WASHINGTON (Reuters) - The Federal Reserve, the top U.S. banking regulator, on Thursday proposed changes to its annual bank “stress testing” process, aiming to give lenders significantly more information about how their portfolios may perform during potential market shocks.
The proposed tweaks mark a major win for big banks which have for years complained that the Fed’s stress testing process is too opaque, leaving them in the dark over whether they will pass or fail.
Under the proposed changes, the Fed would allow banks for the first time to see how hypothetical loan portfolios would perform under the testing model. The Fed would also provide more information about the scenarios it builds each year to put bank balance sheets under stress.
Giving banks better clarity about how they may perform during the annual Comprehensive Capital Analysis and Review (CCAR) process would come as a significant relief, as major Wall Street banks complain the current process is time consuming and resource intensive. Better predictors for stress test success could also aid banks in capital planning, as they need a passing grade from the Fed before paying out more capital to shareholders.
Under the proposed changes, the Fed would provide a list of hypothetical loan portfolios, and then allow banks to see how those portfolios perform under the Fed’s model before testing begins each year. This approach would allow banks to compare their own portfolios to the Fed‘s, as well as see how closely their own internal models compare.
The Fed also said it would be providing more detailed descriptions of its models, including certain equations and variables it uses. It also plans to give banks more information about how home prices would hypothetically sink in an economic crisis, and additional variables it may include in concocting those scenarios.
The Fed is soliciting public comment on those changes until Jan. 22.
The move marks the first significant policy shift at the Fed under the watch of Randal Quarles, who became the central bank’s chief regulator in October. However, Fed officials had indicated they were looking for ways to increase transparency around the tests for some time.
Fed officials, including Chair Janet Yellen and her nominated replacement, Governor Jerome Powell, have said they want to improve transparency around stress tests. But there remains concern at the central bank that giving banks too many specifics about the testing model could render it less effective.
Former Fed Governor Daniel Tarullo, who built the original stress testing process after the 2007-2009 financial crisis, proposed the idea of creating hypothetical portfolios as a way to give banks some sense of how their portfolios may perform without giving away exactly how the Fed will do the testing.
“A set of hypothetical portfolios ... would permit a fairly accurate inference of the expected losses on any given set of assets. At the same time, they would not permit participants to game the models by scrutinizing them for the precise points where they were weakest,” he said in his farewell remarks in April.
Consumer advocates have argued against giving banks more information on the models, arguing banks could game the system, or risk management in the industry will become focused around a single ‘mono’ model, potentially increasing concentration risk.
Speaking during an event in New York on Friday, Quarles dismissed concerns over banks gaming the system, saying over time they would inevitably work out more or less how the models work – but he did acknowledge concerns over mono models.
“The proposals that you’ll see coming out from us will be significantly more transparency than we have had – but not full transparency because we still don’t have an answer in my view to the mono-model risk,” he said.
Reporting by Pete Schroeder, Michelle Price and Jonathan Spicer; Editing by David Gregorio and Susan Thomas