The Federal Reserve Board is adding a component to its annual stress-testing program for large banks this year.
Along with its usual baseline and severely adverse scenarios, this year's examination will include an exploratory market shock that will be applied to the trading books of the country's biggest and most complex banks.
The market shock scenario will only be applied to global systemically important banks, and it will not be factored into their capital requirements. However, it will be used to evaluate the resiliency of the banks' testing, and it could shape how future tests are conducted.
The Fed rolled out the scenarios that will be used in this year's stress test on Thursday afternoon.
The severely adverse scenario, which runs from the first quarter of 2023 through the first quarter of 2026, includes a 6.5 percentage-point rise in the unemployment rate to 10%, severe market volatility, a widening of corporate bond spreads and a collapse in asset prices. Residential and commercial real estate values decline by 38% and 40%, respectively. There are also sharp drops in gross domestic product in the U.S. as well as the United Kingdom and Japan.
The baseline scenario, against which the results of the severely adverse scenario are measured, is based on third-party forecasts. The adverse scenario is not a projection for future economic outcomes, but rather a set of conditions devised by the Fed to evaluate banks' abilities to maintain tier 1 equity under duress.
Compared with last year's adverse scenario, 2023's will see a higher ultimate unemployment rate and a sharp fall in home prices — the Fed's response to rising property values through the end of 2022. This year's scenario will also begin with higher starting interest rates, due to monetary adjustments made by the Fed last year, which will give them more room to fall over the testing period.
Other factors in the 2023 adverse scenario, such as potential spillover effects on corporate bonds and equity prices, and inflation risks, are less severe than last year's. In its publication about the scenario, the Fed noted this change was intended to "limit procyclicality in the survey."
Typically, the Fed aims to make its stress tests more difficult when actual economic conditions are strong and less onerous when the economy is on shakier footing. Because stress-testing results determine how much of a stress capital buffer banks must maintain, the central bank prefers they hold on to more capital in good times so they can use it freely to support the economy in difficult times.
After the
Banks and their advocates took issue with the severity of last year's scenario, noting that it was intentionally more difficult than 2021, resulting in higher stress capital requirements across the board even though all the banks passed with relative ease. When a bank sees its tier 1 capital decrease more in a given year than the year before, the Fed requires it to add the difference to its stress capital buffer.
"The nation's largest banks are highly capitalized and resilient. They have shown repeatedly — in both hypothetical stress tests, and in the real-life stress test of the pandemic — that they can and will support American households and businesses even in the face of a severe recession," Financial Services Forum President and CEO Kevin Fromer said in a written statement Thursday afternoon. "We will review the scenarios, which every year have been more severe than the financial crisis."
The fact that no bank failed the stress test — or even came particularly close to doing so — drew criticism from advocates of higher capital requirements.
The exploratory market shock scenario will pit the largest banks in the country against an additional stress scenario, one with a less severe recession but greater inflation linked to higher inflationary expectations. The goal is to see how portfolios perform under the different conditions.
The Fed plans to release the bank-by-bank results from this exploratory scenario alongside the severely adverse scenario findings in June.
