The Federal Reserve plans to comprehensively reform its review mechanism and will implement an "open book exam" for bank stress tests.

The Federal Reserve is considering a new plan to comprehensively reform its core review mechanism. Under the plan, Wall Street banks will be able to know in advance the upcoming stress test standards. According to documents released on Friday, the Federal Reserve's plan aims to improve part of the model design, covering credit losses, operational risks, and the securities sector. Other adjustments include the Federal Reserve seeking input from the banking industry in advance on the "severely adverse scenario" to be used in the next round of stress tests. The documents also contain the standards for the 2026 stress tests. The most severe scenario requires banks to assess how they would respond to a global economic recession, sharp drops in stock and real estate values, and a double-digit unemployment rate in the US. Michelle Bowman, the Federal Reserve's chief bank regulatory officer, stated that she hopes to implement these adjustments before the 2026 tests after the public comment period ends. The Federal Reserve has already voted on Friday at a meeting in Washington to formally propose advancing this plan. In her prepared remarks for the meeting, Bowman said, "Currently, stress test models, scenario design frameworks, and specific scenarios are not fully disclosed, nor are comments sought openly. This lack of transparency can lead to uncertainty for banks in capital planning, potentially leading to capital requirements not matching actual risks, while also restricting public understanding and oversight of the stress testing process." The Federal Reserve's plan requires institutions to disclose all key details of their stress tests for the current year annually before undergoing testing. In April this year, the Federal Reserve proposed another plan to calculate test results on a two-year average and give banks more time to adapt to new capital requirements. At that time, the Federal Reserve stated that it would further relax the testing process to increase transparency, thus this adjustment also aligns with the general expectations of large US banks. The reform will also change the data date for the balance sheet used in stress testing from December 31 to September 30. The Federal Reserve stated that overall, these adjustments to stress test models and scenarios are not expected to have a substantial impact on the capital requirements of participating institutions. Severely Adverse Scenario As per the new plan, the Federal Reserve specified the most severe scenario proposed for the 2026 stress tests on Friday. This hypothetical crisis scenario includes: a severe global economic recession, significant declines in high-risk asset prices, decreased risk-free rates, and increased financial market volatility - where stock prices will drop by 54% in the first three quarters. Corporate bond spreads will widen to 5.7 percentage points, the US unemployment rate will rise to approximately 10%, real estate prices will plummet, and there will be a sharp slowdown in the Asian economy. Consistent with previous years, this scenario is only for testing purposes and does not represent an economic forecast. Bank stress tests began after the 2008 financial crisis, aimed at strengthening banks' ability to withstand future economic shocks by evaluating their response capabilities during a hypothetical recession. Banks have long sought modifications to these regulatory rules linked to capital requirements, arguing that the current rules are too burdensome and hinder their normal operations. Earlier this year, all 22 large US banks successfully passed the Federal Reserve's annual stress tests, laying the foundation for banks to increase the scale of stock buybacks and dividend payouts. Former Federal Reserve chief bank regulatory officer Michael Barr has criticized these adjustments, stating that early disclosure may weaken the effectiveness and credibility of the tests. He argued that the new approach "may turn stress tests into a rigid process that gives a false sense of financial system resilience," "this could lead to overly optimistic test predictions, firstly because of non-conservative model choices, and secondly because banks may have room to 'game the system.'" "Open Book Exam" Controversy The Federal Reserve stated in December last year that it would adjust the stress testing process. However, in the same month, industry organizations representing institutions such as JPMorgan Chase, Goldman Sachs, and Bank of America sued the Federal Reserve over this. These organizations argued that the opaque process of setting test standards led to "inconsistent and unexplained changes in bank capital requirements and restrictions." On Friday, the Bank Policy Institute and the Financial Services Forum each issued statements praising the Federal Reserve's actions. Jeremy Kress, a former lawyer for bank policy at the Federal Reserve and currently a business law professor at the University of Michigan, criticized the Federal Reserve, stating that the plan is a compromise in response to bank lawsuits. Kress said, "From a legal standpoint, there is absolutely no requirement to turn stress tests into an 'open book exam' where banks participate in setting the questions. This is a policy choice, and a bad one at that."