The Federal Reserve plans to comprehensively reform its new review mechanism, implementing an ‘open-book exam’ approach for bank stress tests.

The Federal Reserve is considering a new plan to comprehensively reform its core review mechanism. Under this plan, Wall Street banks will be able to gain advance knowledge of the upcoming stress test standards. According to documents released on Friday, the Fed’s plan aims to improve certain model designs, covering areas such as credit losses, operational risk, and securities. Other adjustments include the Fed seeking input from the banking industry in advance regarding the ‘severely adverse scenario’ intended for use in the next round of stress tests.

The documents released this time also include the standards for the 2026 stress test. Among them, the most severe scenario requires banks to assess how they would respond amid a global economic recession, a collapse in stock and real estate values, and a U.S. unemployment rate reaching double digits.

Michelle Bowman, the Federal Reserve’s Vice Chair for Supervision, stated that she hopes to implement these adjustments after the public comment period ends and before the 2026 test. The Federal Reserve has already voted at a meeting held in Washington on Friday to formally propose moving forward with the plan.

Bowman said in prepared remarks for the meeting: “Currently, the stress testing models, scenario design framework, and specific scenarios are neither fully disclosed nor open for public comment. This lack of transparency creates uncertainty for banks in their capital planning, potentially leading to a mismatch between capital requirements and actual risks, while also limiting public understanding and oversight of the stress testing process.”

The Fed’s proposal requires the agency to disclose all key details of the annual stress test before banks undergo testing, including models and scenario settings. In April this year, the Federal Reserve proposed another measure to average test results over two years and provide banks with more time to adapt to new capital requirements. At the time, the Fed indicated it would further ease the implementation of tests to enhance transparency, so this adjustment aligns with the general expectations of major U.S. banks.

The reforms will also shift the balance sheet data date used in stress testing from December 31 to September 30. The Federal Reserve stated that, overall, these adjustments to stress testing models and scenarios are not expected to have a material impact on the capital requirements of participating institutions.

Severely Adverse Scenario

Under the new plan, the Federal Reserve specified on Friday the most severe scenario intended for the 2026 stress test. This hypothetical crisis scenario includes: a severe global recession, a sharp decline in high-risk asset prices, a drop in risk-free interest rates, and a surge in financial market volatility – with stock prices falling 54% in the first three quarters. Corporate bond spreads will widen to 5.7 percentage points, the U.S. unemployment rate will climb to approximately 10%, real estate prices will plummet, and Asia’s economy will experience a sharp slowdown.

Consistent with previous practice, this scenario is only for testing purposes and does not represent an economic forecast.

Bank stress tests were introduced following the 2008 financial crisis with the aim of enhancing banks’ resilience to future economic shocks. The core focus is to evaluate their ability to withstand hypothetical recessions. Banks have long advocated for revisions to these capital requirement-linked regulatory rules, arguing that the current framework imposes excessive burdens and hinders their normal operations.

Earlier this year, all 22 major U.S. banks successfully passed the Federal Reserve’s annual stress test, paving the way for increased stock buybacks and dividend payouts.

Michael Barr, a Federal Reserve Governor who previously served as the agency’s chief banking regulator, expressed opposition to these adjustments in prepared remarks. He argued that advance disclosure would undermine the effectiveness and credibility of the tests. Barr stated that the new format “could turn stress testing into a rigid process, creating a false sense of security about the resilience of the financial system,” adding, “This could lead to overly optimistic forecasts, partly due to less conservative model selection and partly because banks might exploit loopholes.”

Controversy over the ‘Open-Book Exam’

In December last year, the Federal Reserve announced plans to adjust its stress-testing procedures. However, industry groups representing institutions such as JPMorgan, Goldman Sachs, and Bank of America filed lawsuits against the Fed that same month. These organizations argued that the opaque process of setting testing standards resulted in “arbitrary and unexplained fluctuations in bank capital requirements and restrictions.” On Friday, the Bank Policy Institute and the Financial Services Forum issued separate statements applauding the Fed’s move.

Jeremy Kress, a former Federal Reserve banking policy attorney and current professor of business law at the University of Michigan, criticized the Fed, stating that the plan represented a concession to the banks’ litigation.

Kress remarked, “There is no legal requirement to turn stress testing into an ‘open-book exam’ where banks help write the questions. This is a policy choice, and a poor one at that.”

Editor/melody