From Blueprint to Burden: My Call to Scrap US Bank Stress Tests

Key Takeaways:

• Eroding Credibility:Once a vital tool for market confidence during the 2009 crisis, US bank stress tests have become a diluted, adversarial ritual, fostering complacency rather than true resilience amidst persistent industry lobbying.
• Blind Spots & Mispriced Risk:Current stress scenarios are backward-looking, failing to account for contemporary threats like high interest rates, inflation, cyberattacks, private credit turmoil, or algorithmic market distortions, potentially leading investors to misassess true bank vulnerabilities.
• Urgent Reform Needed:To restore market discipline and genuine financial stability, regulators must decouple stress tests from capital setting, embrace dynamic, forward-looking scenarios, cease accommodating industry pressure, and implement a consistent, robust supervisory framework.

Unlock the White House Watch newsletter for free

Your guide to what Trump’s second term means for Washington, business and the world

The writer is a former chair of the US Federal Deposit Insurance Corporation and author of the book ‘How Not to Lose a Million Dollars’

In the crucible of the 2009 Great Financial Crisis, as credit markets seized and global economies teetered, US bank regulators deployed an unprecedented measure: public stress tests for the nation’s largest financial institutions. As the then-chair of the Federal Deposit Insurance Corporation, I was intimately involved in co-leading and supporting this critical initiative. The objective was clear – to pierce through the opacity that had fueled panic, restore market confidence, and definitively prove that major banks held sufficient capital to weather the storm and continue the vital flow of credit to a deepening recession-hit economy. These tests were, by all accounts, a resounding success, injecting much-needed transparency and stability into a fractured system.

Fast forward to today, and the landscape has changed dramatically, but not for the better. What began as a potent tool for safeguarding financial stability and market integrity has, unfortunately, degraded into a largely annual, time-consuming ritual. Far from informing the public and investors about banks’ true financial health, these exercises now do more to mislead, creating an illusion of resilience that may be masking underlying vulnerabilities. This erosion of purpose demands significant, immediate reform, lest we sow the seeds of future instability.

The current stress test framework, spearheaded by the Federal Reserve, operates on the premise of hypothesizing an adverse economic scenario and then assessing whether the largest banks possess adequate capital to absorb potential losses and sustain lending. Conceptually, this should be a collaborative learning exercise, enriching both banks’ risk management practices and regulators’ supervisory insights. However, a pivotal shift occurred in 2020: the test results became directly tethered to a bank’s capital requirements. This linkage dramatically elevated the stakes, transforming the exercise from a supervisory dialogue into an increasingly adversarial negotiation with direct implications for banks’ bottom lines and shareholder returns. This commercial pressure has fueled an aggressive lobbying campaign by the banking industry, often resulting in the central bank accommodating demands to weaken the tests, a trend that carries significant implications for market confidence and systemic risk.

The evidence of this dilution is pervasive. Originally, banks were compelled to demonstrate resilience across multiple metrics, including both risk-based capital measures and crucial leverage ratios. The leverage ratio, a simpler, less manipulable measure of capital relative to total assets, provides a vital backstop against excessive balance sheet growth. Yet, in 2020, following intense industry lobbying, the Fed controversially abandoned the leverage ratio component. This single change signaled to the market a willingness to prioritize industry comfort over robust, multi-faceted capital assessment, potentially encouraging riskier asset expansion without commensurate capital backing, which could lead to increased volatility in bank stock valuations if market conditions deteriorate.

Further concessions have accumulated. Requirements for banks to demonstrate the capacity to expand lending during a recession – a core purpose of the original tests and vital for economic recovery – have been significantly softened. Assumptions around pre-funding shareholder distributions and maintaining variable pay commitments in times of stress, which are crucial for preserving capital buffers, have also been weakened. This directly impacts investor perception of a bank’s ability to retain capital during downturns. Previously, tests assumed abrupt and significant losses on banks’ private equity holdings during global market shocks, reflecting the illiquid and volatile nature of these investments. Now, the framework assumes a more gradual, less impactful loss trajectory, understating potential market-driven shocks in this increasingly interconnected asset class and potentially underpricing the risk exposure for investors.

Most recently, in a move widely criticized by public advocacy groups like Better Markets, the Fed, responding to an industry lawsuit, has begun making detailed public disclosures of the proprietary models it uses to calculate losses. This decision has been equated to “giving the banks the answers before they take the test,” undermining the integrity of the exercise. For market participants, this transparency might seem beneficial, but when it allows banks to reverse-engineer and optimize their portfolios to merely pass the test rather than truly enhance resilience, it distorts the very purpose of rigorous stress testing. It risks transforming the tests into a compliance checkbox rather than a genuine risk assessment tool, potentially leading investors to overstate bank safety and misallocate capital.

