For release on delivery
12:15 p.m. EDT
September 10, 2024
The Future of Stress Testing and the Stress Capital Buffer Framework
Remarks by
Michelle W. Bowman
Member
Board of Governors of the Federal Reserve System
at
Executive Council of the Banking Law Section of the
Federal Bar Association
Washington, D.C.
September 10, 2024
Thank you for the invitation to join you.1 Given the recent conclusion of the Board's
stress test, it seems timely to share my thoughts on the stress testing program. In the past, I have
noted reservations about the stress testing process, so today I'd like to discuss in greater detail
the benefits, challenges, and issues I would like to see resolved as the stress testing program
evolves in the future.2
Earlier this summer, the Board announced the results of the supervisory stress tests. At a
high level, all 31 banks subject to the test remained above their minimum common equity tier
one (CET1) capital requirements from the hypothetical recession scenario.3 Under this scenario,
banks would have absorbed projected hypothetical losses of nearly $685 billion, and would have
experienced an aggregate CET1 capital decline of 2.8 percent.4 The hypothetical scenario
included a 40 percent decline in commercial real estate prices, a substantial increase in office
vacancies, a 36 percent decline in house prices, a spike in unemployment to a peak of 10 percent,
and related declines in economic output.5 This year also saw the introduction of "exploratory"
stress scenarios, which included two different funding stress scenarios, and for a subset of banks,
1
These remarks represent my own views and are not necessarily those of my colleagues on the Federal Reserve
Board or the Federal Open Market Committee.
2
Michelle W. Bowman, "Large Bank Supervision and Regulation" (remarks at the Institute of International
Finance, Washington, D.C., September 30, 2022),
https://www.federalreserve.gov/newsevents/speech/files/bowman20220930a.pdf; and Statement by Governor
Michelle W. Bowman on the Basel III Endgame Proposal (July 27, 2023)
https://www.federalreserve.gov/newsevents/pressreleases/bowman-statement-20230727.htm, ("Today's proposal is
intended to improve risk capture, but in some circumstances, leaves in place and even introduces new regulatory
redundancies, as with changes to the market risk capital rule, credit valuation adjustments, and operational risk that
overlap with stress testing requirements and the stress capital buffer").
3
Board of Governors of the Federal Reserve System, "Federal Reserve Board Annual Bank Stress Test Showed
That While Large Banks Would Endure Greater Losses Than Last Year's Test, They Are Well Positioned to
Weather a Severe Recession and Stay Above Minimum Capital Requirements," news release, June 26, 2024,
https://www.federalreserve.gov/newsevents/pressreleases/bcreg20240626a.htm.
4
Id.
5
Id.
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included two trading book loss scenarios.6 The Board's press release announcing the results
reported that large banks are well positioned to weather a severe recession and remain above
minimum capital requirements.7
More recently, the Fed announced the final individual capital requirements for all large
banks, effective on October 1, 2024.8 The firm-specific capital requirements are "informed by"
the stress test results, and include a 4.5 percent minimum capital requirement, a stress capital
buffer that is set at a minimum of 2.5 percent, and if applicable, a capital surcharge for the most
complex banks that is based on each firm's systemic risk.9 The announcement of this year's
results also noted the modification of the stress capital buffer for a single firm based on a
reconsideration request. While firms subject to the stress test have long had the ability to request
reconsideration-and many have done so in the past-this was notable as it was the first time
that a reconsideration request was successful in producing a change to a firm's stress capital
buffer.
As we conclude this most recent cycle of stress testing-and as many firms begin to turn
to the next round-I think it is helpful to pause and consider whether and how the process could
be improved. My remarks today will address the value of stress testing on bank safety and
soundness and on financial stability, my concerns about the current implementation of the stress
test, and finally what I see as a potential path forward. I hope this discussion leads to a broader
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consideration of stress testing, its role in the current prudential framework as a supervisory tool,
and as a mechanism to set large bank capital standards through the stress capital buffer.
