As regulators continue to intensify their supervision of the largest institutions, they might soon require a new type of stress testing that would prove expensive and time-consuming for some and potentially open banks up to more risk.

The new approach, known as "reverse stress testing," would require banks to identify future scenarios that could lead to their failures, as opposed to traditional stress testing, which measures banks' ability to withstand the strain caused by certain specific scenarios. Federal Reserve Vice Chair for Supervision Michael Barr said in a recent speech that his agency is considering such testing as part of federal efforts to tighten bank supervision and regulation following recent bank failures, but he did not provide much detail on what exactly the tests could look like.

One key piece for the Fed to consider is whether the results would be private or public, industry experts told S&P Global Market Intelligence. While regulators are aiming to improve safety and soundness after three regional bank failures, publicly releasing the results like the Fed does with its current traditional stress tests could open banks up to risk, they said.

"There is some concern ... this would, or could, be quite damaging to the institution," said Todd Baker, a senior fellow at the Richman Center for Business, Law and Public Policy at Columbia Business School and Columbia Law School.

Baker added that banks would not want a good-faith effort to stress test their organization to lay out a path for "some short seller."

If reverse stress tests results were made public, there is concern about what such information would do to a bank's public image, particularly those with a large retail business, those with short-term products and those heavily dependent on certain types of funding, said Matthew Bisanz, partner with Mayer Brown's financial services regulatory and enforcement practice.

"Would it be a self-fulfilling prophecy if the bank gives people a road map as to what could cause it to fail?" Bisanz said. "Will that encourage failures from people seeking to profit from a bank? No one ever wants to plan their own funeral."

A heavy lift

Such testing would also be resource-intensive and require significant effort from banks, particularly for regionals that would "need to invest a lot" as opposed to the largest banks that already have the resources, said Bisanz.

For example, most regional banks would need to hire technical experts to develop and execute the reverse stress testing models and data governance experts to validate the data used. Banks will also need to take time to ensure that their risk management, compliance and audit teams have the resources to support the reverse stress testing, he added. Those efforts would prove time-consuming and costly.

Such tests would also require time and attention from senior management and governance staff after the fact to act on the results of the test, such as addressing areas of potential risk, Bisanz said.

Questions swirl

Ultimately, how costly these tests would be depends upon what they entail. However, a lot remains unknown about what exactly the tests could look like, which banks will be subject to them and how fast the Fed will move with such a proposal.

"It depends on whether there's a new requirement for formal submission of reverse stress tests meeting particular mandated standards to regulators for review and approval, or whether these tests are just something that examiners will expect to look for and review in the ordinary course of risk management," Baker said.

"In the former case, it would probably require additional resources," Baker said. "In the latter case, probably not."

In any case, when conducting a reverse stress test, banks would need to work hard to identify specific scenarios that would be the areas of greatest struggle for them, such as rapid deposit withdrawals or floating-rate debt that is not hedged, Bisanz said.

Regulators might also "blend" reverse stress testing requirements with current stress testing, both Bisanz and Peter Dugas, who heads the Center for Regulatory Intelligence at financial consulting firm Capco, said. In such an approach, the Fed could ask banks to apply the agency's more traditional stress testing scenarios, including variations on those scenarios such as global market shock, to the bank's own, specific reverse stress test situations.

It is also unclear which banks would be subject to reverse stress testing if the Fed moves forward with the approach.

Baker said he expects regulators to focus reverse stress testing requirements on banks with assets between $100 billion to $500 billion. Since larger banks are already subject to a host of heightened capital and liquidity requirements, agencies are most likely to shine this spotlight on regional financial institutions, with scrutiny focused on banks that serve specific industries, he added.

Since the March failures of Silicon Valley Bank and Signature Bank, as well as the May collapse of First Republic Bank, federal banking regulators have expressed their intention to impose additional requirements on banks with assets of more than $100 billion.

Another question for banks is the speed of the agency's approach toward reverse stress testing.

"We fully anticipate that as one of the areas of focus over the next several months, that [regulators] will issue guidance, and will implement a final rule regarding reverse stress testing," Capco's Dugas said.