Fed stress tests consider a bank’s ability to handle stress, and what would happen if that bank got into trouble. The Central Bank considers a number of scenarios, and then tests an individual bank’s capacity to handle them. The way they work is that the Fed creates two scenarios relating to adverse economic conditions. A crash in the value of the dollar or a sudden surge in unemployment rates for example.
The banks selected for the test must consider how investments and loans would react to such changes in conditions. These conditions are by no means hypothetical in many cases. Each scenario must last for a period of at least nine quarters. Each bank must provide the Federal Reserve with a detailed report on how it would handle such scenarios.
The way each bank would be able to handle these tests, known as ‘capital plans,’ must be provided to the Federal Reserve. The Fed then decides if that bank passes the test or not. In the event of failure, that bank will be barred from increasing dividends or share buybacks. The Federal Reserve must be sure that banks can afford such payments to shareholders.
The purpose is ultimately to avoid the meltdown that occurred during the 2008 financial crisis. The tests increase the likelihood of banks being able to adequately face such difficulties; that they have sufficient cushions to protect themselves from a drop in the economy.
The United States is not the only country involved in stress tests. Each country has its own criteria for testing and the way they do it. In the U.S. any bank with assets of over $50 billion are involved. For this year, 2016, that means 33 banking institutions. Every one of these must take the test! This includes not only banks based within the United States, but also units or branches of global banks within the U.S.
These tests are now to be re-evaluated for their effectiveness. The Federal Reserve is considering whether or not it should make a change to the test to check how major banks would react to a massive financial crisis. It is also considers whether or not the test results could be used to determine what capital buffers banks might be required to maintain in order to reduce the effect of a downturn in the economy to a minimum. This required buffer would be specific to each company.
The Fed’s Janet Yellen believes that this may have a significant result for the eight largest U.S. banks. Because these banks have significant effect on the global economy, this new buffer level would result in a significantly higher ‘aggregate increase in capital requirements’
The results of this Fed stress test on big banks will be released over the next two weeks. On Thursday, the Fed will publish its assessment of the banking system in general. Pass/Fail results will not be published. This will be done Wednesday, October 5, when each bank’s future capital plans will be discussed.
Pvt. Ltd.
