Rethinking the Role of Stress Testing in Bank Regulation

Amid evolving regulatory pressures and ongoing legal challenges, the Federal Reserve’s approach to stress testing for large U.S. banks is under fresh scrutiny.

Since its emergency deployment during the 2008 financial crisis, stress testing has become a cornerstone in safeguarding the soundness of the nation’s biggest banks. Originally designed as a crisis measure to rebuild public confidence through transparency and rigorous analysis, the process has matured into a more institutionalized practice through legislation like the Dodd-Frank Act and the introduction of the Comprehensive Capital Analysis and Review (CCAR). Over time, regulatory adjustments have sought to balance rigor, transparency, and predictability. Notably, the 2020 introduction of the stress capital buffer (SCB) aimed to directly tie stress test outcomes to regulatory capital requirements, addressing industry concerns about unpredictability and a perceived lack of transparency. However, these changes have prompted further legal and policy debates, culminating in recent litigation by major banks challenging the opacity and flexibility of the stress testing framework.

The current controversy centers on proposed changes from the Federal Reserve Board, which would increase transparency by subjecting stress testing models and scenarios to public comment and regulatory review. Critics, including Michael S. Barr, argue that such efforts risk making the stress tests static and easier for banks to game, potentially dulling their effectiveness as a supervisory tool. These critics assert that, if banks know test parameters in advance, they may shift strategies simply to pass the tests, rather than genuinely reducing risk exposure—undermining the intent of ensuring resilience under adverse, unpredictable conditions. Barr advocates for decoupling stress tests from immediate capital requirements, suggesting instead that regulatory buffers be set independently, while stress testing remains an adaptive, supervisory exercise to identify emerging risks and inform oversight. This approach would maintain the flexibility and credibility of stress testing, even as regulatory capital requirements are upheld or increased as needed.

This debate is significant because it touches on the core of financial stability policy—how best to ensure that the largest banks can withstand shocks without compromising system soundness or public trust, especially as the financial landscape continues to evolve.