The Federal Reserve released a list of hypothetical scenarios to be used in its annual stress testing, designed to ensure that large banks can withstand the effects of a severe economic downturn. This year’s stress tests will simulate a major dip in housing prices, among other adverse market conditions.
The process involves measuring an institution’s financial resilience against a variety of adverse conditions that could threaten its ability to lend to households and businesses.
Additionally, the Fed released two hypothetical elements designed to probe different risks through its “exploratory analysis” of the banking system, which will not affect bank capital requirements.
The new scenarios are meant to reflect changes to its testing regime to improve transparency around the process. Although the updates were championed by the financial services industry, advocates sued the Fed to ensure banks would not be subject to the previous stress test framework.
The 2025 stress test scenarios will test 22 banks against a hypothetical severe global recession with heightened stress in both commercial and residential real estate markets, as well as in corporate debt markets. It will measure the banks’ ability to cope with the U.S. unemployment rate rising to 10 percent, accompanied by severe market volatility, a widening of corporate bond spreads, and a collapse in asset prices, according to a Fed press release.
The simulated asset price decline will include an approximate 33 percent drop in housing prices and a 30 percent dip in commercial real estate prices.
One of the two hypothetical elements examined in the 2025 test framework will be how banks would react to credit and liquidity shocks in the non-bank financial institution sector during a severe global recession.
The second element includes a market shock to be applied only to the largest and most complex banks. This shock hypothesizes the failure of five large hedge funds with reduced global economic activity and higher inflation.
The exploratory analysis is distinct from the stress test and will explore additional hypothetical risks to the broader banking system, rather than focusing on firm-specific results. The Fed plans to publish aggregate results for the exploratory analysis alongside the annual stress test results in June.