Fed Unveils Details of 2014 Stress Test with a Few Twists

WASHINGTON — The Federal Reserve Board gave thirty U.S. financial institutions a new batch of instructions Friday on how to perform their annual stress test exercises next year.

The 2014 exercise, building on previous rounds by the U.S. central bank, expanded the number of bank holding companies that will be subject to the yearly check-up by regulators to ensure firms would be resilient enough to withstand another stressful economic episode.

A dozen financial institutions including Comerica (CMA), Huntington Bancshares (HBAN) , M&T Bank (MTB), Northern Trust (NTRS), Discover Financial Services (DFS) and Zions Bancorp. (ZION) will be added to the Fed's roster along with 18 of the other largest bank holding companies, which have previously been subject to the test.

"The capital planning and stress test testing program has been an integral component of the Federal Reserve's broader supervisory and regulatory efforts to make the financial system stronger and safer since the financial crisis," said Fed Gov. Daniel Tarullo.

Unlike last year, the Fed added a few twists given its ongoing concern tied to securities financing transactions. The agency decided to test against the likelihood of a counterparty default among the eight largest firms, including JP Morgan Chase & Co., Goldman Sachs, Wells Fargo and Citigroup.

A Fed official said regulators changed their approach from last year in order focus on identifying a particular counterparty which would lead to the largest net losses and ensure that the company had enough capital if that one counterparty defaults.

Six of those eight firms will also be subject to a global market shock — a large and sudden change in assets prices, rates, or spreads — as part of their exercise.

Fed officials also warned that this year's post-stress test capital ratios would also be impacted by banks having to comply with Basel III capital requirements, which take in effect in 2015 and will be part of the transition over the two-year horizon in next year's exercise.

The central bank outlined more than two dozen economic variables — including unemployment, exchange rates, prices, and interest rates — that will be used to test a firm's capital strength and resiliency to withstand an economic crisis. The Fed tests the firms against three scenarios: baseline, adverse, and severely adverse.

For example, under the baseline scenario, banks would be tested during a period where the U.S. economy saw "moderate expansion" with slightly less than 3% gross domestic product a year and a depressed unemployment rate gradually declining below 6% by the end of 2016. Home prices would edge 3% higher and short-term Treasury rates would remain at 10 basis points for most of the year, and later increase 25 basis points for each quarter until the end of 2016.

Regulators also included two new additional domestic variables from last year: the yield on the five-year Treasury bond and the prime rate.

"The motivation for adding the yield on the five-year Treasury bond is that — together with the rate on the three-month Treasury bill and the yield on the 10-year Treasury bond — it provides a more thorough characterization of the Treasury yield curve," the Fed said in its instructions. "The motivation for adding the prime rate is that it is a commonly used base rate for many types of loan products."

Under a hypothetical "adverse" scenario, however, the U.S. would be facing a weakening of economic activity with a global aversion to long-term fixed-income assets that brings about rapid rises in long-term rates and steepening yield curves in the U.S. and U.K., Europe, Asia and Japan.

Similarly, under a "severely adverse" scenario, the U.S. economy would be in a severe recession with an unemployment rate peaking at 11.25% by the middle of 2015. Real gross domestic product would decline by nearly 4.75% between the third quarter of 2014 and the end of 2014.

The exercise also requires firms to submit their capital before Jan. 6 to get regulators' blessing to proceed with their capital distribution plans, such as buyback programs and dividend payments. Regulators aim is to ensure that these firms would have enough capital on hand to continue to lend to consumers and businesses and still be able to issue dividends to shareholders.

On a call with reporters, a Fed official stressed that regulators would rigorously assess a firm's ability to capture its own specific risks and idiosyncratic risks stemming from its activities — and would be a critical part of the Fed's overall assessment.

Last year, JPMorgan Chase & Co., Goldman Sachs and BB&T were criticized by the Fed for their ability to effectively estimate how a particular risk might affect their portfolio and required to draft new capital plans as a result.

The decision by the Fed signaled that even if banks, in the case of JPMorgan and Goldman Sachs, were able to pass the regulatory exercise, they could still face some adversity in getting regulators to agree with their capital plans.