The Value of Stress Testing
Let me start by emphasizing that my remarks today should not be interpreted as a
wholesale criticism of the stress testing process and framework. I firmly believe that stress
testing is and will remain a valuable mechanism that provides insights that can inform
supervision and can inform the public about how the largest and most complex banks would fare
under a severe stress scenario. This exercise helps us gauge a bank's capital position and
determine whether it has sufficient capital to absorb losses and continue lending during an
economic stress event.
In practice, stress testing provides a very granular assessment of a firm's risk, one that is
more refined and risk-sensitive than capital standards alone. It relies on detailed balance sheet
information-fixed at a particular date in the past-to do a deeper analysis of the firm's financial
condition at that point in time. By subjecting this balance sheet to a hypothetical shock, we
develop a better sense of not only the firm's risk, but also the firm's capacity to respond and
adapt to changing economic conditions. This type of analysis would be impractical to conduct
on a continuous basis, but it is a useful periodic supplement to ongoing capital requirements and
can be used to support more robust supervisory practices.
The Need for Reform
While there are many virtues of stress testing, as currently implemented and executed
there are several significant drawbacks. These drawbacks arguably make the process less fair,
transparent, and useful than it could and should be.
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I have long supported and argued in favor of fairness and transparency in the bank
regulatory framework.10 The rules and supervisory practices that comprise this framework
should be consistent among firms, and consistent over time. Banks should have a clear
understanding of these rules to allow them to make informed business decisions that consider the
impact of the regulatory framework. But we also know that the diversity and variability of bank
business models can present a challenge to the clarity of the framework. Clarity is needed both
to promote equitable treatment among banks with different business models, and to create rules
that are fair over time. This allows firms to anticipate regulatory expectations as their business
activities and balance sheets evolve in response to, among other things, changing economic
conditions. Each bank is unique, and one need look no further than the balance sheets, business
activities, and risk profiles of large banks to observe this variability. But the onus is on
regulators to ensure that over time, regulations and supervisory practices are applied fairly and
consistently, and that evolution in the framework is accompanied by appropriate transparency for
regulated entities.
The challenge of creating rules that are fair and transparent is nowhere more notable than
in stress testing. Stress testing serves an important role in our regulatory framework, but one that
requires evolution to ensure relevancy and effectiveness. To date, the evolution of stress testing
has focused on refining the tests to be more robust over time and to provide more granular risk
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information about these banks. While these incremental improvements have been helpful, the
task of addressing identified problems is equally important.
To be clear, these problems extend beyond model accuracy and consistency across firms.
While by no means a comprehensive list, I would like to address four of my concerns in
particular: (1) volatility in firm results from year to year, (2) the challenge of linking stress
testing outcomes with capital through the stress capital buffer, (3) the broad lack of transparency,
and (4) the overlap with other capital requirements like the overlap between the global market
shock in stress testing and the market risk rule under the Basel III endgame proposal.
Volatility
One area of particular concern is the year-over-year volatility in stress testing results.
Many of the stress test design features are intended to promote consistency across firms-the
exercise uses a common scenario design, and subjects similarly situated firms to stress testing at
the same frequency. This format allows for comparisons across firms and can provide important
supervisory insights as regulators can look across firms to find common risk factors that could
affect multiple firms-and lead to more significant and widespread economic impacts-in a
stress event. But we have seen that stress test results for several firms vary considerably from
year to year based on the interaction of the specific scenario being tested with a firm's business
model, changes to the model, and each firm's balance sheet. This variability then flows through
to the stress capital buffers that apply to the largest firms.11
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Some variability is to be expected as the risk factors and balance sheet composition of the
tested firms both change over time. However, the test results observed year over year often
produce results that are not predictable in advance-for example, some of the volatility we see is
not based on fundamental changes to a tested bank's business model.
The link between stress testing and capital also creates a practical timing issue for firms.
The time frame for compliance with stress capital buffers compounds the issue of excessive year-
over-year volatility. While many capital requirements give firms a runway to comply and adjust
capital planning projections going forward, stress capital buffers allow a very brief window of
time for firms to comply.12 As a real-time example, this year's preliminary stress capital buffer
requirements were announced in late June, with required compliance by October 1st.
