The Federal Reserve will examine large banks' resiliency to a tougher hypothetical downturn in the 2019 stress tests, though it will also make it easier for banks to understand the examinations by disclosing more details, analysts say.
The regulator on Feb. 5 released the hypothetical scenarios that banks will be tested against this year to see if they would be able to withstand a pullback in the economy.
The toughest of the three scenarios the Fed laid out features a "modestly harsher" U.S. recession compared to last year's hypothetical scenario, said Moody's Vice President Rita Sahu. This year's scenario envisions the U.S. unemployment rate peaking at 10% and real GDP tumbling by about 8% from a pre-recession peak, both of which mark larger changes compared to the 2018 stress tests.
Some aspects of this year's scenario are less dire, such as a 50% decline in equity prices instead of last year's 65% fall, though market volatility would be even more elevated in the Fed's 2019 scenario. The less-steep yield curve that the scenario envisions would also generally be a negative for banks, Sahu added.
The stress tests this year will only apply to banks that the Fed views as the largest and most complex: Bank of America Corp., Bank of New York Mellon Corp., Barclays US LLC, Capital One Financial Corp., Citigroup Inc., Credit Suisse Holdings (USA) Inc., Deutsche Bank AG's DB USA Corp., Goldman Sachs Group Inc., HSBC North America Holdings Inc., JPMorgan Chase & Co., Morgan Stanley, Northern Trust Corp., PNC Financial Services Group Inc., State Street Corp., TD Group US Holdings LLC, UBS Americas Holding LLC, U.S. Bancorp and Wells Fargo & Co.
Other smaller banks will be exempt from the stress tests this year and are being switched into a two-year stress test cycle, the regulator said. Those banks will undergo their next round of stress tests in 2020, and the staggered timeline should provide some cost savings to institutions, said consultant Mayra Rodríguez Valladares of MRV Associates, adding that she was concerned over several foreign-owned banks being part of that group.
The Fed sent letters to the smaller firms providing details on how their capital planning process will work this year and has posted those letters on its website.
Analysts say that all banks subject to stress tests should benefit from a separate Fed announcement that it will begin disclosing more details on how it conducts its stress tests, including some key equations and variables it uses. Other information will include the estimated range of losses on companies' actual loans and portfolios of hypothetical loans.
The industry has long argued that more transparency would improve the predictability of the system and the capital planning process, a point Fed Vice Chairman for Supervision Randal Quarles said he was sympathetic to in a November 2018 speech. He also has said the Fed can share more details without "giving away the test."
"I think they're trying to find the middle ground here," said Adam Gilbert, financial services global regulatory leader at PricewaterhouseCoopers, adding that he is waiting for more details from the Fed on the issue.
The disclosures will help banks better understand how the Fed may view hypothetical losses stemming from firms' portfolios, said Andrea Usai, associate managing director at Moody's. That would likely lower the capital cushions banks currently build into their annual capital plan submissions to avoid getting dinged on potential shortfalls, Usai added.
"Banks would be able to do this much better," Usai said. "If they make more informed decisions, then in reality, they can tailor their capital cushions to the minimum required."
Meanwhile, the Bank Policy Institute, a trade group that represents leading U.S. banks, renewed its call for the Fed to put out its scenarios for public comment before making them final. In a blog post, BPI's Francisco Covas and Bill Nelson wrote that this year's stress test is "significantly more severe" than the financial crisis and therefore goes against the Fed's guidance of using scenarios similar to those of post-war U.S. recessions.
Analysts are also keeping an eye on another pending Fed announcement: whether it will activate the countercyclical capital buffer, or CCyB, for large banks. The CCyB is aimed at temporarily raising capital requirements at big banks at times of elevated risk of losses, to ensure they have enough capital available to withstand a potential downturn.
Quarles and Fed Chairman Jerome Powell have said in the past that risks remain moderate, though a handful of regional Fed officials and Fed Governor Lael Brainard have said it may be time for the Fed to deploy the tool.