Will These Top Banks Pass the New Stress Tests?

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The United States Federal Reserve has released the scenarios it will use for the upcoming round of financial stress tests. The Fed will issue a baseline projection as well as adverse and severely adverse hypothetical situations to 19 banks in the 2013 Comprehensive Capital Analysis and Review. Major participating banks include Bank of America (NYSE:BAC), JPMorgan Chase (NYSE:JPM), Citigroup (NYSE:C), Goldman Sachs (NYSE:GS), and Morgan Stanley (NYSE:MS).

Each scenario is described through 26 variables, ranging from economic activity, asset prices, interest rates, international economic activity, and foreign exchange rates. All the scenarios are set to start in the fourth quarter of 2012 and continue through the fourth quarter of 2015. Separately, unique “market shocks” will be presented to different institutions at the beginning of December.

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The Fed constructed a baseline scenario based on predictions and expectations of businesses and economists. In it, the GDP grows at a rate of 2.75 percent per year, while unemployment falls to 6.75 percent by the end of 2015. Equity prices increase at a rate of 5.5 percent per year with low volatility, and home prices climb just under 3 percent per year. The baseline scenario also expects the European GDP to contract 0.5 percent in the fourth quarter of 2012 and grow between 0.25 percent and 1 percent through 2015.

The adverse scenario describes an economy in moderate recession that begins in the fourth quarter of 2012 and lasts until 2014. Over the course of two years, real GDP declines 2 percent and unemployment climbs to 9.75 percent. The equity volatility index spikes to over 40 percent and equity prices fall 25 percent by mid-2013. Home prices decline by over 6 percent. Recovery slowly begins in 2014, with unemployment hitting a high of 10 percent and a recession in Europe and Japan.

The severely adverse scenario describes a more substantial economic recession. By the end of 2013, the GDP declines 5 percent, while unemployment climbs to 12 percent. Equity prices collapse over 50 percent, with the volatility index surpassing 70 percent. Home prices decline 20 percent by the end of 2014. The dollar appreciates relative to the euro as the European region faces a 5.75 percent GDP contraction and slow recovery.

With the fiscal cliff looming in the real world, the stress tests are designed to ease uncertainty and help stabilize the markets. The theory is that since even the best predictions fail, preparing for the worst can’t hurt. By gaining an understanding of how financial institutions would react to adverse scenarios, both the private sector and the government can be more confident in its ability to react competently should the economy enter a recession.

In March, all but four of the 19 participants passed the stress tests. Passing was required in order for banks to perform certain actions like raising dividends. A notable failure of the March testing was Citigroup.

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