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WASHINGTON—Fed Chairwoman Janet Yellen faced pointed questions from lawmakers in both parties Thursday about the Fed's handling of financial regulation, the latest evidence of the political minefield the central bank is navigating ahead of some critical decisions this year.

During a hearing that was nominally about monetary policy, members of the Senate Banking Committee peppered Ms. Yellen with questions about the pending decision on big banks' "living wills," potential changes to the Fed's annual "stress tests," and the role of regulation in recent market volatility.

Two liberal Democrats, Sens. Sherrod Brown of Ohio and Elizabeth Warren of Massachusetts, pressed her on perhaps the toughest decision facing the Fed at the moment: How will it carry out the living will process in the 2010 Dodd-Frank financial-overhaul law?

Dodd-Frank required banks to write plans for managing their own failure without taxpayer help. Under the law, if the Fed and the Federal Deposit Insurance Corp. found the plans to be not credible, the regulators could impose significant sanctions and even force firms to break into pieces.

In an intriguing exchange with Ms. Warren, Ms. Yellen raised the possibility that regulators will publicly release their criticisms of individual bank's living wills. That could put a harsher spotlight on banks whose bankruptcy plans fall short.

In August 2014, months after another hearing in which Ms. Warren pressed Ms. Yellen to be aggressive on living wills, the Fed and FDIC took a shot across the bow of 11 giant banks by sending letters detailing deficiencies with their living wills. But publicly, the regulators only described the problems in general terms. The banks, which include J.P. Morgan Chase & Co., Bank of America Corp. and Citigroup Inc., filed revised plans last year, and are awaiting regulators' response.

Ms. Warren asked Ms. Yellen to promise that the Fed would explain its assessment of the plans if it differed from the FDIC's conclusion. In 2014, the FDIC found the banks' plans "not credible," but the Fed didn't. A joint finding is necessary for the agencies to "use statutory tools to push these risky banks in the right direction," Ms. Warren noted.

"It seems like that's the least the Fed could do," Ms. Warren said, referring to her request that the Fed issue a public statement explaining differences with the FDIC.

Ms. Yellen replied: "My expectation is that we will release the letters that we send to the firms giving our evaluations of their living wills."

It wasn't clear whether she meant the Fed would release the letters publicly. A Fed spokesman declined to elaborate. Moments later, Ms. Yellen again said she hoped the Fed and FDIC would agree on the verdict and "release letters" explaining deficiencies in the living wills, but added: "I cannot guarantee you that we will arrive at identical conclusions."

Ms. Warren's questions highlight the political pressure on the Fed, which endured some criticism in 2014 after it was perceived to be less aggressive than the FDIC on living wills.

Ms. Yellen said a decision on the living wills would be coming "in the not-too-distant future." She said the Fed and FDIC are still working to reach an agreement on how to respond to the banks' 2015 plans. The Fed board of governors has met seven times to discuss the living wills, she said.

Separately, Ms. Yellen told Senate Banking Committee Chairman Richard Shelby (R., Ala.) that she opposes a bill that would give municipal securities more credit under bank liquidity rules. Municipalities, states and the financial industry have been pushing the measure, saying that the cost for municipalities to issue debt could increase in the future because the securities aren't treated favorably under the Fed rules.

Ms. Yellen said a bill that would change the Fed rules, which recently passed the House, "would interfere with our supervisory judgments about what constitutes adequate liquidity." Her statement likely hurts the bill's chances of easily passing the Senate.

Asked about pending changes to the central bank's annual stress tests of the nation's largest financial firms, Ms. Yellen said the Fed is looking to make them harder for the very biggest banks but potentially easier for banks with assets close to $50 billion. The changes likely won't take effect until next year, and the Fed will be looking at "the costs and benefits of particular changes" and how they affect individual banks, she said.

Ms. Yellen told Sen. Mike Crapo (R., Idaho) the central bank isn't ignoring concerns that fundamental changes in financial markets have made them more volatile during stressful periods. Experiences such as a big price swing in Treasury markets in October 2014 "suggest that under stressed conditions liquidity may disappear when it is most needed," she said.

She said "regulation is on the list" of potential causes, but other factors are as well, such as high-frequency trading, changes in brokers' behavior, and disclosures in the corporate-bond market. "We want to try to disentangle the impact of all those different influences," she said.

Ms. Yellen also pushed back against legislation that would force regulators to tell big financial firms what they should do to avoid or shed a designation as a "systemically important financial institution," or SIFI. The SIFI label comes with tighter oversight by the Fed.

The SIFI designation from the Financial Stability Oversight Council, of which Ms. Yellen is a member, "is not intended to be permanent," she said. Still, the council "should be careful not to micromanage firms," she said.

She said that firms are told why they receive the label, and added: "I just don't think it's appropriate for the FSOC to say, 'We want you to do the following'…There are a lot of different ways in which a firm may decide to address those issues."

Write to Ryan Tracy at ryan.tracy@wsj.com

(END) Dow Jones Newswires

February 11, 2016 19:55 ET (00:55 GMT)

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