Federal Reserve Board Releases 2022 Bank Stress Hypothetical Scenarios
According to the Dodd-Frank Act, the Federal Reserve Board (“FRB”) is required to design and construct stress testing that can be utilized by financial institution regulators or the institutions themselves. Stress tests are considered a “tool” that should be used to measure whether the capital available to support the institution throughout a “period of stress,” such as a recession, is sufficient and to identify the institution’s potential risk exposures.
On February 10, 2022, the FRB released a report of hypothetical scenarios meant to portray a “period of stress” extending more than two years into the future that will be utilized for annual bank stress tests. This year, 34 large banks will be tested against the stress of a “severe global recession with heightened stress in commercial real estate and corporate debt markets.” In this hypothetical, commercial real estate values decrease due to the continuation of remote work which leads to negative impacts in the corporate sector and investor sentiment. In addition to these domestic changes, the hypothetical reflects greater stress in the emerging market economies which is partially “driven by building risks in the Chinese economy.”
Specifically, under the 2022 stress test scenario, the following hypotheticals are posed:
The U.S. unemployment rate rises 5 3/4 percentage points from that reported in the fourth quarter of 2021 to a peak of 10 percent in the third quarter of 2023.
CPI inflation falls from an annual rate of 8¼ percent at the end of 2021 to an annual rate of about 1¼ percent in the third quarter of 2022 and then gradually increases above 1½ percent by the end of the scenario
Real GDP declines more than 3½ percent from the fourth quarter of 2021 to its trough in the first quarter of 2023
The spread between yields on investment-grade corporate bonds and yields on 10-year Treasury securities widens to 5¾ percentage points by mid–2022, an increase of close to 4¾ percentage points relative to the fourth quarter of 2021. Corporate bond spreads then gradually decline to 2¼ percentage points by the end of the scenario.
The spread between mortgage rates and 10-year Treasury yields widens to 3 percentage points by mid–2022 before declining to slightly above 1½ percentage points at the end of the scenario. Asset prices drop sharply in the severely adverse scenario.
Equity prices fall 55 percent from the fourth quarter of 2021 through the fourth quarter of 2022, accompanied by a rise in the VIX, which reaches a peak value of 75 in the second quarter of 2022. House prices and commercial real estate prices also experience large declines.
At their trough at the end of 2023, house prices are 28½ percent below their level at the end of 2021. Commercial real estate prices experience larger declines, reaching a level in the fourth quarter of 2023 that is nearly 40 percent below the level at the end of 2021.
Additionally, banks with “large trading operations” will be stress-tested against a “global market shock component” intended to show vulnerabilities in the banks' trading positions. Banks with “substantial trading or custodial operations” will be stress-tested against the default of their largest counterparty.