The Federal Reserve told the 30 largest banks to test whether they could withstand a severe recession in the U.S. and other major economies with weakening housing markets.
The most severe scenario outlined by the Fed includes a nearly 6.1 percent decline in U.S. gross domestic product in the first quarter of 2013 and an average unemployment rate of as much as 12.1 percent in the second quarter of 2014. Real disposable income contracts for five consecutive quarters, and house prices fall 21 percent from the third quarter of 2012 to the first quarter of 2015.
The Fed will conduct its own tests on the 19 largest institutions, including Citigroup Inc., JPMorgan Chase & Co. and Bank of America Corp. The remaining 11 firms will test themselves and submit results to the Fed.
The Fed said the adverse scenarios were not forecasts and were “designed to assess the strength and resilience of financial institutions and their ability to continue to meet the credit needs of households and businesses.”
The Fed said the international component of its severely adverse scenario also features recessions in the euro area, the United Kingdom, and Japan. It said the main difference between this year and last year’s scenarios is a more substantial slowdown in Asia.
“This feature of the scenario is designed to assess the effect on large U.S. banks of the important downside risks to the global economic outlook that could result from a sizeable weakening of economic activity in China,” the Fed said in a press release.
The Fed drew up a stress test in 2009 to restore confidence in the financial system after the worst financial crisis since the Great Depression brought down Bear Stearns Cos. and Lehman Brothers Holdings Inc. Regulators have since complemented the test with a capital planning-requirement to improve boards’ management of risk and dividend and stock-buyback decisions.
Banks “need to make a convincing argument to their regulators that they know their risks well, take capital planning seriously, and that they execute capital planning competently,” said Jeffrey Brown, a managing director at Promontory Financial Group in Washington and former head of the Office of the Comptroller of the Currency’s risk analysis division.
Banks will be required to maintain a tier one common equity ratio of 5 percent of assets weighted for risk throughout the stress scenario even with dividend and stock buyback plans.
The 19 largest banks have boosted their tier one common equity to $803 billion in the second quarter of 2012 from $420 billion in the first quarter of 2009, the Fed said in a press release last week.
The KBW Bank Index of 24 large U.S. banking companies has risen 19 percent this year compared with a 7.6 percent gain for the Standard and Poor’s 500 Index.
Last year’s test featured a recession combined with a 52 percent plunge in stocks and an unemployment rate of as much as 13 percent.
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