Fed proposes averaging large bank stress test results to reduce volatility

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By Pete Schroeder

WASHINGTON (Reuters) – The Federal Reserve kicked off a sweeping effort to overhaul its annual stress tests of large banks on Thursday, proposing to average results over two years in setting capital requirements.

The central bank also proposed giving banks three more months to adjust to the capital requirements set by the exam, as part of its overarching bid to make the process more transparent and less volatile. Under the proposal, banks receiving test results in June would have until January to adjust capital plans, as opposed to the current October deadline.

In addition, the Fed said it was streamlining the data it collects from banks under the process, but noted that none of the changes are designed to significantly change the capital requirements banks face.

The Fed announced in December that, following several court rulings curtailing regulatory authority, it would begin making several changes to the annual exams of big bank health. The industry has griped for years the tests, which set the so-called “stress capital buffer” for large banks, are opaque and subjective.

More changes to the stress tests will be coming later this year, as the Fed said it planned to propose allowing the public to see and comment on the models and hypothetical scenarios it applies to the test each year, a longtime industry priority.

The changes were opposed by Fed Governor Michael Barr, who served as the Fed’s top regulatory official until he stepped down from that post in February. In a statement, he warned the changes, and others in the works, risked turning the tests into an “ossified exercise that will provide false comfort in the resilience of the system.”

Specifically, he said opening up the tests to public comment not only could give banks a chance to whittle away at stricter aspects of the exam, but also allow them to maximize results by identifying areas that may underestimate risk. And the process of requiring the Fed to regularly solicit and incorporate feedback could make the tests less dynamic, as Fed staff have less time to build ways to measure different types of risk.

Separately, Fed Governor Adriana Kugler voted in favor of the proposal, but expressed concern about relying equally on financial statements submitted by banks over a year ago with more recent figures. She said she would welcome feedback on whether to place more emphasis on fresher numbers to be more sensitive to current economic conditions.

(Reporting by Pete Schroeder; Editing by Alistair Bell)