Groups representing the banking industry recently sued the Federal Reserve, arguing that the secret procedures the central bank uses to formulate its annual bank stress tests are illegal.

The tests are notable because they are conducted absent the notice-and-comment formula that defines the bulk of US regulation.

As such, the plaintiffs argued that the practice violates the Administrative Procedure Act, and is arbitrary and capricious. They seek increased transparency over how the tests are formulated, and the ability for banking industry participants and the public to weigh in.

While such an argument would have been difficult with Chevron deference to agency rulemaking in play, the banks now stand a formidable chance of victory.

That lawsuit came just one day after the Fed opened its stress testing criteria policy to public comment and stated that it would work to reduce test result volatility. That was an unusual reversal: The Wall Street Journal’s editorial board deemed the public comment opportunity an outright admission that the stress testing protocols were not working, and an indication that they expected to lose in court.

However, that concession did not placate the banks. The plaintiffs stated that the Fed’s attempt at reform did not guarantee “timely remedy to the harms arising under the current system.”

Under pressure

The Fed’s stress tests subject the portfolios of America’s largest banks to simulated economic shocks. The test results determine banks’ mandatory stress capital reserve levels, which comprise stockpiles of liquid assets that they could burn during a crisis to prevent insolvency.

Stress capital reserve levels are applied on top of minimum capital reserve levels, which are uniformly applied to all big banks. The worse a bank fares under simulated stress, the higher the Fed sets their stress buffers. But banks almost never “fail” the tests outright.

Inadequate capital reserves were a significant contributing factor to the 2007/08 financial crisis, which was exacerbated by banks possessing insufficient liquidity to cover their short-term obligations.

The necessity of larger capital buffers was raised once again amidst the 2023 failures of Silicon Valley Bank, Signature Bank, and First Republic Bank, although questions persist over whether larger buffers could have prevented the outcome.

Stress tests have frequently come under fire for lacking clarity and for being poor predictors of actual financial shock.

Stress testing was also criticized for failing to raise red flags over the fatal deficiencies.

But the larger the buffer, the less capital there is for a bank to participate in money-generating activities, which can lead to higher fees and diminished lending opportunities for customers during the good times.

And the stress tests have frequently come under fire for lacking clarity and for being poor predictors of actual financial shock. For instance, in 2022, the stress tests simulated an environment of lowered interest rates, while in fact that year interest rates grew.

The Fed provides scant information on how it formulates the tests. Each year the variables shift depending on what the agency considers the status quo of the economy.

In 2020, the Fed permitted banks to challenge their capital buffer requirements, but it took until July 2024 for them to agree to a reduction: Goldman Sachs successfully negotiated its post-stress-test capital buffer from 6.4% to 6.2%.

Are we living in a post-2008 world?

The melee over stress tests comes after Fed backtracked in September 2024 on its plans to significantly raise minimum capital reserve requirements for some of the largest banks in the US.

Under those plans, those banks would have seen their capital buffer requirements raised on average by an estimated 19%. Those increases were part of the implementation of the Basel III Endgame, the final step in a multinational plan to bolster banks’ resiliency during financial crises.

However, the tough buffer increases prompted a strong backlash from industry participants, lobbying groups and commentators alike, who lambasted the increase as draconian and counterproductive when the rulemaking was first proposed in 2023.

They argued that the Basel III requirements would cause an outflow of capital from banks into less transparent markets, tie up necessary services for customers, increase prices, and shrink the economy.

That argument found support from a surprising coalition, including racial and climate justice groups.

The Fed ultimately acquiesced, nearly halving its proposed capital rate increases across the board, to around 9%. Federal Reserve Vice-Chair Michael S Barr said that it provided an opportunity to “relearn the lesson of humility.”

But the decision to back off from the tough requirements was far from universally praised. University of Michigan Professor Jeremy Kress described the retreat from Basel III Endgame as a “capitulation” to banks, and far from a compromise solution.

Senator Elizabeth Warren (D-Mass), called the back-off a “a Wall Street giveaway, increasing the risk of a future financial crisis and keeping taxpayers on the hook for bailouts.”