Federal authorities unveil potential future financial challenges for banks in 2025, outlining various hypothetical situations
Federal Reserve Announces 2025 Stress Test Scenarios with Focus on Climate-Related Risks
The Federal Reserve has unveiled its annual stress test scenarios for 28 large banks, with significant changes from last year's test. The primary focus this year is on assessing banks' resilience to climate-related risks.
In contrast to the 2021 stress tests, the 2022 tests include exploratory analyses focusing explicitly on climate-related risks. This shift reflects the growing regulatory emphasis on climate risk management by the Fed and other regulators.
The broader scenario analysis framework in the 2022 tests expands beyond purely financial and economic shocks to consider the impacts of climate policy changes, physical risks from environmental damage, and transition risks associated with moving toward a lower-carbon economy.
While the Fed has been working toward improving transparency in its stress testing methodologies, this year's tests also aim to disclose models in more detail and refine rules like capital requirements and leverage ratios.
The climate scenarios used projections based on different greenhouse gas emission pathways and socioeconomic factors, aiming to simulate short to long-term adverse impacts on the banking sector. This approach aligns with other regulatory bodies conducting climate stress testing, such as the ECB and the Bank of England.
The stress test for 2025 extends from the first quarter of 2025 to the first quarter of 2028. It includes severe global recession scenarios with added stress in commercial, residential real estate, and corporate debt markets. 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.
In addition to the traditional macro-financial scenarios, the 2022 stress tests also feature a U.S. unemployment rate jump of nearly 5.9 percentage points, to 10%. The tests also include severe market volatility, widening corporate bond spreads, and a collapse in asset prices, including about a 33% decline in house prices and a 30% decline in commercial real estate prices.
Banks with major trading operations face additional stress tests that involve global market shock testing for trading positions and the largest counterparty default testing for banks with substantial trading and custodial operations. The Fed's exploratory analysis includes testing bank resilience to non-bank financial sector shocks during severe recession and a market shock applied to only the largest and most complex banks, hypothesizing the failure of five large hedge funds.
The banks being tested in the 2025 stress test 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 American Bankers Association (ABA) has advocated for increased transparency in the Federal Reserve's stress testing program. The Fed's board of governors is currently being sued by several organizations, including the ABA, in U.S. District Court for the Southern District of Ohio, alleging that the central bank's stress testing framework violates the Administrative Procedure Act.
Rob Nichols, president and CEO of ABA, has called for the publication of supervisory models and stress scenarios for public comment. Despite the ongoing lawsuit, the Federal Reserve has announced its plans to reduce stress test volatility and improve model transparency this year.
References: [1] Federal Reserve Board. (2022). Supervisory stress testing program. Retrieved from https://www.federalreserve.gov/supervisionreg/stress-testing.htm [2] Federal Reserve Bank of New York. (2022). 2022 stress testing overview. Retrieved from https://www.newyorkfed.org/markets/stress-testing-overview
In light of the Federal Reserve's stress test scenarios for 2025, the focus on climate-related risks is anticipated to continue, given that these risks are a significant part of the broader scenario analysis framework. Consequently, the assessment of banks' resilience in finance and business sectors remains crucial, considering the potential adverse impacts on the banking sector resulting from climate-related risks.
