The Federal Reserve has released new hypothetical scenarios for its upcoming round of stress testing in 2021.
The Fed conducts stress testing every year on the largest banks with a presence in the U.S. in order to ensure the safety and soundness of the banking system.
The exercise puts each bank through a hypothetical economic scenario to see how its balance sheet would hold up during a severe economic downturn. The goal is to make sure that individual banks could not only survive, but that they would also be able to keep lending to individuals, families, and businesses during a downturn.
Image source: Getty Images
In this year's "severely adverse" scenario, U.S. unemployment would rise to 10.75% by the third quarter of 2022. Gross domestic product in that same time period would drop by 4%, with equity prices declining 55%.
Randal Quarles, vice chair for supervision at the Fed, said in a statement: "The banking sector has provided critical support to the economic recovery over the past year. Although uncertainty remains, this stress test will give the public additional information on its resilience."
In 2021, only 19 of the largest banks will be required to undergo stress testing. Banks with more than $100 billion in assets only have to do stress testing every other year, but they can opt in to testing during off years if they wish.
The new scenario comes after 33 of the largest banks in the U.S. just went through a rigorous year of stress testing in 2020.
For the first time, banks were tested on two separate occasions under many different hypothetical scenarios due to the economic uncertainty created by the pandemic.
Both times, banks were found to have sufficient capital to be able to survive some pretty bleak economic conditions, while continuing to be able to lend to consumers and businesses.
But the Fed has been limiting bank dividends and stock buybacks based on a bank's trailing-four-quarter average net income. More positive results from stress testing could give the Fed the confidence to lift these limitations, if it doesn't happen beforehand.
The results also play a role in determining a bank's capital requirements.
