The Federal Reserve plans to make significant adjustments to the annual bank stress tests based on legal rulings

According to the Zhitong Finance APP, the Federal Reserve stated on Monday that it is considering significant adjustments to its annual bank "stress tests" in light of recent legal developments, including allowing banks to comment on the models they use. This is a major victory for Wall Street banks.

The Federal Reserve indicated that it may also allow banks to provide input on the hypothetical scenarios used for the annual bank health checks and may average the results over two years to reduce the annual volatility in the amount of capital banks must set aside to absorb potential losses.

These tests were created after the financial crisis of 2007-2009 to assess whether large banks can withstand economic shocks. They are central to the U.S. capital regime, determining how much cash banks must hold to absorb losses and how much they can return to shareholders.

The Federal Reserve stated that the proposed reforms are not intended to affect overall capital requirements but were put forward after recent court rulings significantly changed the administrative law framework. The Federal Reserve said, "In light of the changing legal environment, the committee has analyzed the current stress tests and is determined to modify the tests in significant ways to enhance their resilience."

In June of this year, the U.S. Supreme Court overturned a ruling from forty years ago in the case of Chevron U.S.A. Inc. v. Natural Resources Defense Council. This case is one of the most cited precedents in U.S. law. The Chevron principle requires courts to defer to administrative agencies' "permissible" interpretations of the regulations they enforce, even if the court has a different interpretation of the regulations. However, in June, the U.S. Supreme Court ruled that even in cases where the regulatory language is ambiguous, courts are not required to defer to administrative agencies' interpretations of the law. This ruling dealt a significant blow to federal regulatory power.

Although the Dodd-Frank Act was passed in 2010, generally requiring the Federal Reserve to test banks' balance sheets, the capital adequacy analysis conducted by the Federal Reserve as part of the tests, or the capital it instructs banks to set aside as a result, is not legally mandated. Analysts say that the overturning of the Chevron precedent makes stress tests more susceptible to litigation.

According to industry insiders and publicly available records of meetings between industry groups and the Federal Reserve, Wall Street banks and their industry groups in Washington have been quietly lobbying this year to try to increase the transparency of stress tests. These discussions are part of a large-scale effort by the banking industry to mitigate the increased capital requirements under the so-called Basel Endgame rules. In response, Wall Street banks have taken the unusual step of threatening to sue the Federal Reserve and the other two federal regulatory agencies responsible for drafting the rules.

The banking industry has historically been very reluctant to sue federal banking regulators, but as conservative U.S. courts have become increasingly willing to entertain industry lawsuits regarding federal agency overreach, they have become bolder. The Bank Policy Institute (BPI), which has consistently criticized stress tests, stated in a release that Monday's announcement is "a first step toward transparency and accountability." BPI President and CEO Greg Baer said, "We are carefully reviewing it and considering other options to ensure timely reforms that are both good law and good policy." ”