This concern is experienced differently across firms-for example, some firms can likely
predict that they will be subject to the stress capital buffer "floor," which perhaps can help with
longer-term capital planning. But for those firms whose stress capital buffers exceed the floor,
this short turnaround can pose significant planning challenges. Although banks historically have
not been required to raise capital to meet higher stress capital buffer results, volatility is not a
nonissue. As a matter of practice, banks maintain management buffers-additional capital in
excess of capital and regulatory buffer requirements-to ensure that they operate at levels
significantly above the "well-capitalized" threshold. Unexpectedly steep increases in stress
capital buffers may force firms to recalibrate or reconsider their management buffer, perhaps
operating at a higher level than would otherwise be necessary to account for known volatility in
stress capital buffers over time.
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This variability is not without cost. Firms engage in capital planning over a long-term
planning horizon. Significant variability can disrupt these practices and require firms to hold
more capital and higher capital management buffers than prudent business practices would
indicate.
The link between stress testing and capital-the stress capital buffer
As currently implemented, the stress test exercise presents a single hypothetical shock to
a firm's balance sheet, with the goal of better understanding firm performance and risks in the
face of this stress. But the test is not intended to be-nor is it in practice-predictive of an actual
stress event that the firm would experience. During the banking stress of 2023, the key risk
factor was rapidly rising interest rates, and yet this type of economic stressor was not included in
any past iteration of the test design.
Why do we select one scenario and use that hypothetical to establish binding capital
requirements for many firms regardless of their business model? What incentives does this
system create as regulators design scenarios?
Unquestionably, stress testing can provide valuable insights to inform supervision.
Testing multiple stress scenarios could provide additional information that could be used to
probe the unique risks and resilience of particular firms. And it could provide regulators and the
public with a clearer understanding of financial stability risks across firms under different
plausible future states of the world.
But a more robust use of stress testing would require rationalizing the link between stress
testing and capital to ensure that any change in overall calibration was driven by an intentional
process that results in a reasonable policy outcome. As a practical matter, testing additional
scenarios raises the question of what consequences should flow from a multi-scenario testing
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regime. Would such an approach require across-the-board capital increases, as regulators
calibrate stress capital buffers based on the most severe outcome of any tested scenario for each
firm? Or should regulators pick a common scenario to calibrate stress capital buffers for all
firms, even in a multi-scenario stress testing regime? Or should regulators take a different
approach and sever the link between stress testing and capital requirements?
The link between stress testing and capital raises important policy questions about the
optimal level of capital, but ultimately should not dissuade us from using stress testing to better
understand firm-specific and broader financial stability risks. At the same time, we need to pay
careful attention to the design of all capital requirements-including not just the stress capital
buffer, but also other risk-based capital requirements, leverage requirements, and long-term debt
requirements-to ensure that the overall calibration of these requirements is proportionate to
risk. In my view, an up-calibration of capital requirements through an expanded scenario-testing
regime would not be supportable based on the underlying risks.
Transparency
One persistent issue with the stress tests is the lack of public transparency around the
models. This opacity frustrates bank capital management and allocation. When a bank engages
in an activity or prices a product or service, as a sound business practice, they must anticipate the
financial consequences and the accompanying risks. Before making any decisions, a bank will
often try to project the anticipated costs and revenues. In addition, the bank will want to evaluate
the projected growth of the business or activity over time, determine whether the activity
complements other existing products and services, and decide whether there will be sufficient
customer demand to justify the cost based on the contemplated pricing levels and margins. One
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important consideration in this exercise is the cost of capital. Banks often quantify the cost of
capital and "allocate" those costs across various business lines.
