Fed poised to hand banks a win with proposed 'stress test' overhaul

By Pete Schroeder WASHINGTON (Reuters) -The U.S. Federal Reserve on Friday unveiled an overhaul of its annual "stress tests" of large banks, handing the industry a long-sought win over an exercise they complain is opaque and onerous. The proposal that the Fed's Board of Governors will vote on later Friday will hand banks significantly more information about how the U.S. central bank conducts the annual exam by disclosing and soliciting feedback on once-confidential models, as well as making public its process for concocting hypothetical economic downturns each year as the basis for the test. Fed Vice Chair for Supervision Michelle Bowman, who is leading the effort as the central bank's top regulatory official, touted the effort as providing overdue transparency to the exercise, which helps set large bank capital levels each year. "Since its inception, the Board's stress testing program has operated with limited transparency, unreasonable year-over-year volatility, and the absence of any meaningful appeals process," she said in a prepared statement. "This lack of transparency can lead to uncertainty for banks in capital planning, potential misalignment of capital requirements with actual risks, and limited public understanding and scrutiny of the stress testing process." Banks have complained for years that the test should be more transparent and predictable, and several industry groups went so far as to sue the Fed late last year in an effort to try and compel those changes. The lawsuit was postponed after the central bank said it was already considering several of the changes sought by the industry. The Fed's board is expected to advance the proposal, which could be finalized next year following public feedback. But Fed Governor Michael Barr, who previously led the Fed's rule-writing efforts during the Biden administration, strongly opposed the changes.  In prepared remarks, Barr argued that making so much of the test public will render it "weaker and less credible." While the Fed said the disclosures should not affect bank capital, Barr said banks will soon be able to fine-tune their books to pass the test with the lowest possible capital requirements, which are meant to cushion against potential losses. "I believe today's proposal will significantly weaken the stress test and, consequently, bank resilience," he said. STRESS TESTS BECAME ANNUAL EXERCISE AFTER 2008 CRISIS The examination of large banks' resilience became an annual exercise following the 2008 global financial crisis, as the Fed sought to determine how banks would perform during a hypothetical severe economic downturn. The results dictate how much capital the big banks must hold in the coming year, with greater losses in the test requiring a larger "stress capital buffer" against potential losses for each firm. The proposed changes to make the test more transparent are likely also to make it more predictable, allowing banks to more precisely set aside capital and deploy excess funds via more lending, dividends or share buybacks, according to analysts. "The Federal Reserve's disclosures should make the annual stress test less volatile. That should allow banks to reduce the amount of extra capital they hold to guard against this volatility. It also should help banks better optimize their use of capital," Jaret Seiberg, an analyst with TD Cowen, said in a note. (Reporting by Pete Schroeder; Editing by Paul Simao)

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