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Fed Reveals 'Mid-Cycle' Stress Test Scenarios for Major Banks

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The Federal Reserve has revealed hypothetical scenarios with regards to ‘mid-cycle’ stress test for 34 major banks. This is the first time that the central bank is conducting the stress test twice in a year.

The results of the test will be released by the year end. Further, this time, the Fed will come out with bank-specific results unlike in June, when it didn’t release the same stating that some fell below the minimum capital requirements.

In June, the Fed had announced the results of 2020 stress test, which reflected financial stability of the banking system. Apart from previously disclosed hypothetical scenarios, the central bank had taken into account three other recovery scenarios amid the coronavirus pandemic to decide major banks’ capital adequacy and payouts.

Before check what the new scenarios are, let’s understand why the stress test is being conducted again.

When results were out in June, the U.S. economy was in midst of a severe meltdown. The coronavirus outbreak had wreaked havoc on consumer sentiments, and the unemployment level was at a record high level.

Though the participating banks were able to clear the stress test, the Fed suspended major banks’ buyback plans for the third quarter and put a limit on dividend distributions. The step was taken to maintain adequate liquidity amid the challenging backdrop. Owing to the cap on banks’ dividend payout, Capital One (COF - Free Report) and Wells Fargo (WFC - Free Report) slashed their third-quarter dividend.

Since then the economic data indicates a marginal improvement. However, “the continued uncertainty from the COVID event” is the primary reason for the second round of stress test. .

New Hypothetical Scenarios

The Fed has come up with two hypothetical scenarios – “severely adverse” and “alternative severe” – to test the resilience of the major banks for nine quarters into the future.

The “severely adverse” scenario includes unemployment rate peaking at 12.5% at the end of 2021 and then declining to roughly 7.5% by the end of the scenario; GDP declining approximately 3% from third-quarter 2020 through fourth-quarter 2021. It also features a substantial global slowdown.

Under “alternative severe” scenario, the economy will decline nearly 2.5% from the third quarter to the fourth quarter of 2020. Further, the unemployment rate will peak at 11% by 2020-end and fall only to 9% by the end of the scenario.

The unemployment rate was 8.4% in August, and the U.S. economy shrank at the rate of 31.7% (per second estimate).

Also, these two scenarios include a global market shock component, which will be applied to banks with large trading businesses. Further, these banks, along with those with substantial processing operations, will be required to add the default of their largest counterparty.

The banks subjected to both market shock and a counterparty default are Bank of America (BAC - Free Report) , Barclays US LLC, Citigroup (C - Free Report) , Credit Suisse Holdings (USA), Inc., DB USA Corporation, Goldman Sachs (GS - Free Report) , HSBC North America Holdings Inc., JPMorgan (JPM - Free Report) , Morgan Stanley (MS - Free Report) , UBS Americas Holding LLC and Wells Fargo.

What’s Next?

Apart from the above-mentioned hypothetical scenarios, the central bank said that it will decide whether the banks will be able to resume buybacks in the fourth quarter or not by the end of this month.

The chances are slim for the resumption of normal level of capital deployments owing to the economic uncertainty over the next few quarters. Thus, banks might be required to maintain enhanced level of liquidity.

This is likely to be disappointing for many banks, which are adequately capitalized and are ready to reward shareholders. Earlier in the week, at a virtual investor conference, JPMorgan’s chief financial officer Jennifer Piepszak stated that the company has excess capital despite the ongoing crisis, and if permitted it is ready to use cash to buy back shares next quarter.

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