In advance of its first set of "midcycle" bank stress tests, the Federal Reserve has divulged the two scenarios under which the regulator will put big American lenders through their paces.
The first is a "severely adverse" model, in which a spike in national unemployment to 12.5% at the end of 2021 declines to roughly 7.5% by the end of the scenario. Gross domestic product (GDP), meanwhile, falls by around 3% from the third quarter of this year through the fourth quarter of 2021. This is combined with significant economic deceleration.
The second is the "alternative severe" projection. In this model, unemployment peaks at 11% by the end of this year, declining slowly to 9% by the end of the scenario. GDP in this model decreases at a 2.5% clip from Q3 of this year.
In the aftermath of the financial crisis of the late 2000s, the Fed has conducted once-per-year stress tests on the largest U.S. financial institutions. It has already completed the 2020 version, however it is mandating the upcoming "midcycle" round due to the economic damage caused by the coronavirus pandemic.
In the regular 2020 stress tests, all banks passed (i.e., the Fed found them sufficiently capitalized to withstand heavy economic shocks). However, the regulator capped their dividend payouts according to the average net profit of their preceding four quarters. This particularly handcuffed Wells Fargo (NYSE:WFC), which has struggled with profitability. In July, rather expectedly, Wells Fargo slashed its dividend.
The Fed said it would release the results of the upcoming stress tests by the end of this year.
Save for Citigroup, shares of the "big four" American banks generally did better than the S&P 500 index on Friday, which fell by over 1.1%. Wells Fargo, for example, traded sideways on the day.