Hypothetical scenarios for a second round of bank stress tests – to be conducted due to continued uncertainty related to the coronavirus crisis – were released Thursday by the Federal Reserve.
The Fed said that large banks will be tested against two scenarios featuring severe recessions to assess their resiliency under a range of outcomes resulting from the scenarios. The agency said it will release firm-specific results from banks’ performance under both scenarios by the end of this year.
“The Board’s stress tests help ensure that large banks are able to lend to households and businesses even in a severe recession,” the Fed said in a release, noting that the first round of stress tests from earlier this year found large banks were well capitalized under a range of hypothetical events. (However, the Fed noted that it still required banks to take several actions to preserve their capital levels in the third quarter of this year. The Fed said it will announce by the end of September whether those measures to preserve capital will be extended into the fourth quarter.)
The second round of stress tests will evaluate the resilience of large banks by estimating their loan losses and capital levels under hypothetical recession scenarios over nine quarters into the future, the central bank said.
More specifically, the Fed said two hypothetical recessions in the scenarios feature severe global downturns with substantial stress in financial markets. The first scenario – the “severely adverse” – features the unemployment rate peaking at 12.5% at the end of 2021 and then declining to about 7.5% by the end of the scenario. Gross domestic product (GDP) declines in the scenario about 3% from the third quarter of 2020 through the fourth quarter of 2021. The scenario also features a sharp slowdown abroad.
The second scenario – which the Fed dubbed the “alternative severe” – features an unemployment rate that peaks at 11% by the end of 2020 but stays elevated and only declines to 9% by the end of the scenario. GDP declines about 2.5% from the third to the fourth quarter of 2020.
Both scenarios also include a global market shock component that will be applied to banks with large trading operations, the Fed said. Those banks, as well as certain banks with substantial processing operations, will also be required to incorporate the default of their largest counterparty.
In a statement attached to the release, Fed Vice Chair for Supervision Randal Quarles said that uncertainty continues to hector the economy, even though there have been improvements. He said that uncertainty over the course of the next few quarters remains unusually high, and these two additional tests will provide more information on the resiliency of large banks.