The Federal Reserve Board released the three economic and financial market scenarios that will be used for the current stress test cycle on the largest financial institutions, as required under the Dodd-Frank Act, and in connection with capital plans due in January 2013 under the Board’s capital plan rule.
The scenarios will be used in company-run tests and tests conducted by the Fed on the 19 banks that are part of the Fed’s Comprehensive Capital Analysis and Review. The scenarios include baseline, adverse, and severely adverse scenarios, and include 26 variables such as economic activity, unemployment, exchange rates, prices, incomes and interest rates. All scenarios start in the fourth quarter of 2012 and extend to the fourth quarter of 2015. An additional 11 firms that are part of the Capital Plan Review will test themselves using the baseline and severely adverse scenarios, and will submit their results to the Fed.
Under the worst case scenario, gross domestic product would fall 6.1 percent in the first quarter of 2013, with an unemployment rate as high as 12.1 percent in the second quarter of 2014. The Fed noted that the main qualitative difference between this year’s severely adverse scenario, and last year’s scenario, is a much more substantial slowdown in developing parts of Asia. The Fed noted that this is designed to assess the effect on large U.S. banks of the important downside risks to the global economic outlook that could result from a sizeable weakening in China.
The Fed’s adverse scenario features a moderate recession that begins in the fourth quarter of 2012 and lasts until early 2014. During this period the level of real GDP declines 2 percent and the unemployment rate rises to 9.75 percent. Meanwhile, the baseline scenario shows a moderate expansion in economic activity, with real GDP increasing an average of 2.75 percent per year, and the unemployment rate edging down in 2013, and falling to 6.75 percent by the end of 2015.
The Fed released a proposed policy statement describing the processes it would use to develop its stress test scenarios in future years. Comments on the policy statement are welcome by Feb. 15, 2013. In addition, the FDIC released its own economic scenarios for institutions under its supervision that must conduct stress tests.
Kamal Mustafa, chairman and CEO of Invictus Consulting Group LLC, said the stress tests “in some ways are not so severe as last year.” He noted that under the latest scenario there is “a very subtle shift in terms of different loans being subjected to different degrees of stress… that’s really the change.” Mustafa added that the scenarios also ignore one very key number, which is the “inevitable interest rate shock” that comes after the floor set by Federal Reserve Board Ben Bernanke disappears.
Mustafa predicted that the largest banks would pass the latest round of tests, noting “this time they’ve learned their lesson…they can’t afford the public negative view of failing the test.” However, once the tests are over they will go back and change their strategic plans, Mustafa said. He explained that on average, about 30 percent of outstanding assets held by the top 19 banks will disappear over the next two years due to natural repayment. The banks will replenish these loans in order to maintain their size, he said, adding “the question is how they redistribute that replenishment…that’s where the business strategy and the game-playing will come in.”