The Office of the Comptroller of the Currency (OCC) recently released the economic and financial market scenarios that will be used in the upcoming stress tests for covered institutions. Federal bank regulators work together to design Comprehensive Capital Analysis and Review (“CCAR”) stress tests that are designed to ensure that even in the case of a severe recession, significant banks can lend to households and businesses. The annual exercise evaluates large banks’ resilience by estimating their loan losses, revenue, and capital levels — which provide a cushion against losses — under hypothetical recession scenarios that extend nine quarters into the future.
The federal regulators’ scenarios include baseline and severely adverse scenarios, as described in the OCC’s rule that implements stress test requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act).
Section 165(i)(2) of the Dodd-Frank Act, as amended by the Economic Growth, Regulatory Relief, and Consumer Protection Act, requires certain national banks and federal savings associations to conduct periodic stress tests.
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Covered institutions are required to use specific scenarios to conduct the stress tests. The results of the company-run stress tests provide the OCC with forward-looking information used in bank supervision, as well as assist both federal and state bank regulators in their assessments of a financial institution’s risk profile and capital adequacy.
As repeated by federal bank regulators, the required economic scenarios are not forecasts. Rather, they are designed to assess the strength and resilience of covered institutions in varying economic environments.
In the baseline scenario for the United States, real Gross Domestic Product (GDP) growth declines from about 6 percent at the end of 2021 to 2 percent at the end of the scenario. The unemployment rate declines gradually from close to 4.25% at the end of 2021 to 3.50% percent by the end of the scenario, and inflation, as measured by the Consumer Price Index (CPI) likewise declines from around 8.25% percent at the end of 2021 to approximately 2.25% percent by the end of the scenario. The scenario includes increases in interest rates. The 3-month Treasury rate increases from 0 percent to 1.5% at the end of the scenario. Ten-year Treasury yields increase from around 1.5% to hover around 2.50 percent at the end of the scenario.
Equity prices remain steady throughout the scenario. Equity market volatility, as measured by the Chicago Board Options Exchange Volatility Index (VIX), declines in 2022 by about 6.5 points before gradually increasing to reach about 28 points at the end of the scenario, which is slightly below its level at the start of the scenario. The baseline scenario for international economic activity and inflation features a relatively steady expansion in activity, albeit one that proceeds at different rates across countries.
Severely Adverse Scenario
In the severely adverse scenario, the economy is characterized by a severe global recession accompanied by a period of heightened stress in commercial real estate and corporate debt markets. The U.S. unemployment rate rises significantly by 5.75% percentage points from the starting point of the scenario in the fourth quarter of 2021 to a peak of 10% in the third quarter of 2023. The sharp decline in economic activity is also accompanied by increases in market volatility, widening of corporate bond spreads, and collapse in asset prices, including a nearly 40 percent decline in commercial real estate prices. The international component of the scenario features deep recessions in four countries or country blocs followed by declines in inflation and large swings in the value of the U.S. dollar against those countries’ currencies.
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