Bank Groups Weigh Legal Challenge to Fed Stress Tests
Bank trade groups and industry advisers are debating the possibility of legally challenging the Federal Reserve in an attempt to force changes to annual “stress tests” of the biggest U.S. lenders, people familiar with the talks said.
Even if banks ultimately decide against action, serious contemplation of such a challenge is somewhat extraordinary. It shows growing frustration among big financial firms with the tests, which have become even more of a burden with superlow interest rates weighing on profits.
The discussions are at an early stage and big banks are divided over whether the talks should continue, the people familiar with the matter said. Over the past several months, industry advisers and representatives from some big U.S. banks have been involved in several calls discussing the possibilities, with the latest occurring a few weeks ago, the people said. That said, there hasn’t been a formal presentation or meeting yet involving top bank executives.
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The discussions have centered on legal strategies that would allow a challenge to the stress tests, with much of the focus on their opacity and how the Fed changes certain aspects of the exams each year.
Additionally, participants in the talks have weighed how the Fed and tests could be influenced by the outcome of the presidential election and whether that would argue for a more cautious course of action.
A Fed spokesman declined to comment on the potential suit.
The Fed-administered stress tests are the centerpiece of the post-financial-crisis regulatory overhaul and affect firms with more than $50 billion in assets. Last year, 33 firms took them.
The exams arguably have made banks safer by forcing them to better measure risks they face. They also dictate the amount of capital banks can return to shareholders, in turn influencing returns on equity and share-price valuations. Given that, the tests in some ways have become a deciding factor in how banks run their businesses.
A big point of contention among banks is the opacity of the tests, as well as the ability of regulators to block capital returns for subjective reasons.
Fed officials have disclosed more in recent years about how the tests work. They have described in more detail the mathematical models used to determine how much money banks would lose under the tests, pointing out changes from year to year.
But the central bank still unilaterally designs the doomsday scenarios that are simulated during the tests. It also doesn’t disclose all the details of the models, which keeps banks guessing about their results. The central bank says that if it gave banks more information about the models, bankers might be able to game the tests.
In considering a legal challenge, banking groups have discussed an argument that would center on the opacity concern: that the Fed is violating the Administrative Procedure Act by not allowing meaningful public input into the tests, according to the people familiar with the talks.
Should banks decide to proceed, it isn’t clear which of the many Washington-based trade groups affiliated with the industry would take the lead. In such matters, banks tend to use trade groups as proxies since a suit by individual banks would place them in direct conflict with their regulator.
“If (regulators) view you as difficult to deal with, they are going to be difficult to deal with,” said Oliver Ireland, partner at Morrison & Foerster LLP and former associate general counsel at the Fed from 1985 until 2000. Mr. Ireland said he wasn’t involved in the stress-test lawsuit discussions.
Traditionally, banks and regulators have attempted to settle their differences behind closed doors. Since the financial crisis, though, regulators have taken a harder line with banks, showing far less inclination to negotiate with entities they oversee.
At the same time, regulators are taking banks to task in a more public fashion. The Fed in 2012 started naming banks that don’t meet its expectations under the stress tests. Earlier this year, both the Fed and the Federal Deposit Insurance Corporation publicly rebuked individual banks for alleged flaws in “living wills” showing how they could be unwound in a crisis.
The industry is starting to think more about pushing back. For instance, the American Bankers Association has said it is considering suing the Fed over cuts in the dividends banks receive from their stock in the Fed. The group hasn’t announced a final decision about a possible lawsuit yet.
Earlier this year, banks also took notice when insurer MetLife Inc. convinced a U.S. District Judge to overturn its designation as a “systemically important financial institution” subject to oversight by the Fed. The Obama administration’s appeal on that case will be heard in October.
A stress-test lawsuit would carry greater risks than any of those. Fed officials, for example, might actually welcome an ABA lawsuit related to dividend payments since many opposed the law that the group wants to reverse.
And unlike MetLife, even if banks won a stress-test suit, they would still be regulated by the Fed “every minute of every day of every week,” one of the people involved in the discussions said.
The presidential race is another consideration. A new administration, either Democrat or Republican, is likely to appoint a vice chair of supervision at the Fed. Such an appointee could supplant the role of Fed governor Daniel Tarullo. Mr. Tarullo is the Fed’s point person on bank regulation, although he doesn’t officially hold the vice chair’s spot. The Obama administration has never made an appointment for that position.
Given this, participants in the bank talks have weighed whether it would be worth waiting on any legal action to take into account the outcome of the vice chair’s position, the people said.
Separately, the Government Accountability Office, a watchdog that works for Congress, is reviewing the tests at the behest of House Financial Services Committee Chairman Jeb Hensarling. The Texas Republican has said he is concerned the exams “lack transparency.”
Many bankers have been critical about the tests, but whether they would sue the Fed is another matter. One vocal critic has been Zions Bancorp Chief Executive Harris Simmons. Last year, he testified to Congress that the tests’ secrecy “finds little, if any, parallel in our legal and regulatory system.”
Through a spokesman, Mr. Simmons said he wasn’t aware of the lawsuit discussions, adding: “We are not involved in that kind of activity.”
Write to Emily Glazer at
emily.glazer@wsj.com and Ryan Tracy at
ryan.tracy@wsj.com