital across various business lines and products like mortgages and corporate debt.
Covas noted that excessive volatility in the stress capital buffer complicates efficient capital allocation across different business lines if requirements fluctuate annually. He also pointed out issues with transparency in forecasting models, inaccurate results inconsistent with real-world experience, flawed reconsideration processes for appealing test results, and overlaps between stress tests and risk-weighted assets frameworks.
In conclusion, Covas asserted that the lack of transparency in the Federal Reserve’s stress-testing process has significant economic costs and hinders banks' future planning capabilities. He suggested that increased transparency could lead to a more efficient banking system better suited to meet the U.S. economy's needs.
The Bank Policy Institute is a nonpartisan public policy research and advocacy group representing universal banks, regional banks, and major foreign banks operating in the United States. The Institute conducts academic research on regulatory topics, analyzes proposed regulations, and represents the financial services industry on cybersecurity issues.
Tara Payne
Bank Policy Institute
tara.payne@bpi.com