The Federal Reserve's Stress Tests May Be Illegal

A new paper by the nonprofit Committee on Capital Markets Regulation (CCMR) suggests that banks subject to the Federal Reserve’s annual stress tests and CCAR could have grounds for a lawsuit against the government. The CCMR includes senior management representatives from JPMorgan Chase & Co. JPM, Citigroup Inc C, Goldman Sachs Group Inc GS, Wells Fargo & Co WFC and State Street Corp STT.

According to the CCMR paper, the Fed may be violating the terms of the Administrative Procedure Act by not publicly disclosing the assumptions and mathematical models it uses during its stress tests.

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“We find that the Federal Reserve has likely not complied with the procedural requirements in adopting key aspects of its Comprehensive Capital Analysis and Review stress tests,” the paper read.

The CCMR argues that the models and assumptions “function as rules” because they directly dictate the capital requirements of the banks. According to the Administrative Procedure Act, the Fed should publicly release drafts of rules.

However, Fed officials have argued that releasing their models and assumptions would allow the banks to game the tests and would run counter to the purpose of the annual review.

The banks must now decide whether the huge cost of a lawsuit against the Federal Reserve coupled with the likelihood of a positive outcome would be a worthwhile endeavor.

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Disclosure: The author is long C.