Fed will conduct ‘independent assessment’ of second round of stress tests

Following an independent assessment by the Federal Reserve, bank-specific results will be released before year’s end from a second round of bank stress tests that start next month aimed at gauging the financial impact of the coronavirus crisis, the Federal Reserve’s top supervisor reiterated Wednesday.

In remarks to a group of international bankers meeting virtually, Federal Reserve Vice Chair for Supervision Randal Quarles indicated that the results of the stress tests will be subject to an “independent assessment” by the Federal Reserve. He said the tests are intended to assess “the resilience” of the financial sector.

On Sept. 17, the Fed announced the second round of large bank stress tests to be conducted due to continued uncertainty related to the pandemic. The Fed then that the 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 also said then that it would release firm-specific results from banks’ performance under both scenarios by the end of this year.

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 other comments, Quarles said nonbank financial firms involved in liquidity transformation experienced acute strains in March in the wake of the pandemic’s impact. He said that despite some nonbank regulatory reforms in the United States, such as efforts to increase the resilience of money funds, the Fed needed to provide significant emergency support to the firms. “This is why, at the Financial Stability Board, I have put together a senior group of market regulators and central bank governors to develop a holistic review of the March stresses in nonbank finance,” Quarles said.

He said the results of that review will be delivered to the group representing the 20 largest national economies (the “G20”) in November. Accompanied with the results will be what he called “a work plan” on potential methods to “address the vulnerabilities that may amplify stresses in funding markets.”

Fed Vice Chair for Supervision Randal K. Quarles: Optimism in the Time of COVID