Fed plans new round of bank stress tests in response to Covid-19

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Further stress tests to analyse how large banks stand up against two scenarios featuring severe recessions.

The ongoing uncertainty around the Covid-19 pandemic has prompted the US Federal Reserve Board to announce another round of bank stress tests to see how large banks stand up against two scenarios featuring severe recessions.

“The Fed’s stress tests earlier this year showed the strength of large banks under many different scenarios,” said Fed vice chair Randal Quarles.

“Although the economy has improved materially over the last quarter, uncertainty over the course of the next few quarters remains unusually high, and these two additional tests will provide more information on the resiliency of large banks.”

Uncertainty remains high and these additional tests will provide more information on the resiliency of large banks.

The first scenario, rated as “severely adverse”, sees the unemployment rate peaking at 12.5% at the end of 2021 and declining to around 7.5% by the end of the scenario. GDP declines about 3% from the third quarter of 2020 through the fourth quarter of 2021. The scenario also features a sharp slowdown abroad.

The second scenario, rated as “alternative severe”, features unemployment peaking at 11% by the end of 2020 and only declining to 9% by the end of the scenario. GDP declines about 2.5%t from the third to the fourth quarter of 2020.

Shock component

Both scenarios include a global market shock component that will be applied to banks with large trading operations. Those banks, as well as certain banks with substantial processing operations, will also be required to incorporate the default of their largest counterparty. The results are to be released by the end of the year.

The Fed explained that the scenarios are not forecasts and are significantly more severe than most current baseline projections for the US economy under the stress testing period. Each scenario includes 28 variables covering domestic and international economic activity.

“The second round of Fed stress tests is credit positive for the US banks’ creditors because it will provide insight into the banks’ capital strength under a more tailored set of assumptions, given the ongoing coronavirus-related uncertainty,” said Andrea Usai, associate managing director at Moody’s Investors Service.

This article first appeared in The Banker’s sister publication Global Risk Regulator. 



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