Federal authorities unveil 2025 financial resilience test scenarios
The Federal Reserve has recently announced its annual stress test scenarios for large banks, marking a shift towards less severe conditions compared to the previous year.
In a move towards increased transparency, the American Bankers Association (ABA) president and CEO Rob Nichols has called for the publication of supervisory models and stress scenarios, inviting public comment. The ABA has been advocating for more transparency in the Federal Reserve's stress testing program.
This year's stress test includes a U.S. unemployment rate jump of nearly 5.9 percentage points, to 10%, and features severe market volatility, widening corporate bond spreads, and a collapse in asset prices. However, the scenarios involve a smaller jump in unemployment, less reduction in interest rates, and smaller declines in asset values compared to the 2022 test. This reflects real-world changes in economic variables like unemployment, interest rates, and commercial property values, aiming to avoid procyclical results that could exacerbate economic swings.
The stress test also includes a new exploratory analysis, testing bank resilience to non-bank financial sector shocks during severe recession. The Fed's exploratory analysis also includes a market shock applied to only the largest and most complex banks, hypothesizing the failure of five large hedge funds.
The 2023 scenarios have shown banks' best performance under stress since the 2018 protocols, with an aggregate decline in Common Equity Tier 1 (CET1) capital of 1.8% compared to 2.8% the previous year. This marked a record low loss rate since 2020.
Moreover, the Fed has improved the treatment of hedging and accounting methods in its stress tests. For the first time, the Fed recognized offsetting positions in Accumulated Other Comprehensive Income (AOCI) by better incorporating hedges and synthetic risk transfers that reduce credit exposure via derivatives. This reduced the capital impact from rising rates, lowering stressed capital buffers and effectively freeing capital for banks to deploy in other activities.
The Fed is also reforming stress testing to increase transparency and reduce volatility by averaging results over two consecutive years (2023 and 2024). However, these reforms were not implemented in the current year as the scenarios were already developed.
This year, 22 banks will be tested for resilience in harsh economic conditions, compared to 32 last year. Analysts at Keefe, Bruyette & Woods believe the 2025 assumptions are less stressful than recent tests, with lower market declines, lower [market volatility index], and lower changes in unemployment, residential, and commercial mortgage indexes.
The banks tested this year include American Express, Bank of America, BNY, Barclays US, BMO, Capital One, Charles Schwab, Citi., DB USA Corporation, Goldman Sachs, JPMorgan Chase, M&T Bank, Morgan Stanley, Northern Trust, PNC, RBC US Group Holdings, State Street, TD Group US Holdings, Truist, UBS Americas Holding, U.S. Bank, and Wells Fargo.
The Fed plans to reduce stress test volatility and improve model transparency this year. However, the ABA's call for the publication of supervisory models and stress scenarios remains unanswered.
In a separate development, the American Bankers Association, the Bank Policy Institute, the Ohio Chamber of Commerce, the Ohio Bankers League, and the Chamber of Commerce of the United States of America have sued the Fed's board of governors in U.S. District Court for the Southern District of Ohio, challenging the stress test's constitutionality.
References:
- Federal Reserve, 2023. "2023 Stress Test: Supervisory Scenarios and Assumptions." Board of Governors of the Federal Reserve System.
- Federal Reserve, 2023. "2023 Comprehensive Capital Analysis and Review (CCAR) and Dodd-Frank Act Stress Test (DFAST) Results." Board of Governors of the Federal Reserve System.
- Federal Reserve, 2023. "Improved Treatment of Hedging and Accounting Methods in the 2023 Stress Test." Board of Governors of the Federal Reserve System.
- Keefe, Bruyette & Woods, 2023. "2023 Stress Test Assumptions: A Preview." Keefe, Bruyette & Woods.
- Federal Reserve, 2023. "Frequently Asked Questions about the 2023 Stress Test." Board of Governors of the Federal Reserve System.
- Given the American Bankers Association's call for transparency, it would be beneficial for the Fed to publish the supervisory models and stress scenarios used in stress testing, thereby facilitating a comprehensive review and supporting an informed dialogue within the finance and banking-and-insurance industries.
- Despite the Fed's efforts to reduce stress test volatility and improve model transparency, the ongoing lawsuit instigated by the American Bankers Association, the Bank Policy Institute, the Ohio Chamber of Commerce, the Ohio Bankers League, and the Chamber of Commerce of the United States of America challenges the constitutionality of the stress test, potentially adding complexity to the industry's regulatory landscape.
