The Federal Reserve’s 2024 hypothetical stress test
scenarios are the first to incorporate elements the agency is studying as part
of its “exploratory analysis” of the banking system. The analysis is distinct
from the stress test but will complement it by offering aggregate results
tested against different economic and financial conditions.
As a companion to its annual supervisory stress test,
designed to ensure large banks have the liquidity necessary to continue lending
during a major recession, the Fed released a summary describing four factors
incorporated into this year’s scenarios.
“Taken together, the
stress test and exploratory analysis will provide insight into the resiliency
of the U.S. banking system,” the summary states. “The conditions for the
exploratory analysis are not Federal Reserve forecasts. The exploratory
analysis will not impact large bank capital requirements.”
Two of the elements the Fed is studying are designed to test
adverse conditions banks may experience under various types of funding stress. The
other two are designed to help the Fed understand banks’ vulnerabilities
related to exploratory market shocks.
Funding stress elements
The Fed notes that a variety of economic conditions can
result in funding stress, which could cause banks to take remedial actions to
maintain adequate deposit levels. The two funding stress elements incorporated
into this year’s stress test are described as follows:
“The first set of macroeconomic conditions considers a
moderate global recession combined with increasing inflationary pressures,
rising interest rates, and an increase in banks’ cost of funding. Supply
disruptions cause inflation expectations to rise, pushing short- and long-term
interest rates higher through 2024. These conditions also feature persistently
elevated inflation and acute stress in advanced economies. Additionally, the
U.S. dollar appreciates against all countries and country blocs’ currencies,
except for the Japanese yen.
“The second set of macroeconomic conditions features a
severe global recession combined with high and persistent inflation and rising
interest rates. The conditions also include elevated inflation and U.S. dollar
appreciation against currencies, except for the Japanese yen, as in the first
set of conditions.”
Exploratory market shocks
The nation’s largest banks have certain vulnerabilities to market
exposures. Given that these can vary significantly across firms, the Fed
crafted multiple hypothetical market shocks to test the implications of a wider
range of vulnerabilities, as described below:
“The first exploratory market shock is characterized by a
sudden dislocation to financial markets stemming from expectations of reduced
global economic activity and tighter financial conditions. Elevated
expectations for a U.S. recession weaken the U.S. dollar. Long-term Treasury
securities rates increase sharply because of the adverse outlook for inflation
over time, while short-term rates increase mildly. An increase in anticipated
defaults leads to a widening in credit spreads. The expected fall in economic
activity leads to equity price declines, while volatility rises from heightened
market uncertainty. The increase in market volatility leads to higher margin
requirements. Hedge funds unable to meet the higher margin requirements are
forced to unwind their positions at a loss; as a result, the five hedge funds
with the largest counterparty exposures for each firm subject to exploratory
market shocks fail.
“The second exploratory market shock is characterized by a
sudden dislocation to financial markets stemming from expectations of severe
recessions in the U.S. and other countries. The effects on equity and credit
markets are similar to those experienced in the first market shock, while the
effects on other markets differ. In particular, Treasury securities rates fall
in the second market shock as inflation expectations decline, while the U.S.
dollar appreciates against most currencies, reflecting flight-to-safety
considerations. Consistent with expectations for a severe recession, most
commodity prices fall. Precious metals prices increase as investors seek to
diversify their investments, such as through the purchase of gold and silver.
As in the first market shock, market volatility leads to the default of the
five hedge funds with the largest counterparty exposures for each firm subject
to the exploratory market shocks.”
Stress test scenarios
The Fed’s annual stress test evaluates large banks’
resilience by estimating losses, net revenue and capital levels — which provide
a cushion against losses — under hypothetical recession scenarios looking two
years into the future.
Thirty-two banks will be tested this year against a severe
global recession with heightened stress in both commercial and residential real
estate markets, as well as in corporate debt markets, the Fed explained in a
press release. The scenarios are not forecasts and are also not intended to be
misconstrued as economic predictions.
In the 2024 stress test scenario, the unemployment rate jumps
by nearly 6.5 percentage points, topping out at 10 percent, accompanied by
severe market volatility, widening corporate bond spreads and a collapse in
asset prices. This includes a 36 percent drop in home prices and a 40 percent drop
in commercial real estate prices.
The Dodd-Frank Act requires large banks with substantial
trading or custodial operations to also incorporate a counterparty default
scenario component for estimating and reporting potential losses and capital
effects should a firm’s largest counterparty default.
The Fed included a table on its website showing the
components of the annual stress test applicable to each of the 32 banks
scheduled to be tested, based on data gathered as of the third quarter of 2023.
The table indicates nine banks will be subject to scenarios simulating global
market shocks and 11 banks are subject to scenarios simulating counterparty
default.
The Fed plans to publish results from its exploratory
analysis alongside its annual stress test results in June.