Fed publishes final rules on stress testing

The Federal Reserve has published final rules related to the stress-testing of major bank-holding companies, state member banks, savings and loan-holding companies, as well as some non-bank financial institutions.

The new rules state that financial institutions will be required to conduct stress tests based on three scenarios set by the Fed. The rules address the stress-test requirements set out in article 165 of the Dodd-Frank Act, while further requirements for enhanced prudential standards and early remediation requirements are due to be published at a later date. "Implementation of the Dodd-Frank stress-test requirement is an important step in the Federal Reserve's efforts to promote the health of the financial sector," said Daniel Tarullo, a member of the Fed's board of governors.

The 19 bank-holding companies that participated in the 2009 Supervisory Capital Assessment Program and subsequent Comprehensive Capital Analysis and Reviews will be required to run stress tests in the autumn (northern hemisphere), with the results due to be published in March 2013. Most other companies subject to the new rules will have to comply by October 2013. Companies with between $10 billion and $50 billion in assets are required to conduct stress tests in the autumn of 2013, but will not have to publicly disclose these results.

The Fed presented proposals in December 2011 that suggested stress tests could be used as part of a mechanism to "trigger" remedial action by companies to address financial weaknesses, if necessary.

But this could present a number of issues. Tsuyoshi Oyama, writing in the latest edition of Central Banking Journal, said the assumptions made by authorities in setting the stress-test scenarios could lead to financial institutions being forced to hold more capital or sell off certain business units. Furthermore, he warned this would leave the Fed's rules, and similar rules set by the European Union, "out of step" with authorities such as the UK, where institutions set their own scenarios.

Economists Claudio Borio, Mathias Drehmann and Kostas Tsatsaronis also raised issues in a paper published by the Bank for International Settlements in January. "Given current technology, macro stress tests are ill-suited as early warning devices, ie, as tools for identifying vulnerabilities during seemingly tranquil times and for triggering remedial action," they said.

Nevertheless, Borio, Drehmann and Tsatsaronis said stress tests can be useful as crisis management and resolution tools: "In [a crisis] environment, the technical shortcomings of the tests are less of an issue. It is easier to identify relevant scenarios. It is easier to take them seriously. And the system does not need to be shaken so hard to reveal weaknesses."