The Federal Reserve’s stress tests have many virtues, but as currently implemented, several significant drawbacks make the process less fair, transparent and useful than it could be, Fed Governor Michelle Bowman said today. During a speech in Washington, D.C., Bowman made four recommendations for improving stress tests.
First, regulators need to address the excessive year-over-year volatility in stress testing results, which are used in the calculation of stress capital buffers, Bowman said. Second, there is a benefit to promoting greater transparency in stress testing, particularly as it relates to the disclosure of the underlying models.
“The simple solution here seems to be disclosure of more granular information about all of the models used in stress testing,” she said. “In my view, disclosure of these models—and even subjecting the models to appropriate notice and comment processes and public feedback—would not undermine the goal of the stress tests of having a regulator-created model that is separate and distinct from the internal models used by firms.”
Third, regulators should adjust the compliance framework for stress capital buffers. “Firms should not be forced to comply with higher capital requirements after only a few months’ notice but should have a reasonable time frame for compliance,” Bowman said.
Finally, as regulators move forward with Basel III implementation, they must take a careful look at whether market risk and operational risk requirements in that proposal overlap with the “global market shock” and operational risk elements of stress testing, and think about the calibration of such requirements in the aggregate.
“In my view, there are strong indications that as currently formulated, the combination of these requirements would result in an excessive calibration of risk-weighted assets for market making and trading activities,” she said.
