It is common practice in both middle school and stress testing for the teacher/regulator to require you to show all the intermediate steps you went through to get to the final result. On the student and bank side, this scrutiny is often construed as unnecessary, tedious, and overly controlling.
What is more unusual is for the 7th-graders to ask the math teacher to disclose their thinking behind 38 minutes of daily homework, but in the bank world that is just what has happened.
Since the Dodd-Frank Act was put in place in 2010, the largest banks* have been required to hand in detailed financial information to the Federal Reserve for the Fed to subject it to the annual stress test (DFAST) that determines the minimum capital requirement for each bank.
While the banks might agree that it is in their own best interest to have a cushion to withstand severely adverse events such as the 2008 global financial crisis, they are also of the opinion that over the years the required capital ratios have been a tad—to use a technical term—willy-nilly, and when they have asked for more information, it seems the Fed has not been that forthcoming.
Alas, until recently there hasn’t been a lot the banks could do about it. Then last year the Supreme Court overturned what is called the Chevron deference. After 40 years the practice for federal courts to defer to agencies (of which the Fed is one) for their interpretation of ambiguous laws ended. That enabled the banks to take it to court if they were unhappy with the capital requirement they were dealt.
Goldman Sachs did not have to go that far. In August 2024, only a month after the Chevron deference’s overturn, Goldman Sachs became the first US lender to successfully appeal its capital requirement to the Federal Reserve. The bank argued that the Fed had not considered what it had done to make its business more stable, and thus the estimate of $40BN in losses in a severe event was too high.
The Fed had a rethink and agreed and cut Goldman’s overall capital ratio from 13.9% to 13.7%.
As a group the banks have also been more effective in their quest for a “fairer” grade. In late December the Fed announced it was weighing “significant changes” to the DFAST exercise to make the capital requirements less volatile and the process more transparent.
“Yeah, that’s fine,” said the banks, “but just to be sure, let’s try it for real.”
The day after the preemptive strike some of the largest banks, together with the industry group Bank Policy Institute, sued the Federal Reserve to gain full transparency into both models and scenarios, and to have a say in future models before they are used.
Now, just as it is not likely that middle schoolers would request insight because they thought their grade was too high, it is also not likely that the banks’ court argument will be that they think the current models and scenarios underestimate the capital requirements.
Either way, I hope the trial will be televised and sprinkled with that sound from Law & Order (DUN-DUN).
In the meantime, the Fed has released the stress test scenarios for this year’s DFAST.
The scenario, that will determine the capital requirement, consists of a spike in unemployment, severe market volatility, a massive increase in credit spreads, and a nosedive in asset prices, including housing and commercial real estate.
The Fed is careful to point out that this is not a forecast, but only the worst (economic) nightmare imaginable still within the realm of possibility.
So that’s nice.
*What constitutes a large bank has changed over time. Right now, those categorized as globally systemically important as well as domestic banks with total assets of more than $250BN are included every year. Domestic and foreign banks in the US with assets of more than $100BN are included every other year.
Regitze Ladekarl, FRM, is FRG’s Director of Company Intelligence. She has 25-plus years of experience where finance meets technology.
This article is part of the FRG Risk Report, published weekly on the FRG blog. To read other entries of the Risk Report, visit frgrisk.com/category/risk-report/.