On September 25, Fed Governor Michael Barr spoke at a conference on the evolution and future of stress testing for large banks, emphasizing the need to maintain its “dynamism and rigor” as a supervisory tool and suggesting separating capital buffer requirements from stress testing. Barr described stress testing as a “vital tool” for supervising the safety of large banks, and in effect, the stability of the U.S. financial system — noting it had evolved from its origins in the 2007-2009 global financial crisis to become an integral part of the bank regulatory framework.
Barr credited stress testing with bolstering both the amount of capital held by banks and their ability to manage risk effectively. Addressing recent legal challenges and changes to the stress testing framework proposed by the Fed in April, Barr cautioned that subjecting models and scenarios to the notice-and-comment process could lead them to “ossify” and hinder their dynamism and efficacy. Barr warned that full transparency could enable banks to “game the results” for lower, more favorable capital requirements, without a corresponding reduction in risk, thus undermining stress tests altogether.
As an alternative, Barr proposed that stress testing be decoupled from binding regulatory capital requirements, so that the tests would primarily serve as a supervisory tool rather than a direct determinant of capital buffers. He also argued that this approach would preserve the utility of stress testing as a “supervisory exercise,” would allow for “continued innovation in stress testing,” and would enable the Fed to adjust scenarios and models as needed to ensure “rigor and robustness.”
He concluded by expressing “concern[]” that the changes being considered by the Fed risked reliance on a type of stress test incapable of gauging the risk and “resilience of the largest banks” — introducing risk in the financial system.
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