Wall Street sues Fed over stress test transparency, reforms likely.

Federal Reserve Stress Test Controversy Sparks Lawsuit by Wall Street Banks

On December 24, local time, several banking and business groups, including the Bank Policy Institute (BPI), the American Bankers Association (ABA), and the U.S. Chamber of Commerce, filed a lawsuit in the federal court in Columbus, Ohio, accusing the Federal Reserve's annual bank stress test procedures of being unlawful. The lawsuit seeks a court ruling declaring the stress test models and scenarios for 2024 and the following two years illegal, urging the Federal Reserve to disclose the test models and assumptions while inviting public comment.

The groups pointed out in the lawsuit that the Federal Reserve's lack of transparency leads to fluctuating bank capital requirements, which not only disrupt banks' capital allocation capabilities but also weaken their ability to lend to small businesses and other economic pillars. They emphasized that they do not oppose the stress testing program itself but called for improvements in the procedures to ensure greater transparency and public participation.

Controversy Surrounds Stress Testing Mechanism

The Federal Reserve's annual stress test is a system introduced after the 2007-2009 financial crisis, designed to assess banks' resilience during economic crises. Test results directly affect the amount of capital banks need to reserve and indirectly influence their ability to pay dividends to shareholders. However, this mechanism has long been controversial.

The 2024 stress test scenarios include a 40% drop in commercial real estate prices and a 36% drop in residential prices. Banking groups believe the formulation process for these assumptions lacks transparency and does not provide an opportunity for public feedback. Industry leaders, such as JPMorgan CEO Jamie Dimon, have repeatedly criticized the test system for being overly complex and potentially misleading. Dimon stated that the current system is a product of "layered rules" that may create a false sense of security.

The industry organization Bank Policy Institute (BPI) also mentioned in the lawsuit that the Federal Reserve's Basel III capital requirements proposed last year have already shown the necessity for public commentary, yet the stress tests have not followed this principle. They called on the Federal Reserve to accept more public feedback on model development and assumption scenario selection to enhance the credibility and rationality of the system.

Federal Reserve Responds: Major Changes Planned

On December 23, the day before the lawsuit was launched, the Federal Reserve announced that it is considering significant adjustments to the stress testing mechanism, including allowing banks to provide input on the test models and assumption scenarios. The Federal Reserve plans to launch a public consultation process in early 2025 to improve test transparency and reduce market uncertainty.

The Federal Reserve's proposed adjustments include averaging the test results over two years to reduce volatility in annual capital provisions and allowing banks to learn about test scenarios earlier to prepare in advance. These reforms are seen as part of a concession to Wall Street banks. The Federal Reserve emphasized that these changes would not have a substantive impact on overall capital requirements but would optimize the existing process.

Legal and Regulatory Challenges Intensify

The context for the Federal Reserve's stress test reform plans is a continuously evolving legal environment. This year, the U.S. Supreme Court has limited regulatory agencies' power to interpret laws, making it more likely for businesses to win legal disputes with federal agencies. Meanwhile, calls for looser financial regulation are growing louder from the Trump administration and the banking sector, adding more pressure on the Federal Reserve's stress test reforms.

Although the Federal Reserve's statement is considered "a step towards transparency," some banking groups believe it is still not sufficient, and the reform process may lag behind. Greg Baer, President of BPI, stated that while the Federal Reserve's adjustment plan is commendable, industry organizations will continue to pursue legal avenues to ensure comprehensive reform of the testing mechanism.

Future Outlook: Transparency and Accountability as Key Focus

The Federal Reserve's stress test reform is a significant topic in the field of financial regulation in recent years, with outcomes directly affecting bank capital requirements and industry stability. As the legal environment evolves and public demand for transparency continues to grow, the pressure on the Federal Reserve for reform may intensify further. The game between banking groups and the Federal Reserve will determine the final direction of this core mechanism in the coming months.

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