Fed's Two-Year Stress Test Averaging: A Balancing Act for Bank Capital Stability
73min read The Federal Reserve’s proposal to average bank stress test results over two years, set to take effect in 2025, has ignited a fierce debate among regulators, banks, and legal experts. The rule aims to reduce the volatility of capital requirements by smoothing out results over a two-year period, but it faces opposition from critics who argue it could undermine the tests’ effectiveness and transparency.
At its core, the proposal seeks to stabilize capital buffers for large banks by averaging results from consecutive stress tests. Banks would no longer face abrupt changes in capital requirements based on a single year’s results, potentially reducing the incentive to hoard excess capital in anticipation of uncertain outcomes. The Fed also extended the deadline for banks to comply with new stress capital buffer requirements from October 1 to January 1 of the following year, granting institutions more time to adjust their strategies.
The Case for Stability
Proponents argue that averaging results will create a more predictable environment for banks. Federal Reserve Governor Adriana Kugler, while raising concerns about an 18-month lag between financial data and effective capital requirements, acknowledged the need for “greater consistency in capital standards.” The Fed estimates that this approach could reduce year-to-year volatility in capital charges by up to 30%, allowing banks to better plan for dividends, share buybacks, and lending.
For investors, this predictability could be a boon. Historically, volatile stress test outcomes have caused sharp swings in bank stocks. For instance, in 2022, Bank of America’s shares dropped 5% after a stress test revealed unexpectedly high capital requirements. A two-year average might dampen such volatility, potentially boosting investor confidence in bank equities.
The Risks of Predictability
Critics, however, warn that the proposal could erode the rigor of stress tests. Federal Reserve Governor Michael Barr, who voted against the rule, argued that averaging results would make the tests “ossified,” enabling banks to “game” the system by structuring their balance sheets to pass predictable scenarios. In a memo, he noted that banks might underinvest in risk management, relying instead on “window-dressing” to meet regulatory thresholds.
Barr’s dissent is echoed by banking trade groups. The Bank Policy Institute (BPI) has long pushed for greater transparency in stress test models, but its lawsuit against the Fed—filed in December 2024—alleges that the central bank’s “secretive” approach to modeling has led to “vacillating requirements.” BPI President Greg Baer called the Fed’s transparency pledges “a step forward,” but emphasized that full disclosure of stress test scenarios and models remains critical to prevent regulatory arbitrage.
Legal and Regulatory Crosscurrents
The Fed’s transparency commitments include public disclosure of stress test models and scenarios by late 2025. This move aims to comply with the Administrative Procedure Act, which requires agencies to provide public notice and comment on significant rules. However, legal experts warn that delayed implementation of the rule—due to the ongoing Ohio lawsuit—could complicate its rollout.
For investors, the legal battle adds uncertainty. If courts side with the BPI and ABA, the Fed may be forced to revise its approach, potentially delaying the two-year averaging framework. This underscores the tension between regulatory reform and legal accountability.
The Bottom Line for Investors
The Fed’s proposal presents a trade-off: reduced volatility in capital requirements versus concerns about diminished regulatory effectiveness. For bank shareholders, the rule’s success hinges on whether averaging leads to more stable capital buffers without compromising safety.
If implemented as planned, the two-year averaging could ease near-term pressures on bank capital planning, potentially supporting dividend growth and stock buybacks. However, if critics like Barr are proven correct—that banks exploit the system—investors may face a repeat of the 2008 crisis-era risks, this time masked by smoothed capital metrics.
Conclusion
The Fed’s averaging proposal is a bold attempt to modernize stress testing, but its success depends on balancing stability with vigilance. While it may reduce short-term volatility in bank capital requirements—a positive for investors—the risks of regulatory complacency and legal hurdles loom large.
Data suggests that major banks have already begun preparing: JPMorgan Chase’s capital ratio (13.2% as of Q1 2025) and Bank of America’s Common Equity Tier 1 ratio (12.7%) are well above the Fed’s minimum requirements, indicating a buffer against potential shocks. Yet, if stress tests become too predictable, these metrics may no longer reflect true resilience.
Investors should monitor two key indicators: the outcome of the Ohio lawsuit and the Fed’s transparency reforms. A win for the BPI could delay implementation, while robust disclosure of stress test models might alleviate concerns about opacity. For now, the Fed’s proposal remains a high-stakes experiment in regulatory innovation—one that could redefine the safety and profitability of banking for years to come.
