The Federal Reserve’s Annual Bank Stress Tests Come Under Stress

Every year the Federal Reserve conducts a stress test on about 30 U.S. banks to evaluate their ability to withstand economic crises, using hypothetical scenarios such as when the unemployment rate rises to 10 percent and housing prices drop 40 percent. This past Christmas, the Bank Policy Institute, a trade organization representing major banks like JPMorgan Chase (JPM), Citigroup (C), and Goldman Sachs (GS), filed a lawsuit against the Fed jointly with the American Bankers Association, the Ohio Bankers League, the Ohio Chamber of Commerce and the U.S. Chamber of Commerce.

The plaintiffs allege that the Fed has been conducting stress tests on the banks without transparency into the tests’ process and criteria, violating the Administration Procedure Act, which prohibits the government from regulating behind closed doors. The plaintiffs argue the Fed should publicly disclose any changes to its stress tests, and solicit public input before making those changes.

This suit came on the heels of the Supreme Court repealing the “Chevron doctrine” in June 2024, which curtailed federal agencies’ ability to use reasonable discretion to interpret ambiguous U.S. law to write regulations. While the 2010 Dodd-Frank Act requires the Fed to stress test major banks, the central bank has used its discretion to come up with hypothetical economic situations to test the banks against.

The lawsuit was filed a day after the Fed announced that it would “seek public comment on significant changes to improve the transparency of its bank stress tests” in early 2025. The plaintiffs said they “do not oppose stress testing or capital requirements” and applauded the central bank’s announcement.

To conduct stress tests, banks are asked to submit detailed data about their liquidity levels, loan and deposit, and asset holdings. The Fed then input these data into its stress test models, which predict how banks might perform under unfavorable economic conditions. The results help the central bank determine capital requirements, ensuring that banks have enough reserves to weather these conditions. However, a higher capital requirement can limit the funds available for lending, potentially hurting a bank’s profitability.

Stress tests have come under scrutiny after the Silicon Valley Bank’s collapse in March 2023. In a post-mortem report, the Fed said it must strengthen the Federal Reserve’s supervision and regulation, specifically pointing to the “treatment of held-to-maturity (HTM) securities in our standardized liquidity rules and in a firm’s internal liquidity stress tests.”

Under U.S. accounting rules, banks report HTM securities at their principal value rather than the market value. When a bank needs to cash out these securities for fulfill liquidity needs when their market value is significantly lower than the principal value (as was the case with the U.S. Treasury bonds in SVB’s portfolio), it could find itself unable to raise sufficient funds.

“We would be far better off if they were required to mark-to-market for regulatory purposes,” Kim Schoenholtz, who served as Citigroup’s global chief economist from 1997 to 2005, told Observer last year. Current HTM reporting practices allow banks to fall under a regulator’s radar, rendering them useless in helping at-risk banks. The Fed has yet to announce whether it will adjust any reporting practices for HTM assets.