US Fed floats major changes to bank stress tests in light of legal rulings

By Pete Schroeder

WASHINGTON (Reuters) -The U.S. Federal Reserve said on Monday it was considering major changes to its annual bank "stress tests" in light of recent legal developments, including allowing lenders to provide comment on the models it uses, in a major victory for Wall Street banks.

The Fed said it may also allow lenders to provide input on the hypothetical scenarios it uses for the annual bank health checks, and it may also average results over two years to reduce annual volatility in how much capital banks must set aside to absorb potential losses.

Created following the 2007-2009 financial crisis, the tests assess whether big lenders could weather an economic shock. They are core to the U.S. capital regime, dictating how much cash lenders must put aside to absorb losses, and how much they can return to shareholders.

The Fed said the proposed changes were not designed to affect overall capital requirements, but followed recent court rulings that have significantly changed the framework of administrative law in recent years.

"The (Fed) Board analyzed the current stress test in view of the evolving legal landscape and determined to modify the test in important respects to improve its resiliency."

In June, the Supreme Court dealt a major blow to federal regulatory power by overturning a 1984 precedent that had given deference to government agencies in interpreting laws they administer. That precedent arose from a ruling involving oil company Chevron that had called for judges to defer to reasonable federal agency interpretations of U.S. laws deemed to be ambiguous.

While the 2010 Dodd-Frank law passed following the crisis broadly requires the Fed to test banks' balance sheets, the capital adequacy analysis the Fed performs as part of tests, or the resulting capital it directs lenders to set aside, is not mandated by law. Analysts have said the overturning of Chevron makes the stress tests more vulnerable to litigation.

Wall Street banks and their Washington trade groups have been quietly lobbying this year to try to increase the transparency of the stress tests, according to industry sources and public records of meetings industry groups had with the central bank.

Those discussions were part of a massive industry effort to water down the so-called Basel Endgame capital hikes, over which Wall Street banks had taken the unusual move of threatening to sue the Fed and the two other federal regulators working on the draft rules. Both the Basel standards and the tests help set bank capital.

Banks have in the past been extremely reluctant to sue federal banking regulators, but have grown bolder as conservative-leaning U.S. courts have proved increasingly receptive to industry litigation arguing federal agencies are overstepping their authority.

The Bank Policy Institute, an industry trade group that has been a vocal critic of the tests, said in a statement Monday's announcement was the "first step towards transparency and accountability."

"We are reviewing it closely and considering additional options to ensure timely reforms that are both good law and good policy," said BPI President and CEO Greg Baer.

(Reporting by Pete Schroeder; Editing by Michelle Price, Mark Porter and Chris Reese)