Bowman criticizes stress tests for their volatility, duplicity and opacity

WASHINGTON — Federal Reserve Governor Michelle Bowman has come under fire Bank stress tests because of their opacity and the Fed’s regulatory requirements regarding the redundant burdens they can impose on the entities it supervises.

“These problems – the volatility, the link between stress test results and capital “Compliance issues related to capital implementation, lack of transparency, and the overlap between the global market shock in stress testing and the Basel III market risk test – all of these can be addressed and should be prioritized in the continued evolution of the stress testing framework and stress buffer requirements,” Bowman said Tuesday. “It is important for regulators to consider lessons learned from past tests and feedback from banks and other members of the public to ensure that stress tests are fair, transparent and more useful in the future.”

Bowman presented her criticisms in remarks to the Federal Bar Association’s Banking Law Section Executive Council and proposed reviewing the results over several years, improving transparency and reexamining some of what she sees as regulatory overlaps to improve stress testing within the agency.

Bowman stressed the need to take a broader approach to determining optimal overall capital levels for the banking system. She stressed the importance of considering not only risk-based and leverage-based capital requirements, but also long-term debt obligations, a concept proposed by regulators and still pending.

In his speech just hours before Bowman, Michael Barr, the Fed’s vice chairman for supervision, describes the important changes The Basel III proposal, which would require banks to invest more of their own funds and less of their borrowed funds in lending activities, allowing them to absorb losses in the event of a financial crisis.

Barr proposed narrowing the scope of Basel III to exclude banks with assets between $100 billion and $250 billion from the broader capital requirements and reducing the capital increase for large banks from 19% to 9%. He also recommended reducing capital for operational risk and allowing banks to use internal models for market risk.

Bowman warned that this could lead to excessive capital requirements, particularly for market-making and trading activities, which could harm U.S. financial markets. She called for careful review to ensure that these overlapping requirements are appropriately calibrated.

Bowman identified as a problem the significant change in stress test results from year to year. This unpredictability, she said, complicates long-term capital planning for banks and forces them to hold more capital than they need. If a bank fails the test, it has months to defend itself. to meet capital buffers, which can be particularly difficult for banks that exceed the 2.5% buffer floor.

“One solution might be to average the results over several years, so that a company’s working capital moves in small increments during the averaging process,” she said. “Another possibility is to limit variability in the design of annual stress test scenarios.”

Bowman also said that an aspect of stress testing known as countercyclicality contributes to the volatility of stress test results and suggested re-evaluating whether this approach is appropriate given the instability it can create.

The countercyclicality of stress testing means that when economic conditions are good, stress scenarios for banks are more severe, acting as a balance to the natural procyclicality of risk models.

“Countercyclicality is also a driver of volatility,” she said. “And we should look more closely at whether our attempts to adjust for countercyclicality are appropriate through the lens of stress-test volatility.”

She said the current approach to stress testing does not always reflect the range of real risks banks face, as seen in 2023, when rising interest rates were a key stressor but were not incorporated into previous test designs.

Bowman said testing multiple scenarios would provide more valuable insights into different risks and help regulators better understand both firm-specific risks and broader financial stability risks. She also said stress testing should not be a rigid indicator of capital levels, but rather should serve as a tool to refine supervision and risk assessment.

“A more rigorous use of stress testing would require streamlining the link between stress testing and capital to ensure that any changes in overall calibration are driven by an intentional process that results in a reasonable policy outcome,” she said. “In my view, further recalibration of capital requirements through an expanded scenario testing regime would not be justifiable given the underlying risks.”

The Fed official expressed concern about the lack of transparency in the stress testing process, particularly regarding the models the central bank uses. She said greater transparency would help banks better understand the regulatory outlook and make more informed choices about capital allocation.

Bowman acknowledged that increased disclosure of test models could lead banks to adjust their operations solely to reduce stress losses and lower their capital requirements. However, she believes this concern is overblown and that transparency should be coupled with ongoing adjustments to prevent such manipulation.

“Greater transparency and transparency should be accompanied by careful consideration of how companies incorporate and use any additional information,” she said. “To the extent that gambling activity is identified, further changes to the test design may be appropriate.”

Bowman also highlighted what she saw as a risk of double counting of risks for the purposes of banks’ capital requirements. She noted that the rules on market and operational risks, currently under consideration as part of the Basel III capital cycle reforms, could potentially overlap with the requirements of the stress testing framework, particularly the “global market shock” component.

“In my view, there are strong indications that, as currently worded, the combination of these requirements would result in an over-calibration of risk-weighted assets for market-making and trading activities,” she said. “We need to ensure that the risks considered and the methodologies underlying these separate requirements do not lead to an over-calibration of capital requirements for activities that support the important role of U.S. financial markets in the global economy.”