The Federal Reserve Board took a significant step on Thursday by releasing the hypothetical scenarios for its annual stress test, a pivotal tool in assessing the resilience of large banks. This year’s unveiling is particularly noteworthy as, for the first time, the Board has introduced an “exploratory analysis” segment, probing into various risks that could impact the banking system. Unlike the main stress test, this exploratory analysis will not influence bank capital requirements, but it marks a significant expansion in the scope of the Federal Reserve’s oversight.

At its heart, the Federal Reserve’s annual stress test is designed to ensure that large banks can continue to support households and businesses through lending, even in the face of severe economic downturns. By simulating hypothetical recession scenarios extending two years into the future, the test evaluates how banks would fare in terms of losses, net revenue, and capital levels. Capital levels are crucial as they serve as a buffer against losses, ensuring banks’ operational resilience.

This year, the stress test encompasses 32 banks, testing their endurance against a severe global recession scenario. This scenario posits heightened stress in commercial and residential real estate markets, as well as corporate debt markets. It’s important to clarify that these scenarios are hypothetical and are not intended as forecasts or predictions of future economic conditions.

The 2024 stress test scenario is particularly stark, envisioning a situation where the U.S. unemployment rate surges by nearly 6-1/2 percentage points, reaching a peak of 10%. Accompanying this rise in unemployment are severe market volatility, widening corporate bond spreads, and a dramatic collapse in asset prices. Specifically, house prices are projected to decline by 36%, with commercial real estate prices plummeting by 40%. Furthermore, banks with significant trading or custodial operations must also prepare for a scenario involving the unexpected default of their largest counterparty.

For banks with extensive trading operations, the stress test includes a global market shock component. This component subjects banks’ trading and related positions to hypothetical stresses reflecting market distress and heightened uncertainty.

The 2024 stress test cycle also introduces an exploratory analysis comprising four hypothetical elements aimed at assessing the banking system’s resilience against a broader range of risks. Two of these elements simulate funding stresses leading to a rapid repricing of a significant proportion of deposits at large banks, each under different economic and interest rate conditions. The other two elements are designed to test the largest and most complex banks against market shocks, including the hypothetical failure of five large hedge funds under varying financial market conditions.

The exploratory analysis is a distinct component from the stress test, focusing on broader banking system risks rather than individual firm-specific results. The Federal Reserve plans to publish aggregate results of both the annual stress test and the exploratory analysis in June 2024. This comprehensive approach underscores the Federal Reserve’s commitment to ensuring the stability and resilience of the banking sector, preparing it to withstand severe economic scenarios and continue its crucial role in supporting the economy.