This systematic mollification of industry concerns has coincided with a noticeable, and frankly alarming, decline in the Fed’s calculations of how much capital banks would actually lose under its hypothetical stress scenarios. This year’s test results were particularly striking: a severe economic downturn featuring a 10 percent unemployment rate, a 39 percent drop in commercial real estate prices, and a 30 percent decline in home prices – conditions reminiscent of, or even exceeding, aspects of past crises – would purportedly lead to only a 1.6 percentage point decline in the aggregate capital ratio for the tested banks. This is the lowest decline ever recorded under the current framework. As a veteran of the financial crisis, I find this minuscule projected drop hard to reconcile with historical precedents or realistic market dynamics. It raises serious questions about the severity of the scenarios or the realism of the loss models, potentially fostering a dangerous sense of complacency among investors and regulators alike, leading to an underappreciation of systemic risk within the broader financial ecosystem.

Beyond the diluted methodology, the fundamental scenarios themselves are backward-looking and increasingly out of step with current and emerging market realities. They predominantly assume a deflationary, credit crunch-driven recession, much like the 2008 financial crisis, where interest rates plummet to near zero. Yet, today’s prevailing macroeconomic environment is one of persistent inflation, elevated interest rates, and a weakening but not collapsing economy – a scenario that presents a fundamentally different set of challenges for bank balance sheets, particularly regarding interest rate risk, funding costs, and asset valuations. Moreover, the tests conspicuously omit critical, evolving risks that could trigger systemic shocks: system-wide cyber attacks capable of paralyzing financial infrastructure; AI-generated fraud and algorithmic herding that could amplify market volatility; turmoil in the opaque and rapidly growing private credit markets; and structural vulnerabilities in the critical US Treasury market. Ignoring these contemporary threats leaves gaping holes in the perceived safety net, encouraging market participants to underestimate true systemic risk and potentially exposing the financial system to unquantified dangers.

The current approach also inadvertently dilutes market discipline and reinforces the problematic notion of “too-big-to-fail” (TBTF). When the central bank publicly certifies banks as resilient, it inherently reduces the incentives for investors, analysts, and rating agencies to conduct their own rigorous, independent analyses of these colossal institutions. JPMorgan chief executive Jamie Dimon has pointed out that these tests make it difficult for bank boards to challenge their own risk managers – if the Fed, the ultimate authority, declares the banks strong, why should anyone worry? This creates a moral hazard, subtly suggesting an implicit state guarantee. Furthermore, it puts the Fed in an awkward and compromised position: should a bank it recently declared “resilient” encounter serious trouble, the central bank would have a strong incentive to orchestrate a bailout to save face and preserve its own credibility, further entrenching the TBTF problem and shifting potential losses onto taxpayers rather than shareholders or creditors. This distorts fair market competition and penalizes smaller institutions not afforded the same implicit protections.

While the Federal Reserve is legally mandated to conduct annual stress tests, it retains broad authority over their design and disclosure. This latitude provides a crucial opportunity for fundamental reform. The Fed should scrap the current, compromised framework and instead integrate stress testing into a truly dynamic, ongoing supervisory process. This would involve stressing multiple, diverse scenarios that genuinely reflect current and potential future financial and economic conditions, moving beyond the static, backward-looking models. Crucially, stress testing should be formally divorced from the direct setting of bank-specific capital requirements. Instead, all systemic banks should be subject to a strong, uniform stress capital buffer, providing a consistent baseline of resilience for the market to evaluate. Furthermore, the Fed must cease making one-way concessions in response to relentless industry lobbying. How can investors and analysts reliably assess bank capital adequacy and risk if the regulators themselves keep changing the goalposts and diluting the very definition of resilience? Such inconsistency undermines market confidence and makes robust risk assessment a moving target.

By diluting market discipline, fostering complacency, and misrepresenting the true risk profile of major financial institutions, the current iteration of bank stress tests is, paradoxically, making the financial system less safe. As the new Fed chair, Kevin Warsh, seeks to reform the central bank’s operations and restore its credibility, the urgent and comprehensive overhaul of the stress testing regime deserves his immediate and priority attention. The stability of our financial markets and the trust of investors depend on it, requiring a framework that truly tests resilience, not merely compliance.