Fed offers details on additional bank stress test triggered by COVID-19

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WASHINGTON — The Federal Reserve published hypothetical scenarios Thursday for the supplemental stress tests the largest banks must undergo in light of the uncertain economic environment.

The central bank is holding the first-ever "midcycle" stress test to get a firmer grasp of banks' capital strength since onset of the coronavirus pandemic. The most recent results of the Fed's normal test were based significantly on yearend 2019 financial data. The supplemental tests will use data from this year's economic tremors.

The midcycle test will include two scenarios: a “severely adverse” scenario and an “alternative severe” scenario. Both are much more dire than current forecasts for the U.S. economic recovery from the pandemic.

The first scenario factors in an unemployment rate that tops out at 12.5% at the end of 2021, a sharp slowdown abroad and a decline of 3% in gross domestic product from the third quarter of 2020 through the fourth quarter of 2021. The second scenario will test banks against an unemployment rate that peaks at 11% by the end of this year but remains high through the end of the scenario, and a 2.5% decline in GDP.

“The Fed’s stress tests earlier this year showed the strength of large banks under many different scenarios,” Vice Chair for Supervision Randal 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’s stress tests earlier this year showed the strength of large banks under many different scenarios,” Vice Chair for Supervision Randal 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.”

Banks with large trading operations will also be subject to a global market shock component, and will be required to factor in the default of their largest counterparty. Banks with substantial processing operations will also have to incorporate the default of their largest counterparty.

The banks subject to both a global market shock and a counterparty default include Bank of America, Barclays, Citigroup, Credit Suisse, DB USA (the U.S.-based affiliate of Deutsche Bank), Goldman Sachs, HSBC, JPMorgan Chase, Morgan Stanley, UBS and Wells Fargo.

The Fed will release bank-specific results for the 34 banks subject to the midcycle test by the end of this year, the central bank said in a press release.

“The Fed’s stress tests earlier this year showed the strength of large banks under many different scenarios,” Fed Vice Chair for Supervision Randal Quarles said in the release. “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.”

As part of its regular stress testing cycle this year, the Fed included additional “sensitivity analyses” that tested banks against hypothetical economic models of recovery from the pandemic.

In aggregate, all 34 banks maintained the minimum capital requirements under each of the scenarios tested, although “several would approach minimum capital levels,” the Fed said at the time. The regulator added that it would require banks to resubmit their capital plans in the fall to reflect more current stresses on the economy.

When the Fed released the results of the annual Comprehensive Capital Analysis and Review stress tests in June, it also said it would require big banks to suspend share repurchases during the third quarter of this year and limit dividend distributions to the levels banks paid out in the second quarter. The Fed will announce by the end of September whether it will extend those restrictions into the fourth quarter.

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