Bloomberg News
A global recession, commercial and residential real estate stress and a corporate debt crunch are among the scenarios explored in this year’s Federal Reserve stress test.
The central bank unveiled the details of its annual exploration of large bank resilience on Wednesday afternoon. With the Fed eyeing changes to its stress testing protocol, this year’s exam could mark the end of an era for a key element of post-financial crisis bank regulation.
On Christmas Eve, two large bank lobbying organizations joined the U.S. Chamber of Commerce and a pair of Ohio trade groups in filing a lawsuit against the Fed, arguing that its stress testing practices were too opaque and not in compliance with administrative law. It is unclear what, if any, impact the lawsuit might have on this year’s stress test.
The results of the annual stress test are used to determine the so-called stress capital buffer for large banks, an additional level of capital intended to help them absorb economic and market shocks. This arrangement has frustrated banks on several fronts. Since it results in a new regulatory requirement each year, they argue it should have to go through a formal rulemaking process. Also, because the capital charge is based on a bank’s performance relative to the prior year, a bank can pass the test but still see its capital requirement increase if it performed worse than the year before.
“For years, we have highlighted serious concerns about the stress testing framework and the need for reform,” said Greg Baer, president of the Bank Policy Institute, in a written statement accompanying the announcement of the lawsuit. “The current opaque regime, combined with the lack of clear standards for the global market shock and the operational risk charge, continues to produce capital charges that are inaccurate, volatile and excessive, resulting in reduced lending and economic growth.”
As in years past, the 2025 test includes both a baseline scenario and a “severely adverse scenario” to assess how banks’ balance sheets would respond to a period of broad economic disruption.
This year’s scenario includes a rise in the unemployment rate from 4.1% to 10%, increased market volatility, widening corporate bond spreads, and a “collapse” in asset prices, with home prices falling 33% and commercial real estate falling 30%. It also includes global stresses, such as recessions in several other countries, including Japan.
The Fed described its scenarios as slightly less severe than last year’s test, pointing to a smaller jump in unemployment, less reduction in interest rates and smaller declines in asset values. These adjustments were made because of real-world changes in unemployment, interest rates and commercial property values, and to avoid the results being procyclical.
In total, 22 banks will be subject to this year’s test test: American Express Company, Bank of America Corporation, The Bank of New York Mellon Corp., Barclays US LLC, BMO Financial Corp., Capital One Financial Corp., The Charles Schwab Corp., Citigroup Inc., DB USA Corp., The Goldman Sachs Group, Inc., JPMorgan Chase & Co., M&T Bank Corporation, Morgan Stanley, Northern Trust Corp., The PNC Financial Services Group, Inc., RBC US Group Holdings LLC, State Street Corp., TD Group US Holdings LLC, Truist Financial Corp., UBS Americas Holding LLC, U.S. Bancorp and Wells Fargo & Company.
Some large banks with large trading portfolios will also be put through two additional exploratory scenarios. These exams do not have capital implications but are intended to see how the institutions would respond to specific market shocks.
One of these scenarios includes a credit and liquidity shock in the nonbank financial sector during a global recession. The other, which will only be applied to the eight largest banks in the country, features the failure of five large hedge funds, reduced global economic activity and elevated inflation.
Results of both the main stress test and the exploratory scenarios will be released in June. The corresponding stress capital buffers will be finalized later in the summer.
