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Fed Governor Holds Ground in Debate Surrounding Bank Stress Testing

flag_of_the_united_states_federal_reserveFacing complaints of a lack of transparency in the models the Federal Reserve uses to measure bank capital levels, Fed Gov. Daniel K. Tarullo said on Sept. 26 that he would not give big banks more details about how examiners evaluate capital levels. The Fed also is facing a potential lawsuit by members of the banking industry regarding the legality of some of the Fed’s stress testing.

Banks involved in the Dodd-Frank Act Stress Test (DFAST) and the Comprehensive Capital Analysis and Review (CCAR) have frequently requested more disclosures so that they can better understand the likely impact on their firms. The Fed has taken steps to respond to these requests, according to Tarullo, including publishing descriptions of all models used in the stress tests, hosting an annual conference about modelling practices and disclosing descriptions of the most material changes to stress test models before each stress test, among other actions.

tarullo_danielBut “we do not intend to publish the full computer code in the supervisory model that is used to project revenues and losses,” Tarullo said during a speech at Yale University. “Full disclosure would permit firms to game the system—that is, to optimize portfolio characteristics based on the parameters of the model and take risks in areas not well-captured by the stress test just to minimize the estimated stress losses.”

Tarullo’s speech might be the start of the Fed’s efforts to ward off the possible lawsuit. The Fed is “laying the framework to try to defend a secretive process in court,” Keith Noreika, a partner with Simpson Thacher & Bartlett LLP, said according to Law360.

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