Fed sets a hypothetical scenario for a sharp decline: 10% unemployment and a market collapse

US Federal Reserve issued hypothetical scenarios for the annual stress test, which helps ensure the ability of large banks to lend to families and businesses even in the event of a severe recession.

For the first time, the Board of Directors sets four hypothetical elements as tools to explore various risks through an “exploratory analysis” of the banking system, which does not affect the bank’s capital requirements, as stated in a statement on the Fed’s website.

The board’s annual stress test assesses the resilience of large banks by estimating losses, net revenues and capital levels, which provide a cushion against losses, under hypothetical recession scenarios extending two years into the future.

This year, 32 banks will be tested in the face of a severe global recession as pressure increases in commercial and residential real estate markets, as well as in corporate debt markets. These scenarios are not forecasts and should not be construed as predictions of future economic conditions.

According to what was stated in the US Federal Reserve’s statement, the stress test scenario for the year 2024 includes an increase in the unemployment rate in the United States by about 6-1/2 percentage points, reaching a peak of 10%.

The rise in unemployment is accompanied by sharp market volatility, widening corporate bond spreads, and a collapse in asset prices, including a 36% decline in house prices and a 40% decline in real estate prices.

Large banks with significant trading or custody operations should also incorporate a counterparty hypothetical scenario component to estimate and report potential losses and capital impacts associated with an unexpected default of the company’s largest counterparty.

The Fed, which the world is waiting for to determine the date of changing interest rates, explained that its analysis will include 4 hypothetical elements to evaluate the banks’ ability to confront a wide range of risks, in addition to market shocks, which only applies to large banks. In addition to two elements that include financing pressures that cause a rapid repricing of a large proportion of deposits with major banks, similar to what happened in March 2023.