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Banks face a 'pretty nasty' stress-test scenario for 2018

The Federal Reserve is challenging the capital health of the country's largest banks with a tougher economic downturn in its next round of stress testing.

The 38 companies subject to the 2018 Comprehensive Capital Analysis and Review would have to evaluate how they would respond to a worldwide recession with a U.S. unemployment rate of 10%, equity prices dropping 65%, house prices falling 30%, commercial real estate prices declining 40% and severe recessions in the eurozone, the United Kingdom and Japan.

The central bank on Feb. 1 outlined the scenarios for the CCAR process and Dodd-Frank Act stress tests, which measure how banks would perform under adverse and severely adverse scenarios. Under CCAR, banks must submit their planned use of capital, and regulators have an option to object to that plan.

Craig Brown, managing director in Deloitte's risk and financial advisory team, said in an interview that banks with large wealth management divisions with high exposure to equities, in addition to those with business relationships in Asia, may have a tougher time with the 2018 test compared to the 2017 assessment.

"With this type of scenario, the Fed has increased the chances someone could end up in a situation of a quantitative fail," Brown said. "It depends how well they've done strengthening their equity position across the last year."

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Other analysts pointed out that the banks are starting off in a healthier position year over year. Ian Katz, an analyst at Capital Alpha Partners, described the severely adverse scenario as "pretty nasty" but wrote in a research note that banks are "healthier than they have been in a long time."

Nellie Liang, the former director of the Fed's Office of Financial Stability Policy and Research, noted that the declines the banks will have to factor in might look sharper, but the banks would come from a stronger starting point given that the economy has improved over the past year.

"It's a built-in feature," said Liang, who is now a senior fellow at the Brookings Institution.

After all 34 banks subject to CCAR last year passed the review, the Fed opted to toughen the scenarios. The Fed wrote in a document outlining the scenarios that it wanted to "create a more severe test of the resilience of large firms when current economic conditions are especially strong."

One other major difference in the most severe scenario is that it includes a steepening of the yield curve, with the 10-year Treasury remaining unchanged through the scenario period due to investor aversion to long-term fixed-income assets. Brown said the new assumptions for the 10-year rate could help some banks but negatively impact others depending on the sensitivity of their portfolios.

Eighteen companies will be subject to both the quantitative and qualitative evaluations under CCAR, while twenty banks with less complex operations will need to complete only the quantitative portion.