What Is A Bank Stress Test?

Bank stress tests are administered by some of the world's major central banks to assess the ability of the largest commercial banks they oversee to withstand a major crisis in the economy and financial markets. Stress tests were largely instituted following the 2008 global financial crisis and have become a regular annual exercise in developed economies.

In the U.S., for example, annual stress tests of the nation's largest banks—those with more than US$100 billion in assets—became legally required under the Dodd–Frank Wall Street Reform and Consumer Protection Act that became law in July 2010. According to the Federal Reserve, which administers the tests, the exams are intended to demonstrate each bank's ability to absorb losses and continue to lend while being able to pay their own debts during a severe economic downturn.^[1]

Banks are tested under three different macroeconomic scenarios—baseline, for comparative purposes, and adverse and severely adverse conditions—which the Fed develops and revises annually. Other central banks do something similar.^[1]

Severely Adverse Scenario

According to the Fed, the severely adverse scenario consists of a severe global recession, with U.S. GDP falling by 7.5% and the unemployment rate climbing to 10%. This is accompanied by a "global aversion" to long-term bonds and a steepening yield curve between corporate bonds and U.S. Treasury securities. In addition, the scenario assumes a sharp drop in asset prices, including residential and commercial real estate, a surge in stock market volatility and a steep decline in stock prices.^[2]

Adverse Scenario

The adverse scenario assumes a "moderate" recession, a drop in short-term interest rates to near zero, a steep yield differential between corporate and government bonds, and lower stock prices, although not as steep as in the severely adverse scenario.^[2]

In addition, in 2018, the Fed assumed a "global market shock" to the portfolio of six large financial services companies with large trading and private equity exposures, including a sudden sharp increase in risk, a steepening yield curve, and a "general selloff" of U.S. assets compared to other developed countries.^[2]

Coronavirus Sensitivity Analysis

In 2020, in response to the coronavirus pandemic, the Fed added a "sensitivity analysis" to its regular stress tests to assess the ability of large banks to withstand three different hypothetical recessions stemming from the pandemic. This included^[3]:

• A "V-shaped" recession, in which the U.S. economy falls steeply but then quickly rebounds
• A more moderate "U-shaped" recession and recovery
• A "W-shaped," or "double-dip," recession.

Each of these analyses is "more stringent" than the Fed's normal tests, as they assumed a sharp rise in the unemployment rate to near 20% and steep loan losses that reduce banks' capital ratios.

The results of the tests, released by the Fed on 25 June 2020, "show that our banks can remain strong in the face of even the harshest shocks," and that "most firms remain well capitalized but several would approach minimum capital levels."^[3]

However, it also made several moves to make sure they stay strong. It ordered large banks to suspend their share repurchases in the third quarter of 2020 in order to preserve capital and imposed a cap on dividend payments, with future payouts based on their recent income. By contrast, large banks in the U.K. and the eurozone were ordered by their regulators to suspend dividend payments outright until after the crisis passes. Large U.S. banks were also required to resubmit their longer-term capital plans later in the year.^[3]

Summary

Stress tests are administered by major central banks to test how well large banks under their oversight are able to withstand a hypothetical economic and financial crisis. The tests generally came into being following the global financial crisis of 2008, when many banks failed or had to be rescued. The tests are generally administered once or twice a year, with the assumptions revised to accommodate recent events.