The capital requirements and supervisory risk assessment of activities are important
inputs for bank decision-making. Banks benefit when they understand the regulatory perception
of their activities. That feedback is often a critical part of the supervisory process. A regulatory
perspective is embedded in stress testing, through the common parameters, assumptions, and
conditions that will be used in the exercises. But much of this work remains hidden from public
scrutiny and from the financial institutions subject to the stress tests. Providing access to this
information-making clear the regulatory perspective-by improving the transparency of the
process would enable banks to better manage their business and make more informed decisions.
Of course, greater disclosure is not without its detractors. A common criticism of
increased transparency is that disclosing the more granular parameters of particular calculations
would lead to "gaming" of the test by large banks seeking to optimize their capital. The
underlying premise of this concern seems to be that the stress tests are and must be static over
time, and that if firms make changes to their activities that have no economic consequences-but
instead are used only for "gaming" purposes to reduce stress losses-that regulators are limited
in making further changes. I think this misinterprets the dynamism and review that should
complement the stress testing process. Greater disclosure and transparency should be
accompanied by a careful review of how firms incorporate and use any additional information,
and to the extent that gaming activity is identified, further changes to the test design may be
appropriate.
Another criticism is that by disclosing test results, all firms-including in their internal
stress testing practices-will "converge" on a common standard and that this standard will in
some way increase risk. For example, if firms' stress testing practices are uniform, but include
some flawed assumption or parameter, this could create a systemic weakness. Put differently,
the model "monoculture" caused by greater transparency could miss important systemic risks.
We should ask whether more granular disclosures would override the informed risk assessments
of banks in managing their business-would all firms simply adopt whatever the regulators are
doing in the supervisory stress test, undermining the utility of other practices like internal stress
tests? However, we should not think about stress testing in isolation-supervision informed by
stress testing, and ongoing improvements to supervisory stress testing can operate as a backstop
to address risks that may accompany more transparency.
I am concerned about changes that could undermine the utility of both regulatory and
internal stress testing at large firms. Regulators should not seek to take risk-management
decisions away from banks. But greater transparency, debate, and discussion of test parameters
need not lead to a dilution of standards. These discussions could actually promote a cycle of
continuous improvement and feedback. We have seen over time that the regulatory stress tests
are not static. As regulators learn more, they adjust and adapt different elements of the exercise
in light of lessons learned from the process.
The issues of transparency around the stress tests extend beyond just disclosure. The
reconsideration process itself could be improved by developing a more transparent process and
clearer standards against which reconsideration requests will be evaluated. While this year saw a
positive development with the Board for the first time changing a firm's stress capital buffer
requirement in response to a request for reconsideration, the high failure rate of such requests
over time shows the need for rethinking and revisiting the process.
Overlap with other capital requirements
Finally, as I have noted in the past, we must ensure that each element of the capital
framework operates in a complementary and not contradictory way, and that requirements are
calibrated proportionate to risks. Failing to appropriately calibrate capital and risk requirements
creates risks-incentivizing banks to curtail activities that are assigned a punitive capital
treatment and devoting more resources to activities that are assigned an inappropriately low
capital risk weighting. Over time, these dynamics can have real-world market and economic
consequences, resulting in negative outcomes for customers and economic activity.
When we view capital requirements in their totality, one potential overlap can be found in
the proposed changes to the market risk capital rules and operational risk rules with the "global
market shock" and operational risk elements of the supervisory stress testing framework. We
need to ensure that the risks captured and methodologies underpinning these distinct
requirements do not lead to an over-calibration of capital requirements for activities that support
the important role of U.S. capital markets in the global economy.
The Path Forward
As we look ahead to the future of stress testing, I think we need to carefully consider how
the current framework can be improved. These issues-volatility, the link between stress testing
results and capital and the short capital implementation compliance time frame, the lack of
transparency, and the overlap between the global market shock in stress testing with the market
risk test of Basel III-can all be addressed and should be prioritized in the ongoing evolution of
the stress testing framework and stress capital buffer requirements. It is important that regulators
consider the lessons learned from past tests and feedback from banks and other members of the
public to ensure that stress testing is fair, transparent, and more useful going forward.
