WASHINGTON — The Federal Reserve on Thursday released its 2018 stress testing scenarios, saying that it had dialed up its "severely adverse" scenario from last year.

The central bank said it toughened the test because it is designed to be countercyclical — that is, contemplate more severe shocks when baseline conditions are better and less severe shocks when they are already unfavorable.

“This increase in severity reflects the Federal Reserve’s scenario design framework for stress testing, which includes elements that create a more severe test of the resilience of large firms when current economic conditions are especially strong,” the Fed document said.

Federal Reserve building.
The Fed’s severely adverse scenario, meanwhile, sees a “broad-based and deep correction in asset prices—including in the corporate bond and real estate markets,” according to the Fed document. Bloomberg News

The Fed conducts two separate stress testing scenarios every year on each of the bank holding companies under its supervision with more than $50 billion in assets.

The first test is the Dodd-Frank Act Stress Test, which examines a bank’s balance sheet performance under the scenarios using a standard capital management plan. The second is the Comprehensive Capital Analysis and Review, which differs in that it uses the bank’s own capital management plan to better assess how the bank might actually perform under the same conditions. Each test examines a bank’s performance over nine future consecutive quarters.

Three scenarios are assessed: baseline, where the prevailing market conditions are similar to what is expected over the nine-quarter timeline; adverse, which indicates moderate economic malaise; and severely adverse, which contemplates a major recession along the lines of the 2008 financial crisis.

Under the Fed’s adverse scenario, the U.S. unemployment rate rises to a peak of 6.25% while asset prices face a pronounced decline. Equity market prices decline roughly 30% by the end of 2019 and experience greater volatility in the Fed’s 2018 adverse scenario, while house prices decline by 12% and commercial real estate prices decline by 15% by the end of 2020. This represents a less severe reduction in equity index valuations compared to the 2017 adverse scenario.

The Fed’s scenarios also instructed banks to assume that the decline in real estate valuations “should be assumed to be concentrated in regions that have experienced rapid price gains over the past two years.”

The Fed’s severely adverse scenario, meanwhile, sees a “broad-based and deep correction in asset prices—including in the corporate bond and real estate markets,” according to the Fed document.

Under such a scenario, equity prices would fall by 65% by the beginning of 2019, while the VIX — a metric of market volatility — would exceed 60% by the end of 2018. Home prices would decline by 30% and commercial real estate prices by 40% by the end of 2018 under the severely adverse scenario. The unemployment rate would peak at 10% by the third quarter of 2019, while real GDP would decline to -8.9% in the second quarter of 2018, bouncing back gradually to 4.5% by the first quarter of 2021.

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