Why Banks and Businesses Are Suing the Fed Over Stress Test

The gloves are off as America’s largest banks and business groups band together to challenge the Federal Reserve over its annual stress testing framework. In a lawsuit filed in the U.S. District Court for the Southern District of Ohio, the Bank Policy Institute (BPI), the American Bankers Association (ABA), the U.S. Chamber of Commerce, and other organizations claim that the Fed’s opaque processes and lack of transparency violate federal laws, including the Administrative Procedure Act (APA). Let’s unpack the story behind this high-stakes legal battle and its potential ripple effects on banking and the broader economy.

Opaque Rules, Big Consequences

Stress tests aren’t a new thing. They’ve been around since the 2008 financial meltdown to make sure banks have enough cushion to weather economic storms. But here’s the catch: banks say these tests are a black box. Greg Baer, CEO of the Bank Policy Institute, summarized the frustration: “The current opaque regime continues to produce capital charges that are inaccurate, volatile, and excessive, reducing lending and slowing economic growth. Transparency and accountability are long overdue.”

Every year, the Fed runs its tests, using mystery scenarios and confidential models to decide how much capital banks should set aside. The results? They’re unpredictable and sometimes downright bizarre, according to the banks. That’s a problem since these tests determine everything from lending power to how much cash banks can return to shareholders.

Why Now? The Clock’s Ticking

So, why file this lawsuit now? Two words: statute of limitations. If the banks don’t act fast, they could lose their chance to challenge the Fed’s stress test framework, with the deadline looming in February 2025. Steve Stivers, President of the Ohio Chamber of Commerce, explained the urgency: “Filing comments on potential changes is great, but it doesn’t change anything yet. This lawsuit ensures we preserve our legal rights to demand meaningful reforms.”

Banks are also not buying the Fed’s recent promise to make changes by 2025. Sure, the Fed announced plans to “improve transparency” and “reduce volatility” in the stress tests, but the plaintiffs say that’s all talk until they see actual action.

Banks vs. Regulators

One of the banks’ main grievances is the lack of clarity surrounding the Fed’s stress test models and scenarios. The tests rely on confidential supervisory models to simulate how banks would fare in hypothetical economic turmoil. Critics argue that this secrecy creates a “black box” effect, leaving banks grappling with unpredictable outcomes. Worse, these opaque processes often result in higher capital requirements that limit lending and hurt Main Street businesses.

But there’s a flip side: regulators fear that full transparency could lead to gaming the system. By revealing the models, banks might tailor their portfolios to pass the tests while neglecting broader risk management. As Rob Nichols, CEO of the ABA, put it: “Transparency doesn’t weaken regulation—it strengthens it. Banks need clear expectations to plan and adapt effectively.”

What’s at Stake for Main Street?

Now, you might think this is just a Wall Street problem, but nope—it’s a Main Street issue too. When banks have to hold more capital than necessary, guess what happens?

• Higher Loan Costs: Small businesses and families feel the pinch of steeper borrowing costs.
• Fewer Loans: Banks tighten up, and fewer loans mean fewer growth opportunities.
• Economic Slowdown: Reduced credit availability sets the brakes on job creation and innovation.

The Fed’s Defense

The Fed’s not commenting on the lawsuit (classic move), but they’ve long defended the need for confidentiality. Their argument? If they make their stress test models public, banks could game the system, tweaking their numbers just to pass. It’s a fair point, but critics say there’s gotta be a middle ground. The European Central Bank (ECB), for example, runs a similar stress test program but with way more transparency. They let banks know what’s coming and even provide detailed feedback after the tests. Could the Fed take a page out of Europe’s playbook? Maybe. But for now, the standoff continues.

Lessons from Across the Pond

The European Central Bank (ECB) offers a contrasting approach to stress testing that U.S. regulators might find instructive. The ECB engages banks throughout the process, providing detailed feedback and tailoring requirements to reflect individual institutions’ risk profiles.

Key differences between the Fed and ECB approaches include:

• Transparency: The ECB discloses its methodologies and scenarios, enabling banks to better align their risk management strategies.
• Customization: European stress tests are more tailored, considering the unique business models of individual banks.
• Feedback: The ECB actively offers actionable recommendations, enhancing the value of stress tests beyond mere compliance.

The Fed’s reluctance to fully embrace these practices has drawn criticism, especially as the U.S. banking sector grows more diverse and complex.

Where Do We Go From Here?

This lawsuit is just the opening act. The real drama will play out in court and in boardrooms across the country. If the banks win, we could see a more transparent, predictable stress test process. If not, it’s back to business as usual, with plenty of grumbling from Wall Street. Either way, this battle’s far from over. For now, keep your eye on the calendar, your loan rates, and—if you’re a bank CEO—your stress levels. “You want to stress test something? Try running a bank with these rules,” said no CEO out loud, but probably thought in their head. Subscribe to MYCPE ONE Insights for the latest in finance, accounting, and corporate news delivered straight to your inbox.