Fed to test banks’ ability to withstand 55% fall in equity prices

The top 19 US banks will have to prove they can withstand a 55 per cent fall in equity market prices in this year’s stress tests, regulators said on Friday, outlining the parameters for an exercise that decides how much banks can pay out to their shareholders. 

The Federal Reserve, which undertook an additional stress test last year to assess banks’ resilience through the Covid-19 pandemic, laid out the terms of its annual exercise on Friday. It includes a sharper fall in economic output than the last scenario, which was set in September, alongside a lower peak in unemployment. 

The most adverse scenario — which simulates a 55 per cent shock to equity market prices by the third quarter of 2022 — is worse even than the “almost 50 per cent” decline tested in September. US and global stocks touched record highs earlier this week, fuelling fears of a bubble. 

The new stress test criteria include a 10.75 per cent peak in the US unemployment rate by the third quarter of 2022, compared with the 12.5 per cent jobless rate that was modelled in last year’s exercise. The US unemployment rate is at present 6.3 per cent.

Economic output — as measured by gross domestic product — falls 4 per cent in the updated scenario, versus 3 per cent in September’s.

“The scenarios are not forecasts and the severely adverse scenario is significantly more severe than most current baseline projections for the path of the US economy under the stress,” the Fed said. 

After the last stress tests, the Fed said banks could resume limited share buybacks in the first quarter, as long as they hit profit targets. The central bank has yet to give guidance on how much lenders can pay out in the second quarter. 

“The banking sector has provided critical support to the economic recovery over the past year. Although uncertainty remains, this stress test will give the public additional information to its resilience,” Randal Quarles, the Fed’s vice-chair for supervision, said in a statement.

Some banks, including JPMorgan Chase and Morgan Stanley, have chafed at their inability to return more cash to shareholders given they have enjoyed record profits despite the pandemic.