Big Banks are Suing the Fed?

Yes, Big Banks Are Suing the Fed

Imagine preparing for a high-stakes exam where the questions change every year, but no one tells you the grading criteria. That’s the reality America’s largest banks face under the Federal Reserve’s stress testing framework. These tests, created after the 2008 financial crisis to restore trust in the financial system, have morphed into a black box of unpredictability. The result? Tens of billions in unexpected capital costs for banks—and a ripple effect that slows lending, stifles growth, and dampens economic momentum. And let’s be honest: they also curtail share buybacks and dividends, robbing shareholders of excess returns.

Now, the banks are pushing back. Heavyweights like JPMorgan Chase, Bank of America, Citigroup, and others have taken the fight to court, demanding transparency and accountability. Their argument is simple: stress tests themselves aren’t the issue—it’s the Fed’s opaque, ever-changing approach to them. The lawsuit isn’t just a regulatory squabble; it’s a pivotal moment for the banking industry and its investors.

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A Quick History of Stress Tests

Stress tests were born out of chaos—and the kind of overconfidence that made The Big Short a cultural phenomenon. Remember the Mark Baum (Steve Carell) bar scene? That wasn’t just satire—it was 2008 in a nutshell. Wall Street’s so-called masters of the universe were so busy congratulating themselves, they didn’t notice they were sitting on a powder keg. No one embodied this hubris more than Dick Fuld at Lehman Brothers and Chuck Prince at Citigroup. These men doubled down on toxic assets, leveraged themselves to the hilt, and paid themselves handsomely for the privilege. “When the music stops,” Prince infamously said, “things will be complicated.” Complicated didn’t even begin to cover it.

When the crash finally came, regulators scrambled to ensure it wouldn’t happen again. Enter DFAST (Dodd-Frank Act Stress Test) and CCAR (Comprehensive Capital Analysis and Review)—frameworks designed to keep banks in check and prevent another meltdown. Think of them as annual fire drills for the financial system, forcing banks to prove they can survive an economic apocalypse.

DFAST evaluates a bank’s ability to maintain minimum capital levels under adverse conditions, focusing on metrics like Common Equity Tier 1 (CET1) ratios, loan losses, and profitability. It also establishes the Stress Capital Buffer (SCB), which requires banks to hold extra capital based on their stress test results and historical adequacy. The SCB is calculated by taking projected losses under stress scenarios, subtracting pre-provision net revenue, and adding any planned shareholder distributions. It’s a dynamic measure tailored to each institution’s risk profile.

CCAR takes it further, testing whether banks can maintain capital while still paying dividends or buying back shares. It also assesses whether management teams are genuinely planning for the future—or just hoping for the best. Failure comes with severe consequences: tighter capital requirements, restrictions on shareholder payouts, and a very public mark of shame.

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The Problem: A Black Box Approach

At first glance, stress tests seem like common sense. But what started as a safeguard has turned into a murky, unpredictable process. Greg Baer, President of the Bank Policy Institute, didn’t mince words: “The current opaque regime produces capital charges that are inaccurate, volatile, and excessive, resulting in reduced lending and economic growth.”

The Fed doesn’t explain how it designs stress scenarios or calculates capital requirements. Banks are left guessing year to year, trying to hit a moving target that can impose billions in unexpected costs. This lack of transparency doesn’t just frustrate bankers—it creates broader economic drag. Capital tied up in buffers isn’t being used to fund innovation, expand lending, or drive shareholder returns.

Jamie Dimon, CEO of JPMorgan Chase, has repeatedly sounded the alarm about this. Over-regulation, he argues, doesn’t just burden banks; it pushes financial activity into shadow banking—unregulated areas like private credit funds and non-bank lenders. Recent examples highlight the risks: the collapse of Archegos Capital, which caused billions in losses for banks, and the opaque lending practices of private equity funds illustrate how shadow banking can amplify systemic vulnerabilities. Dimon warns that the Fed’s rigid rules unintentionally create new risks by shifting financial activity into less visible, poorly supervised corners of the market.

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The Lawsuit and Its Implications

The lawsuit filed by trade groups representing banks like JPMorgan Chase, Bank of America, and Citigroup isn’t about scrapping stress tests. It’s about transparency. Banks are demanding clear rules for designing hypothetical scenarios, open models for calculating capital requirements, and a seat at the table through public notice and comment. Even if they don’t win outright, pushing back could yield meaningful changes, reducing unpredictability and enabling better capital planning.

Currently, JPMorgan Chase’s SCB is set at 4.5%, resulting in a total CET1 requirement of 12.3%. Citigroup’s SCB is slightly lower at 4.1%, leading to a CET1 requirement of 12.1%. These figures highlight the high capital thresholds the largest banks must meet, tying up billions of dollars that could otherwise be deployed.

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The Opportunity for Investors

America’s largest banks are sitting on historically high levels of capital, far above regulatory minimums. JPMorgan’s CET1 ratio is 15%, well above its 12.3% requirement. Citigroup’s is 13.7%, exceeding its 12.1% threshold. This excess capital, built up over years of regulatory tightening, isn’t just a safety net—it’s a growth engine waiting to be unleashed.

If the Federal Reserve loosens its grip on capital requirements, even modestly, the impact could be transformative. A 1% reduction in CET1 requirements could unlock tens of billions of dollars across major banks—JPMorgan alone could free up $32 billion, with Citigroup unlocking $16 billion. This isn’t just about boosting dividends or buybacks; it’s about reinvigorating the sector, allowing banks to invest in technology, expand lending, and fuel long-term growth.

For investors, the potential is clear. Despite their strength, bank stocks trade at depressed multiples compared to pre-2008 levels, largely because of stricter capital rules. Easing these constraints could re-rate valuations higher, delivering significant upside in a sector that has been undervalued for years.

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A Turning Point for Banking

The outcome of this legal battle will shape the future of American banking. If the banks succeed in forcing transparency, it could usher in a more balanced regulatory framework—one that protects the financial system without stifling growth. For institutions like JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo, this is about more than capital relief—it’s about the freedom to grow, innovate, and reward shareholders.

But let’s be clear: the stakes extend beyond the banks themselves. This isn’t just a lawsuit; it’s a signal that the regulatory pendulum may be swinging back toward reason. If the Fed gets it right, we’ll see a stronger, more dynamic financial system that balances resilience with flexibility. If it doesn’t? Well, history has shown us what happens when regulation stifles growth and drives activity underground.

For investors, this moment is pivotal. Less capital doesn’t just mean bigger dividends and buybacks; it means a brighter future for the banking sector as a whole. Own the big banks— capital requirements down mean capital returns & profits up.

Wishing you a joyous holiday season filled with warmth, love, and light—Merry Christmas, Happy Hanukkah, and blessings to you and your loved ones!

Victaurs

PS - to learn which big banks should win the most read this premium only post.