The Federal Reserve Bank of Minneapolis on Wednesday updated its online large bank stress test tool, allowing the public to assess the resilience of 22 large banks under two recession scenarios of varying intensity and a scenario characterized by a sustained period of rising interest rates. Additional updates allow users to examine how these large banks perform against stressed conditions under the new framework for capital regulation.
The Minneapolis Fed launched its large bank stress test tool in 2020 to let the public see how large banks perform under a wide range of economic conditions. The tool provides both aggregate results and results for individual banks. Users can select a pre-specified economic scenario or adjust several macroeconomic variables, such as unemployment, interest rates, and the stock market, to see how banks perform in a range of unique economic conditions.
The updated stress test tool allows users to project large bank capital performance under three hypothetical economic scenarios: a “moderate recession scenario,” in which the economy contracts for five quarters and unemployment reaches 8.5 percent; an “extreme recession scenario,” characterized by a sharper slowdown and a more gradual recovery with unemployment climbing above 10 percent; and a “rising rates scenario,” where short-term interest rates increase for five consecutive quarters and long-term interest rates increase for nine consecutive quarters, peaking at 5.6 percent and 5 percent, respectively, before declining through the end of the projection horizon.
If a user chooses the extreme recession scenario, the tool finds that banks would face total projected losses of roughly $530 billion, while the aggregate common equity tier 1 (CET1) capital ratio would fall from an actual 11.2 percent in the first quarter of 2022 to its minimum of 6.1 percent at the end of the projection horizon. A capital decline of this magnitude would be greater than those projected in the COVID-19-related sensitivity analyses performed by the Federal Reserve in the summer of 2020.
The tool shows that the rising rates scenario, if selected by users, would pose significant challenges for banks with large security portfolios and relatively fewer loans (such as the so-called custodian banks). Under this selected scenario, the tool generates sizeable unrealized losses as interest rates climb for such banks, leading to what many would consider low levels of capital. Details about the model and underlying assumptions for each scenario and their implementation are outlined in the “Notes” section.
The Minneapolis Fed large bank stress test tool has also been modified to allow the public to project bank capital performance both with and without the stress capital buffer framework. Adopted by the Federal Reserve in 2020 and implemented in 2021, the framework is intended to reduce the risk of a taxpayer-funded bailout by increasing restrictions on banks’ ability to issue dividends, repurchase stocks, and make other discretionary payments if their CET1 capital ratio falls below certain levels. Sample runs of the tool find that the limitations imposed by the new framework have relatively small effects on aggregate capital ratio declines. The tool also allows users to run stress tests where banks suspend all discretionary payouts, which can have a larger effect.
“We encourage the public to use this stress test tool to review the condition of the largest and most important banks selecting scenarios that they choose. The public is on the hook if these banks need taxpayer support, and sample output from a few pre-specified scenarios suggests that banks remain vulnerable to certain bad economic outcomes,” said Federal Reserve Bank of Minneapolis First Vice President Ron Feldman. “We don’t know where the next economic shock will come from, but we do know that stronger capital requirements and more rigorous stress tests can help reduce the risk of another taxpayer-funded bank bailout. We also know that large bank performance during the initial phase of the COVID-19 pandemic was significantly bolstered by government support and does not suggest that banks are already the strong condition needed to withstand a banking crisis.”
The Minneapolis Fed has long been a proponent of ensuring that large banks are resilient in order to protect taxpayers. Earlier this year, the Minneapolis Fed published its analysis of large bank performance during the COVID-19 pandemic, which showed that government action—such as the unprecedented fiscal stimulus, the Paycheck Protection Program, and restrictions on stock buybacks and dividends—helped shield large banks from serious consequences of the COVID-19 financial shock.
The Federal Reserve Bank of Minneapolis is one of 12 regional Reserve Banks that, with the Board of Governors in Washington, D.C., make up the Federal Reserve System, the nation’s central bank. The Federal Reserve Bank of Minneapolis is responsible for the Ninth Federal Reserve District, which includes Montana, North and South Dakota, Minnesota, northwestern Wisconsin, and the Upper Peninsula of Michigan. The Federal Reserve Bank of Minneapolis participates in setting national monetary policy, supervises numerous banking organizations, and provides a variety of payments services to financial institutions and the U.S. government.