Lenders including JPMorgan Chase & Co and Citigroup Inc will have to show they can survive the demise of a trading partner or a plunge in value of high-risk business loans in next year’s version of US stress tests.
The scenarios for the annual tests, outlined by the Federal Reserve in a statement on Friday, reflect some of the most pressing threats seen by regulators as they gauge the ability of the US financial system to withstand economic shocks. Bankers will have to show what would happen to the value of leveraged loans they hold, the impact of another housing bust and how they would fare if a firm that owes them substantial sums collapses.
The test was designed in part to build resiliency against what some see as emerging asset bubbles, said a Fed official, who spoke on a conference call with reporters. The counterparty failure test aims to prevent a repeat of the 2008 crisis, when distress at Lehman Brothers Holdings Inc and American International Group Inc threatened to destroy their biggest trading partners.
Counterparty credit risk “has been a very big concern since the crisis,” said Karen Shaw Petrou, managing partner at Federal Financial Analytics Inc, a Washington regulatory research firm whose clients include the world’s largest banks. “This is an intervening supervisory step while the broader rules are pending.”
The Fed is using the tests — based on hypothetical adverse conditions and not forecasts — to encourage the 30 biggest banks to build capital cushions against economic turmoil. Twelve banks will be subject to the capital review for the first time.
The six banks with large trading operations — JPMorgan, Citigroup, Bank of America Corp, Goldman Sachs Group Inc, Morgan Stanley and Wells Fargo & Co — will be required to test how their portfolios would perform against a global shock to financial markets. Details of that scenario will be released “soon,” the central bank said. New York-based JPMorgan is the biggest US bank by assets, followed by Charlotte, North Carolina-based Bank of America and New York-based Citigroup.
Those six banks, as well as Bank of New York Mellon Corp and State Street Corp, also will have to test against a scenario in which one of their counterparties experiences an “instantaneous and unexpected” default. Previous tests focused merely on incremental defaults as the economy eroded, a Fed official said on the conference call.
The test shows Fed officials remain concerned that banks might still rely too heavily on a single counterparty to hedge potential losses, a practice that contributed to the 2008 financial crisis.
In the “adverse” scenario, banks will be tested against global flight from long-term debt that pushes the US into a recession, with unemployment rising to 9.25 percent. The yield on the US 10 year Treasury note jumps to 5.75 percent by the end of next year, and corporate bond and mortgage rates also rise.
In the Fed’s “severely adverse” scenario, the jobless rate peaks at 11.25 percent, stocks fall almost 50 percent and US housing prices slide 25 percent, while the euro area sinks into recession. Developing economies in Asia also experience a “sharp slowdown,” the Fed said.
The Fed said the larger drop in US house prices in this year’s severely adverse scenario is “particularly relevant for states or metropolitan statistical areas that have experienced brisk gains in house prices over the past year.”