Dive Brief:

• Stress tests should remain stringent but be simpler, more transparent and less volatile, Federal Reserve Vice Chair Randal Quarles told a conference Tuesday. “Like a teacher, we don’t want banks to fail, we want them to learn,” he said.
• The Fed last year proposed replacing “in the near future” several of 20 metrics taken during stress tests with a stress capital buffer based on capital losses from the previous year’s stress test.
• Former Fed Governor Daniel Tarullo has criticized the plan. “A good bit of … progress could be endangered by a kind of low-intensity deregulation, consisting of an accumulation of non-headline-grabbing changes and an opaque relaxation of supervisory rigor,” he told a conference in May sponsored by Americans for Financial Reform. One fault in using the SCB is that it leaves out the post-stress leverage ratio.

Dive Insight:

The proposed use of the new buffer comes on the heels of other changes to the tests that measure whether banks can continue lending during a hypothetical economic downturn in which unemployment reaches 10 percent and the market drops by half. The Fed this year stopped giving pass-or-fail grades on the qualitative portion of the test for domestic banks that have taken the exam for four or more years and passed in the most recent year. All 18 banks passed the most recent stress test, the Fed reported in June.

The Fed could alleviate volatility in stress testing by averaging results over time, Quarles said. “Mathematically … no single year could have an outsized influence on the amount of capital a bank is allowed to maintain,” he said Tuesday, but added that approach could lead to reduced risk sensitivity.

For his part, Tarullo has criticized the Fed’s attempt to make the tests more transparent, saying if banks know a blueprint of the process, they can make subtle changes to their balance sheets to minimize losses and skew results. “If the stress test becomes predictable, it ceases to have value,” he said.

Quarles on Tuesday said such objections “overstate” the extent of the disclosures banks would receive, adding the goal remains “to improve and sustain good risk management and capital planning.” “If the goal were only to conduct a test that was difficult to pass … then greater stress testing would indeed be a mistake,” Quarles said. “But that is not the purpose of stress testing, and it never has been.”

In a Q&A published Monday, the Brookings Institution said feedback from stress tests has helped banks more effectively focus on tail risks in loan books and prompted greater involvement of upper management in capital planning. Higher capital requirements for large banks have led smaller banks to boost their share of the lending market, Brookings said. But the true measure of stress tests’ effectiveness may not be seen until the next recession.