The Federal Reserve released the results of this year’s bank stress tests on June 23, 2022. The scenario underlying the stress tests was released earlier this year in February. All banks tested passed with post-stress capital ratios above minimum requirements. And despite some economic headwinds starting to appear, evidenced by actual stress events in recent months with some more severe than the hypothetical scenarios used for this year’s exercise, banks are healthy with strong capital positions.
The Federal Reserve’s annual bank stress test exercise is designed to ensure the financial resilience and the ability of large banks to continue lending to households and businesses in a hypothetical recession scenario. All banks subject to the 2022 stress test passed with post-stress capital ratios well above required minimum levels throughout the projection horizon.
Given that stress test exercises tend to use either historical and/or hypothetical scenarios, it is always instructive to compare these with actual events occurring during the time-window covered by the exercise. As we are not currently facing an economic downturn, most of the variables are not close to the levels assumed in the stress test scenarios. For example, even with the recent financial market volatility, the Market Volatility Index (VIX) has not exceeded 40 in 2022 compared to its peak of 75.0 in the 2022 severely adverse scenario (see table below). And the May 2022 unemployment rate of 3.6% would need to more than double to even approach the 8.1% rate assumed for Q2 2022. However, with inflation pressures persisting longer than expected and prices increasing at rates not seen since the early 1980’s, interest rate variables have exceeded their stress test values by a wide margin.
Following the release of the scenarios in February and as events have unfolded over the first half of 2022, inflation pressures led the Fed to raise the federal funds (FF) rate target range from the effective lower bound (0 to .25%). The Fed raised the range by 75 basis points (bps) at its June 2022 meeting, following a 25 bps increase and a 50 bps increase at its March and May 2022 meetings, respectively.
For some historical context, the last time the Fed increased the FF rate target by 75 bps was in late 1994, when the unemployment rate was around 5.5% compared to 3.6% in May 2022. While the 1994 increase was the penultimate increase for that FF rate target cycle (a 50 bps increase in early 1995 completed the cycle and capped off a 300 bps cumulative increase to 6.0%), the rise in short-term interest rates did not lead to an increase in bank failures. Currently, the FF target range is forecast to continue increasing through 2022 and into 2023.
While the unemployment rate is the primary indicator of adverse economic conditions in the stress test framework and currently stands near pre-pandemic lows, some financial condition indicators have tightened beyond their values in the stress test scenario. For example, the table below for the 2022 severely adverse scenario shows that mortgage rates (conforming, 30-year fixed-rate) are assumed to peak at 3.8% and the Prime rate, a reference rate for small business and credit card loans, peaks at 3.1%. As of mid-June, mortgage rates were at a 14-year high around 5.8% and the Prime rate stood at 4.75%. Current values for these rates also exceed their assumed peak values in the baseline scenario.
But even as some economic headwinds are starting to appear, bank capital is strong and no banks have failed since October 2020. Moreover, the number of banks on the FDIC’s Problem Bank List is at a historic low.
We experienced a similar dynamic – in terms of actual events being more severe than the hypothetical scenarios used in a stress test exercise - in 2020. Following the financial market ructions and economic uncertainty during the initial COVID-19 wave, some macroeconomic variables also exceeded their assumed values in that year’s exercise. For example, as shown in the table below for the 2020 severely adverse scenario, the VIX was assumed to peak at 70.0. In fact, in March 2020, the VIX reached an all-time high exceeding 82. And the unemployment rate would jump from 4.4% in March 2020 to 14.7% in April 2020, surpassing the 10.0% peak unemployment rate in the scenario.
As COVID-19 continued to drive economic uncertainty over the course of 2020, the Fed conducted a second round of bank stress tests in the Fall of 2020. So far, there is no indication that the Fed will conduct an additional stress test for the 2022 exercise.
ABA staff analysis does not provide, nor is it intended to substitute for, professional legal advice.