FED Releases Scenarios for Second Round of Stress Tests on Banks
FED released hypothetical scenarios for a second round of stress tests for banks. FED will be performing this additional round of stress tests due to the continued uncertainty from the COVID event. The results of the first round of stress tests had found that large banks are well-capitalized under a range of hypothetical events. In the second round, large banks will be tested against "severely adverse" and "alternative severe" scenarios, both of which feature severe recessions. FED will release results of the second-round stress tests by the end of 2020.
The 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 declines by 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—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. In this second scenarios, gross domestic product declines by about 2.5% from the third to the fourth quarter of 2020.
The two scenarios also include a global market shock component that will be applied to banks with large trading operations. These banks, as well as certain banks with substantial processing operations, will also be required to incorporate the default of their largest counterparty. The scenarios are not forecasts and are significantly more severe than most current baseline projections for the path of the U.S. economy under the stress testing period. They are designed to assess the strength of large banks during hypothetical recessions, which is especially appropriate in a period of uncertainty. Each scenario includes 28 variables covering domestic and international economic activity.
Earlier, in June, FED had released the results of its annual stress tests and additional sensitivity analysis, wherein FED required banks to take several actions to preserve their capital levels in the third quarter of this year. By the end of September, FED will announce whether those measures to preserve capital will be extended into the fourth quarter. The stress tests help ensure that large banks are able to lend to households and businesses even in a severe recession. The exercise evaluates the resilience of large banks by estimating their loan losses and capital levels—which provide a cushion against losses—under hypothetical recession scenarios over nine quarters into the future.
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Keywords: Americas, US, Banking, Stress Testing, COVID-19, Severely Adverse Scenario, 2020 Stress Test, Alternative Adverse Scenario, FED
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