Federal authorities unveil 2025 hypothetical crisis scenarios for banking industry assessment
In 2022, the Federal Reserve unveiled more stringent stress test scenarios for large banks compared to the relaxed environment of 2025. The 2022 tests were designed to ensure banks could withstand adverse conditions, as reflected in the higher Stress Capital Buffers (SCB) for banks, such as M&T Bank's 4.7%.
Conversely, by 2025, the Fed's stress tests had become less demanding. M&T Bank's SCB, for instance, dropped to 2.7%. Key factors contributing to this easing included the Fed's recognition of offsetting positions and better incorporation of hedges impacting Accumulated Other Comprehensive Income (AOCI). The refinement of hedge accounting treatment and synthetic risk transfers also reduced the hit to banks' common equity tier 1 (CET1) capital ratios, freeing up approximately $50 billion in CET1 capital for trading or buybacks.
The 2025 Fed stress tests represented a departure from the 2022 baseline, featuring smaller market shocks, improved treatment of hedges, and less impact from interest rate related items on capital, making the tests "less stressful".
However, specific details about the changes in the 2022 scenario compared to prior years are limited in the search results. Analysts at Keefe, Bruyette & Woods believe that the 2025 assumptions were less stressful, with lower market declines, lower market volatility index, and lower changes in unemployment, residential, and commercial mortgage indexes.
The Fed's stress test scenarios for 2022 to 2028 include 28 variables, unchanged from last year. The tests also feature severe market volatility, widening corporate bond spreads, and a collapse in asset prices. Banks with major trading operations face additional stress tests, and the Fed's exploratory analysis includes testing bank resilience to non-bank financial sector shocks and a market shock applied to the largest and most complex banks.
The Fed plans to reduce stress test volatility and improve model transparency this year. It has also introduced two new elements in its exploratory analysis: testing bank resilience to non-bank financial sector shocks and a market shock applied to the largest and most complex banks. The international section of the stress test considers a recession in four countries or country blocs.
The American Bankers Association (ABA) has advocated for increased transparency in the Federal Reserve's stress testing program. The ABA, along with other organisations, has sued the Fed's board of governors in U.S. District Court over the opaque nature of the tests, which they argue undermines their value.
This year's stress test includes severe global recession scenarios, with the unemployment rate in the U.S. jumping nearly 5.9 percentage points, to 10%. The banks tested in the Fed's stress test include American Express, Bank of America, BNY, Barclays US, BMO, Capital One, Charles Schwab, Citi., DB USA Corporation, Goldman Sachs, JPMorgan Chase, M&T Bank, Morgan Stanley, Northern Trust, PNC, RBC US Group Holdings, State Street, TD Group US Holdings, Truist, UBS Americas Holding, U.S. Bank, and Wells Fargo.
The Fed will open a public comment process on its changes to the stress test, and it is suggested that the Fed should publish supervisory models and stress scenarios for public comment.
The stress test scenarios for 2022 featured more stringent measures in the banking-and-insurance industry compared to the less demanding tests of 2025, enabling banks like M&T Bank to maintain higher Stress Capital Buffers (SCB), such as a 4.7% in 2022. On the other hand, by 2025, the finance sector experienced a relaxation in stress tests due to factors like improved treatment of hedges, allowing banks to release approximately $50 billion in Common Equity Tier 1 (CET1) capital for business operations.
