The Fed’s Averaging Proposal: A New Era of Stability for Bank Capital Requirements?

The Federal Reserve’s recent proposal to average stress test results over two years marks a pivotal shift in how large U.S. banks will manage capital requirements. Designed to reduce the volatility of annual stress test outcomes, this move could reshape the financial landscape for institutions like JPMorgan Chase (JPM), Citigroup (C), and Bank of America (BAC). Let’s unpack the implications for investors and the broader banking sector.

The Averaging Mechanism: Smoothing Volatility

The Fed’s proposal aims to stabilize capital requirements by averaging stress test results over two consecutive years. This approach targets the historical swings in annual outcomes caused by hypothetical severe recession scenarios. For instance, if a bank’s 2024 stress test showed a 3% capital shortfall, but its 2025 results improved to 1%, the averaged requirement would be 2%, creating a smoother path for capital planning.

This method addresses a longstanding criticism: the “yo-yo effect” where sudden regulatory demands strain banks’ balance sheets. By dampening volatility, the Fed hopes to foster more predictable capital management, potentially easing pressure on bank stocks.

Key Components of the Proposal

1. Delayed Stress Capital Buffer (SCB) Implementation:
   Shifting the SCB’s effective date from October 1 to January 1 gives banks three extra months to adjust capital positions. This delay could reduce last-minute liquidity strains, particularly for institutions facing tight margins.

2. Streamlined Data Collection:
   Simplifying the data requirements for stress tests aims to cut administrative costs without sacrificing rigor. Banks may now focus more on core stress scenarios rather than navigating overly complex submissions.

3. Enhanced Transparency:
   Public disclosure of stress test models and pre-finalized scenario feedback will boost accountability. Investors and regulators can scrutinize assumptions behind capital buffers, fostering trust in the process.

The 2025 Stress Test Scenarios: Less Severe, More Predictable

The 2025 scenarios, announced on February 5, reflect a strategic recalibration. Key metrics include:
- Unemployment Peak: 10% (up 5.9 points from the fourth quarter of 2024), slightly milder than 2024’s 6.3-point increase.
- Commercial Real Estate (CRE) Decline: 30%, a 10-percentage-point improvement over 2024.
- Equity Prices: A 50% drop, 5 points less severe than the prior year.

These adjustments suggest the Fed is acknowledging evolving economic risks while maintaining a buffer against shocks. The less severe scenarios may reduce projected loan losses and improve pre-provision net revenue (PPNR) by over $50 billion compared to 2024.

Implications for Investors

The proposal’s success hinges on its ability to balance stability and safety. For investors, the averaging mechanism could:
- Reduce Stock Volatility: Smoother capital requirements may stabilize bank share prices.
- Improve PPNR Projections: Enhanced PPNR (a key earnings metric) could boost valuations for banks with strong trading or fee-based businesses.
- Highlight Bank Resilience: Institutions that consistently outperform stress tests, like Goldman Sachs (GS), may gain a competitive edge.

Risks and Considerations

While the Fed emphasizes that capital requirements won’t decline, the averaging method could inadvertently create complacency. For example, a bank with weak 2024 results might be buoyed by a strong 2025 performance, masking underlying risks. Additionally, the delayed SCB implementation may encourage excessive risk-taking in the final quarter of the year.

Conclusion: A Step Toward Predictability, but Caution Remains

The Fed’s proposal signals a shift toward more stable capital management, aligning with its dual goals of financial stability and regulatory efficiency. With 2025 scenarios already less severe than prior years—CRE declines reduced by 10 percentage points and PPNR gains exceeding $50 billion—the path forward appears cautiously optimistic.

However, investors must remain vigilant. While the averaging mechanism may reduce short-term volatility, it does not eliminate the need for banks to maintain robust capital buffers. Institutions with diversified revenue streams (e.g., higher PPNR from wealth management or investment banking) are likely to outperform peers in this environment.

The Fed’s reforms are a step toward long-term stability, but their true impact will depend on how banks navigate the evolving balance between risk and reward. For now, the message to investors is clear: look for banks that thrive in moderation—those with steady performance across cycles, rather than those relying on one-time boosts.

Data as of Q2 2025. Past performance does not guarantee future results.