- Worst scenario includes U.S. unemployment rising to 10%
- Adverse scenario would entail declining U.S. interest rates
The Federal Reserve said it will analyze in its annual stress tests how 33 large banks, including Bank of America Corp. and JPMorgan Chase & Co., would withstand a severe global recession, a doubling of the U.S. unemployment rate to 10 percent and moderate deflation.
The exams, using hypothetical scenarios, are a centerpiece of U.S. regulators’ efforts to prevent a repeat of the 2008 financial crisis. The Fed uses the tests to push lenders into building up capital buffers. Companies that fail may not be allowed to buy back their own stock or raise dividends.
In the severely adverse scenario, there would be a sudden, sharp increase in credit risk, significant market illiquidity and the “distress” of at least one large entity that rapidly sells assets into an already fragile market, according to documents released by the Fed on Thursday. Under a less severe or so-called adverse scenario, banks would confront an extended low-growth environment and muted market volatility, the Fed said. U.S. interest rates would decline, as would commodity prices due to reduced demand. Global stock markets would experience a mild correction with a measured increase in volatility.
The Fed made an effort to keep the banks guessing what this year’s stress testing would entail. Governor Daniel K. Tarullo said in a statement that it’s “important that the tests not to be too predictable from year to year.” The key difference for the most severe scenario compared with the year before was a heavier downturn in the U.S. economy, and the adverse scenario included the new wrinkle of U.S. deflation.
In last year’s results, Citigroup received the cleanest approval from the Fed among top Wall Street banks, one year after the company had failed its stress exam. Bank of America got a conditional pass, while Goldman Sachs Group Inc., JPMorgan and Morgan Stanley cleared only after revising proposals. The U.S. units of Deutsche Bank AG and Banco Santander SA failed.
The banks with the largest trading operations face additional hurdles in the testing, having to also assume market shocks and trading-partner woes on top of their adverse conditions.
Several banks such as Goldman Sachs, Morgan Stanley and JPMorgan have to factor in the global market shock, which -- in the case of the most severe scenario -- includes plunging liquidity, a spike in credit risk and major foundering firms dumping assets. Meanwhile, they must also assume “the instantaneous and unexpected default of the counterparty that would generate the largest losses across their derivatives and securities financing activities.”
The stress tests also include a baseline scenario that largely reflects the current outlook of economists for a moderate expansion in the U.S. and a modestly declining jobless rate.
Banks are required to submit their capital plans and stress test results to the Fed by April 5. The central bank will announce the results of the stress exams before the end of June.
The U.S. Office of the Comptroller of the Currency on Thursday confirmed that it will use the same three scenarios for bank-run stress tests by lenders with more than $10 billion in assets, as required by the 2010 Dodd-Frank Act. The Fed’s additional testing of the larger firms, the Comprehensive Capital Analysis and Review, or CCAR, decides whether the companies are capable of meeting their plans for disbursing capital, such as dividends.
“The 2016 CCAR is tougher than the 2015 test, which means the hurdle that big banks must clear to boost capital returns is even greater than what was expected,” Jaret Seiberg, an analyst at Guggenheim Securities, wrote in a Thursday research note.