WASHINGTON — The Federal Reserve Board on Thursday gave the 19 largest financial institutions the economic variables that will be used to test a firm's capital strength and resiliency to withstand an economic crisis.
The central bank released information regarding three scenarios — baseline, adverse, and severely adverse — which includes more than two dozen variables such as unemployment, exchange rates, prices, and interest rates that will be used as part of the annual stress test exercise required under Dodd-Frank.
For example, under the baseline scenario, banks would be tested during a period were the U.S. economy would experience "moderate expansion" with real gross domestic product rising 2.75% a year and an unemployment level gradually declining to 6.75% by the end of 2015. Home prices would edge 3% higher each year and short-term Treasury rates would increase about 20 basis point each quarter reaching nearly 2% over the two-year period.
In the "adverse" scenario, however, the U.S. would be in a "moderate recession" beginning in the fourth quarter of 2012 and lasting until early 2014. The level of real GDP would decline 2% with an unemployment rate reaching 9.75%. The prices of homes would decline more than 6% by next year, and the yield on the long-term Treasury note would increase by less, but still rise above 3.5% by the end of 2013.
By 2014, the scenario calls for "quite sluggish" growth in the economy, with real GDP rising just 1% that year and only 2.25% through 2015. Unemployment would continue to rise to as high as 10% by the end of 2015.
In the final "severely adverse" scenario, the U.S. economy would be in a "severe recession" with a further weakening in the housing market. The unemployment rate would remain above any level experienced over the last 70 years from the middle of 2013 through 2015.
Real GDP would decline nearly 5% between the third quarter of 2012 and the end of 2014, causing the unemployment rate to rise to nearly 12 %. Home prices would plummet more than 20% by the end of 2014. Short-term interest rates would remain near zero through 2015, while the yield on the long-term Treasury note would decline to 1.25% next year, before rising 1 percentage point by the end of 2015.
The third scenario is similar to the same variables the Fed used last fall, except this year it accounted for a "more substantial slowdown in developing Asia," rather than a moderate one as it had done previously.
"This feature of the scenario 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 sizable weakening of economic activity in China," according to the Fed.
The Federal Deposit Insurance Corp. and Office of the Comptroller will be using the same scenarios as the Fed during their upcoming stress tests for the institutions they supervise.
Regulators cautioned that data presented in the adverse and severely adverse scenarios are "not forecasts, but rather hypothetical scenarios" used only to determine a firm's ability to continue to lend to households and businesses even during stressful economic periods. The baseline scenario, on the other hand, presents the expectations of private sector forecasters.
In December, the Fed will provide certain firms with global market shock components, considered to be a "one-time, hypothetical shock," to test against in their adverse and severely adverse scenarios.
Banks will once again be tested against a similar set of circumstances as seen during the second half of 2008 during the financial crisis, including hypothetical euro-zone based shocks, sovereign credit default swaps, and large depreciation in the Euro against major currencies. Banks were tested against a similar scenario in this year's supervisory capital analysis.
A global market shock in an adverse scenario would be milder. For instance, it would include an increase in U.S. Treasury yield and the steepening of the yield curve, which could negatively impact market prices of asset classes.
Another additional 11 firms will not have to go through the stress test exercise, but will be part of the capital plan review along with their state member bank subsidiaries.
Separately, the Fed released a proposed policy statement on what steps it might take to develop stress test scenarios in the future. Stakeholders have until Feb. 15 to weigh in on the proposal.