In a bid to ensure the resilience of large banks during times of economic uncertainty, the Federal Reserve Board has released the hypothetical scenarios for its annual stress test for the year 2024. Alongside this, the Board also introduced an "exploratory analysis," aimed at probing different risks within the banking system. Notably, the exploratory analysis will not impact bank capital requirements.

The stress test, conducted each year, evaluates the ability of large banks to handle severe recession scenarios by estimating potential losses, net revenue, and capital levels that act as a safeguard against these losses. This year, 32 banks will be put to the test against a severe global recession, which will primarily stress commercial and residential real estate markets, as well as corporate debt markets. It is important to note that these scenarios are not forecasts and should not be interpreted as predictions of future economic conditions.

The 2024 stress test scenario envisions a significant rise in the U.S. unemployment rate of nearly 6.5 percentage points, reaching a peak of 10 percent. This rise in unemployment accompanies severe market volatility, widening corporate bond spreads, and a collapse in asset prices. House prices are predicted to decline by 36 percent, while commercial real estate prices are expected to decrease by 40 percent.

It is worth mentioning that large banks with extensive trading or custodial operations will be required to include a counterparty default scenario to assess potential losses and capital effects arising from the unexpected default of their largest counterparty. Additionally, banks with substantial trading operations will undergo a global market shock component, which primarily stresses their trading positions. This component encompasses a range of hypothetical stresses reflecting market distress and heightened uncertainty.

The table provided by the Federal Reserve Board outlines the components of the stress test that will apply to each bank, based on data up until the third quarter of 2023. This comprehensive evaluation aims to test the stability and resilience of the banks participating in the stress test.

In a new development, the Board has also introduced four exploratory analysis elements that will assess the banking system's resilience to a broader range of risks. Two of these elements will simulate funding stresses that lead to a rapid repricing of a significant portion of deposits at large banks. Each element incorporates different interest rate and economic conditions, such as a moderate recession with increasing inflation and rising interest rates, and a severe global recession with high and persistent inflation, accompanied by rising interest rates.

The remaining two elements of the exploratory analysis focus on market shocks and will only be applied to the largest and most complex banks. These hypothetical shocks involve the failure of five large hedge funds, with each experiencing different financial market conditions. These conditions include expectations of reduced global economic activity, a negative outlook for long-term inflation, and severe recessions in the United States and other countries.

Importantly, the exploratory analysis serves as a standalone assessment, exploring hypothetical risks to the broader banking system rather than solely focusing on individual bank-specific results. The aggregate results of this exploratory analysis will be published alongside the annual stress test results in June 2024.

The Federal Reserve Board's comprehensive stress test and the newly introduced exploratory analysis aim to ensure that large banks can continue to lend to households and businesses even in the face of severe economic downturns. By evaluating the resilience of the banking system, regulators strive to maintain financial stability and mitigate potential risks within the industry.