Big Banks Tested Against Rising Rates, Housing Crash

Large financial institutions facing their annual round of stress tests were given their scripts by regulators on Friday.  The tests are designed to identify ways these complex institutions might react to severe stress in the national and world economies.  The Office of Comptroller of the Currency, Federal Reserve Bank and the Federal Deposit Insurance Corporation are looking for indications of forward looking capital planning processes and whether the institutions have sufficient capital to continue operations during critical periods.   The information will be used by the agencies for bank supervision.

The scenarios involve a set of baseline, adverse, and severely adverse scenarios against which the institutions must test their level of preparedness.  Large financial institutions with consolidated assets in excess of $10 billion are required, under a mandate of the Dodd Frank Wall Street Reform and Consumer Financial Protection Act to participate.  This year 30 banks will take the tests, an increase of 12 from last year. 

Each of the three scenarios include 28 variables including economic activity, unemployment, exchange rates, prices, incomes, and interest rates.  The Fed says the adverse and severely adverse scenarios are not forecasts but rather hypothetical situations designed to assess the strength and resilience of the participants which are divided into $10 billion to $50 billion and over $50 billion classifications.  Scenarios will be the same for both groups.

Each of this year's scenarios examine how the biggest banks might react to jump in long-term interest rates and another housing crash over which are layered other factors such as high unemployment, or a slowdown in Asian economies.  The intensity of the various factors are manipulated in accordance with the severity of the scenario. 

For example, under the baseline scenario the country shows moderate economic expansion; real GDP growth accelerates while unemployment edges down and interest rates remain flat in 2014.  Then short term Treasury rates increase steadily, reaching nearly 2.5 percent by the end of 2016.  Home equity and property prices would appreciate modestly through 2016 while economic activity, inflation, and exchange rates outside the U.S. expand but with divergent growth patterns.

The severely adverse scenario is characterized by a substantial weakening in economic activity across all of the economies included in the scenario, a significant reversal of recent improvements to the U.S. housing market and the euro area outlook. There will be a sharp slowdown in developing Asian economies as a proxy for severe weakening everywhere.  The larger decline in U.S. house prices in this scenario is viewed as particularly relevant for localities that have experienced brisk gains in house prices over the past year.

Along with the scenarios the regulators released the final "Policy Statement on the Principles for Development and Distribution of Annual Stress Test Scenarios."  The guidance outlines the consultative processes regulators will use to gather information on the institutions' material vulnerabilities and to coordinate with each other to develop the scenarios each year.  Under rules finalized last year OCC must provide the required scenarios by November 15 of each year.