The Federal Reserve is releasing the results of its annual stress tests of big U.S. banks this week and next. Here is what you need to know about the exams.
What do the tests assess? A stress test is an examination of what would happen to a bank if it ran into trouble. At its core, the test is a mathematical forecast of what would happen to a bank given certain events, such as a significant increase in unemployment or a drop in oil prices. In the Fed’s tests, the central bank is the teacher and the banks are the students. The banks are required to submit their tests, also called “capital plans,” to the Fed. The Fed then decides whether the banks pass or fail, i.e. whether it approves or rejects the plans.
In the first part of its annual stress tests released Thursday, the Fed calculated that 33 of the largest U.S. banks would have loan losses of $385 billion under a hypothetical scenario that envisions the U.S. unemployment rate more than doubling to 10%, the stock market losing half its value and financial markets becoming so topsy-turvy that short-term U.S. Treasury rates turn negative as investors pay the U.S. government to hold their money.
Still, the central bank said that despite such big losses, those institutions meet the Fed’s definition of good health—even during a severe recession—due to a steady increase in capital on their books, an improvement in the quality of their loans, and a drop in costs related to crisis-era litigation.