Hypothetical scenarios for annual stress tests this year of very large banks were released Thursday by the Federal Reserve, which also included new, “exploratory” elements designed to test different risks of the banking system.
The Fed said the tests, released separately but largely the same, will be administered to 32 banks. The agency said the banks would be tested against a severe global recession with heightened stress in both commercial and residential real estate markets, as well as in corporate debt markets.
More specifically, the agency said, the scenarios reflect a U.S. unemployment rate rising from nearly 6.5% to a high of 10%. “The increase in the unemployment rate is accompanied by severe market volatility, a widening of corporate bond spreads, and a collapse in asset prices, including a 36% decline in house prices and a 40% decline in commercial real estate prices,” the agency noted about the scenarios.
In addition, the regulator said, large banks with substantial trading or custodial operations are also required to incorporate a counterparty default scenario component to estimate and report potential losses and capital effects associated with the unexpected default of the firm’s largest counterparty. At least 11 banks fit that category.
Also, banks with large trading operations will be tested against a global market shock component that primarily stresses their trading and related positions, the agency noted. The global market shock component is a set of hypothetical stresses to a large set of risk factors reflecting market distress and heightened uncertainty, according to the regulator. At least nine banks are in that group.
The “exploratory analysis” looks at four hypothetical elements in the banking system, according to the Fed. The first two include funding stresses that cause rapid repricing of a large proportion of deposits at large banks. “Each element has a different set of interest rate and economic conditions, including a moderate recession with increasing inflation and rising interest rates, and a severe global recession with high and persistent inflation and rising interest rates,” the agency said.
The other two elements include two sets of market shocks that will be applied only to the largest and most complex banks, according to the regulator. “These shocks hypothesize the failure of five large hedge funds, with each under a different set of financial market conditions,” the agency said. “Those conditions include expectations of reduced global economic activity with a negative outlook for long-term inflation, and expectations of severe recessions in the United States and other countries.”
The Fed said the exploratory analysis “is distinct from the stress test and will explore additional hypothetical risks to the broader banking system, rather than focusing on firm-specific results.”
Aggregate results alongside the annual stress test results will be published in June, the agency said.
Banks subject to the stress tests include:
Ally Financial Inc.
Federal Reserve Board releases the hypothetical scenarios for its annual stress test