Stress test litigation
Bank Policy Institute v. Board of Governors of the Federal Reserve System
Date: Dec. 24, 2024
Issue: Whether the Federal Reserve’s stress testing framework violates the Administrative Procedure Act.
Case Summary: ABA, the Bank Policy Institute, the Ohio Chamber of Commerce, the Ohio Bankers League, and the Chamber of Commerce of the United States of America (collectively ABA) sued the Board of Governors of the Federal Reserve System (the Fed) in the Southern District of Ohio, claiming the Fed’s stress testing framework violates the Administrative Procedure Act (APA).
The Fed conducts stress tests by selecting a hypothetical set of economic conditions, called “scenarios,” and using internal statistical models to project how banks would perform under those conditions. It then converts the results of this analysis into a capital requirement for each bank, known as the “stress-capital buffer.” Specifically, a bank must hold a specific amount of capital based on its performance in the Fed’s stress tests and meet other minimum capital requirements and buffers. If a bank fails to meet these requirements, it faces stricter limits on capital distributions and discretionary bonus payments. Under the Fed’s current regulations, three types of banks must undergo the supervisory stress tests: any U.S. bank holding company with average total consolidated assets of $100 billion or more; any intermediate holding company with total consolidated assets of $100 billion or more; and any nonbank financial company supervised by the Fed that is made subject to the stress-test requirements “pursuant to the rule or order” of the Federal Reserve.
In the complaint, ABA noted that it does not oppose stress testing or capital requirements, which can be instrumental to the safety and soundness of the U.S. financial system. However, stress-testing capital requirements can greatly impact the cost of financial services for all Americans. In turn, ABA stressed that federal regulations in an area this consequential should be adopted in a manner that complies with the requirements Congress laid down to ensure fair, rigorous rulemaking and rational results.
ABA argued that the Fed’s stress test regime is unlawful for at least three reasons. First, under the APA, agencies cannot adopt rules without engaging in notice-and-comment rulemaking. The APA requires agencies to use notice-and-comment rulemaking whenever they issue a new legislative rule. ABA contended that the scenarios and models are integral components of legislative rules, as the Fed uses them to determine banks’ capital requirements. On that basis, ABA argued that the scenarios and models “have the force and effect of the laws.” In effect, the Fed must use notice-and-comment rulemaking to establish the annual scenarios, the models that assess banks’ performance in those scenarios, and any future changes to both the scenarios and the models. ABA emphasized that the Fed’s failure to do so deprives regulated parties of transparency, fairness, and the benefits of the government’s “mature consideration of rules of general application.”
Second, ABA argued the Fed cannot establish a party’s legal obligation in secret because this violates the APA, which requires the publication of “substantive rules of general applicability,” “statements of general policy or interpretation of general applicability,” and “each amendment, revision, or repeal of the foregoing.” ABA emphasized that the Fed’s hidden standards and criteria for setting capital requirements also violate basic principles of due process, which demand that the Fed provide fair notice before restricting banks’ control over their assets.
Third, ABA argued that the Fed’s actions in establishing the current program, under which stress tests determine capital requirements, are arbitrary and capricious. Along with the scenarios and models used to set banks’ stress-capital buffers for 2024 and those planned for 2025, ABA challenged four interrelated actions by the Fed in 2019 and 2020: the Policy Statement on the Scenario Design Framework for Stress Testing (Scenario Policy Statement), the Stress Testing Policy Statement, the Enhanced Model Disclosure document (collectively, the 2019 Policy Statements), and the Rule on Regulatory Capital, Capital Plan, and Stress Test Rules (2020 Rule).
In the Scenario Policy Statement, the Fed explained at a high level how it planned to develop the annual scenarios. The Fed also acknowledged that commenters suggested and supported publishing the scenarios for notice and comment. Still, the Fed failed to meaningfully consider notice-and-comment as required by the APA or give a “reasoned response” to commenters’ concerns. Therefore, ABA claimed the Scenario Policy Statement was arbitrary and capricious and violated the APA.
In the Stress Testing Policy Statement and the Enhanced Model Disclosure Document, commenters again requested greater transparency, but the Fed ignored their comments. When it declined to make the models available to the public, the Fed argued that publication might lead banks to “conceivably use [the models] to make modifications to their businesses that change the results of the stress test without actually changing the risks they face.” ABA argued this reasoning is arbitrary and unlawful, contending any attempt by banks to artificially “game” the models could be addressed by the Fed through its monitoring and supervisory powers. ABA also argued that conformity to legal standards is a desirable outcome, not a “material risk.”
Finally, in the 2020 rule, the Fed formally incorporated the results of the stress tests into banks’ capital requirements through the stress-capital buffer. Banks again requested disclosure, highlighting the volatility and unpredictability caused by the Fed’s unlimited discretion over the contents of the stress tests. Yet the Fed declined again, stating that the Fed’s methodology for conducting the supervisory stress test “was not part of the proposal.”
ABA requested that the court: vacate and set aside the 2019 and 2020 Fed actions that established the current stress-test regime; declare the models and scenarios used in the 2024 stress tests, as well as those planned for the 2025 and 2026 stress tests, unlawful; and require the Fed to subject the stress-testing framework, including its scenarios and models, to notice and comment before starting the 2026 stress tests.
Bottom Line: The Fed’s answer to ABA’s complaint is due Feb. 25, 2025.
Documents: Complaint