First, we need to address the excessive year-over-year volatility, which flows through to
the calculation of stress capital buffers. As I noted, capital planning for many firms is a long-
term enterprise, and excessive volatility and unpredictability of stress capital buffer levels can
increase costs and complicate capital allocation and management. Of course, the goal is not to
eliminate variability over time-variability based on changing economic conditions and
changing firm business activities and balance sheets-but rather to blunt the excessive volatility
observed over the history of stress testing.
There are many possible ways to limit excessive volatility while maintaining the value of
the Board's stress tests. For example, one solution could be to average results over multiple
years, so a firm's stress capital buffer would move in smaller increments through the averaging
process. Another possibility is to constrain variability in annual stress test scenario design.
Countercyclicality in the design of the regulatory stress tests-where the stress
experienced by firms is more severe when economic conditions are better-acts as a
counterweight to the inherent procyclicality of risk models. This approach "eases" capital
requirements (through lower stress capital buffers) as economic conditions decline. But this
countercyclicality is also a driver of volatility, and we should look more closely as to whether
our attempts to adjust for countercyclicality are appropriate through the lens of stress test
volatility.
Second, I think there is a benefit to promoting greater transparency in stress testing,
particularly as it relates to the disclosure of the underlying models. Stress testing need not be an
exercise shrouded in secrecy, and the Federal Reserve has shown in the past that improvements
are possible. For example, in 2019, the Board adopted new principles that guide the design of
the stress tests, and promoted greater transparency.13 In addition to these principles, the Board
moved to provide more information about its stress testing models, including ranges of loss rates
for actual loans held, portfolios of hypothetical loans with loss rates estimated by the Board's
models, and more detailed descriptions of the Board's models (including some granular
information about certain equations and variables used in the models).14 While these were
positive steps in promoting transparency, the announcement of design principles and enhanced
disclosures did not go far enough in my view, and we have seen that even after several years,
firms continue to struggle to understand and anticipate the results of supervisory stress tests and
the accompanying stress capital buffer requirements.
The simple solution here seems to be disclosure of more granular information about all of
the models used in stress testing. In my view, disclosure of these models-and even subjecting
the models to appropriate notice and comment processes and public feedback-would not
undermine the goal of the stress tests of having a regulator-created model that is separate and
distinct from the internal models used by firms. Regulators would still control the contours and
content of the models but would have the benefit of public feedback. If we believe in the
validity and reasonableness of our model design choices, we should not shy away from public
feedback.
Third, we should adjust the compliance framework for stress capital buffers. Firms
should not be forced to comply with higher capital requirements after only a few months' notice
but should have a reasonable time frame for compliance. I would note that a longer compliance
runway is particularly important in a world in which testing is opaque and volatility continues to
be excessive. To the extent that these more fundamental issues are addressed, this may mitigate
the need for a shorter compliance window.
Finally, as we move forward with Basel III implementation, we need to take a careful
look at whether market risk and operational risk requirements are overlapping and redundant
with the "global market shock" and operational risk elements of stress testing and think about the
calibration of these requirements in the aggregate. Would these tests in tandem produce
excessively calibrated capital requirements, and if so, what would the impact be on U.S. capital
markets? In my view, there are strong indications that as currently formulated, the combination
of these requirements would result in an excessive calibration of risk-weighted assets for market
making and trading activities. And of course, we must think broadly about the optimal level of
capital in the banking system, taking into account the full range of risk-based and leverage
capital requirements and long-term debt requirements.
There are many possible ways to move forward with stress testing, and the proposals I
have offered above are merely a subset of possible changes that could improve the process and
address many of the known deficiencies. But I believe there is a growing awareness of the need
for a fundamental rethink and strategic reform of stress testing, and any such process must
acknowledge and address these known issues within the framework.15
Closing Thoughts
Thank you again for the invitation to join you today. The stress test is an important
supervisory tool, and I think it is imperative that we work to continually improve it. I have laid
out a number of my concerns about the current practice, and some potential areas to explore in
terms of improvement. But I also think it is imperative to listen to a wide range of stakeholders
about the path forward.