Banking and Finance Law Daily Fed releases hypothetical scenarios for upcoming round of additional stress tests
Friday, September 18, 2020

Fed releases hypothetical scenarios for upcoming round of additional stress tests

By Charles A. Menke, J.D.

The scenarios will be used by the Fed to conduct its updated stress analyses that are being performed due to the continued uncertainty of the COVID-19 pandemic, as well by the institutions to estimate projected revenues, losses, reserves, and pro forma capital levels as part of their 2020 capital plan resubmission.

The Federal Reserve Board announced it has released hypothetical scenarios for a second round of bank stress tests necessitated by the continued uncertainty stemming from the COVID-19 pandemic. The Fed’s first round of stress tests for 2020 found that large banks were well capitaliszed under a range of hypothetical events (see Banking and Finance Law Daily, June 26, 2020). However, large banks will be further tested against two scenarios featuring severe recessions to assess their resiliency under a range of outcomes.

Uncertainty remains high. "The Fed's stress tests earlier this year showed the strength of large banks under many different scenarios," Fed Vice Chair Randal K. Quarles said. "Although the economy has improved materially over the last quarter, uncertainty over the course of the next few quarters remains unusually high, and these two additional tests will provide more information on the resiliency of large banks." The Fed plans to release firm-specific results from the banks' performance by the end of 2020.

Hypothetically severe but plausible risks. The two hypothetical recessions in the scenarios feature severe global downturns with substantial stress in financial markets. In light of the substantial uncertainty around the likely course of economic activity, the two scenarios—a "severely adverse" scenario and an "alternative severe" scenario—serve to capture a broad set of severe but plausible risks, according to the Fed.

Severely adverse, alternative severe scenarios. The "severely adverse" scenario features an unemployment rate peaking at 12.5 percent at the end of 2021 and then declining to about 7.5 percent by the end of the scenario with gross domestic product declining approximately 3 percent from the third quarter of 2020 through the fourth quarter of 2021. The "alternative severe" scenario, meanwhile, features an unemployment rate that peaks at 11 percent by the end of 2020 but stays elevated and only declines to 9 percent by the end of the scenario while gross domestic product declines about 2.5 percent from the third to the fourth quarter of 2020.

Global market shock component. The two scenarios additionally include a global market shock component that will be applied to banks with large trading operations. These banks, as well as other banks with substantial processing operations, will also be required to incorporate the default of their largest counterparty.

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