Happy Fed day! Let’s discuss a key post-2008 exercise…

IN ACTION

“The 2024 stress test shows that the 31 large banks subject to the test this year have sufficient capital to absorb nearly $685 billion in losses and continue lending to households and businesses under stressful conditions.” - 2024 Federal Reserve Stress Test Results (June 2024)

THE BASICS

The Federal Reserve’s stress tests seek to validate the resilience of the banking system. The tests are completed at an annually frequency, with the largest domestic banks and US holding companies of foreign banks required to participate (the 2024 stress tests included 31 participants). Administered by the Federal Reserve, stress tests are a tool used by regulators and the public to evaluate whether banks are sufficiently capitalized to withstand future economic shocks.

WHY IT MATTERS

Stress testing began in 2009 in response to the Great Recession. The Dodd-Frank Act requires the Federal Reserve to perform annual stress tests with the broader goal of promoting financial stability. The tests start with Fed officials creating hypothetical economic scenarios, developing models to perform the tests, and requesting key data / inputs from participating banks (banks above a certain $ value of assets). Leveraging these tools and information, regulators forecast how participating banks are likely to perform under adverse conditions – informing capital requirements and making bank-level results public.

A more implicit, but crucial, goal of the stress tests – and a key reason the tests were conceived coming out of the Great Recession – is to ensure faith in the banking sector. Public confidence in the banking system had eroded post-2008, and regulators sought to prove to consumers and investors that banks’ capitalization had improved. By completing and making the results of the stress tests public, banks could signal to the market they were positioned to survive unexpected headwinds.

2025 AND BEYOND

Last December, a group of banks and business groups filed a lawsuit against the Federal Reserve arguing that the central bank's annual stress tests lacked transparency and sought to subject the process to public input. The complaint recognized the importance of the annual stress tests but also noted that higher capital requirements hurt consumers’ access to credit. Shortly after, the Federal Reserve announced plans to change how stress tests are conducted and improve transparency moving forward - changes that could significantly impact banks’ capital requirements.

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