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Stress Test Scenarios for '21 Revealed: Will Big Banks Pass?

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The Federal Reserve has revealed hypothetical scenarios with regard to 2021 stress test for major banks. The test helps evaluate safety and soundness of the banking sector.

Vice Chair for Supervision Randal K. Quarles said “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.”

Banks must submit their capital plans to the Fed by Apr 6. The results of the test will be released by June 2021-end.

Before we check out this year’s hypothetical scenarios, let’s see what happened in 2020 amid the coronavirus pandemic.

This is the third time that banks will be undergoing stress test in the past 12 months. Last year, the Fed had conducted tests twice (June and December) amid the coronavirus-related mayhem.

Though banks cleared the tests, the Fed had restricted their capital plans – maintaining dividend rate and no share repurchases – in order to preserve liquidity owing to pandemic induced economic slowdown. This had even resulted in few banks like Capital One (COF - Free Report) and Wells Fargo (WFC - Free Report) cutting their quarterly dividends.

While some banks including JPMorgan (JPM - Free Report) , Citigroup (C - Free Report) and Morgan Stanley (MS - Free Report) have resumed buybacks in first-quarter 2021 (following the central bank’s approval), total distributions are based on a bank's trailing four-quarter average net income. Also, Capital One has now restored dividend to the pre-COVID-19 level.

2021 Hypothetical Scenarios

Like always, the central bank has come out with two hypothetical scenarios – Baseline and Severely Adverse. This covers 13 quarters through the first quarter of 2024.

The baseline scenario includes hypothetical conditions based on average projections from a survey of economic forecasters. This scenario includes domestic economy expanding as quarterly real GDP growth averages 4% (annual rate) this year and then shrinks to 2.5% by 2022-end and further to 2.25% at the end of the scenario period.

Further, unemployment rate gradually falls from 2020-end level of 6.75% to 4.5% by first-quarter 2024. Also, equity market volatility declines, house prices improve and commercial real estate price falls. The hypothetical scenario includes a “steady expansion in international economic activity” as well.

The severely adverse scenario has “hypothetical set of conditions” to test major banks resilience in an adverse economic backdrop. It is characterized by severe global recession along with heightened stress in commercial real estate and corporate debt markets.

Under this scenario, unemployment rate would increase to 10.75% by the third quarter of 2022. Further, real GDP in that same time frame would fall 4%, with equity prices plunging 55%. Additionally, severe recessions in eurozone, the U.K., and Japan, and a substantial slowdown of activity (still with positive growth for most of the scenario period) in “developing Asia” are part of this hypothetical scenario.

How are Banks Likely to Fare?

This time 19 major banks, with more than $250 billion in assets, are part of the stress test. Smaller banks (with assets of $100 billion to $250 billion) face stress tests every alternate year, although they can opt to be part of this year’s stress test.

Moreover, 10 of these 19 banks with the large trading operations will be tested against a hypothetical global market shock, while 12 of these companies that have significant trading or processing operations will be tested against the failure of their largest counterparty too.

Despite the severity of last year’s “mid-cycle” stress test, banks did well. Thus, banks are expected to clear the stress test this time as well.

Also, as mentioned above, since the Fed had restricted capital plans last year, major banks like Bank of America (BAC - Free Report) and U.S. Bancorp (USB - Free Report) have piled up huge levels of capital. Thus, once the Fed removes limits on capital distributions, banks are likely to come up with substantially large capital deployment plans.

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