By Ronald D. Orol, MarketWatch Nov. 15, 2012, 5:05 p.m. EST
WASHINGTON (MarketWatch) — The Federal Reserve is asking 30 big banks to make sure their capital can withstand a deep recession in which the unemployment rate rises to 12%.
The Fed, which first required big banks to conduct “stress tests” in 2009, laid out three scenarios lenders have to test against. The goal is to ensure that the firms have enough capital to continue operations during stressful economic times.
The Fed stressed they were not making economic forecasts “but rather hypothetical scenarios designed to assess the strength of financial institutions in stressful economic environments.”
In addition to considering an unemployment rate of roughly 12% — up from 7.9% in October — in the most severe recession scenario, banks must evaluate how their capital buffers would withstand real GDP declining by around 5%.
Banks will also have to test for equity prices that would fall by more than 50% over the course of the recession, with house prices declining more than 20% and with commercial real estate prices falling by a similar amount.
While harsh, the Fed stress test isn’t necessarily as bad as conditions actually were during the so-called Great Recession from late 2007 to 2009. The unemployment rate rose from 4.7% before the recession started in Nov. 2007 to as high as 10%, the economy shrank as much as 8.9% during one quarter, and home prices have tumbled by roughly a third from their peak.
The 30 largest U.S. financial institutions will be required to submit capital plans to the Federal Reserve by Jan. 7.
The Fed said that 19 of the largest banks under review have hiked their common capital to $803 billion in the second quarter of 2012 from $420 billion in the first quarter of 2009.
The Fed uses the stress tests to decide whether to allow banks to issue dividends and implement stock buybacks. Under the process banks tell the Fed what dividends and stock buybacks they want to issue. For the first time, the Fed will allow banks to modify these proposals while they discuss the ongoing stress tests with the central bank.
The new guidance comes after Ally Financial Inc., Citigroup Inc. , MetLife Inc. and SunTrust Banks Inc. initially failed to have enough capital under a stress test conducted on 19 big banks by the Federal Reserve in March. It was one of the reasons cited by observers as to why Vikram Pandit was pushed out of his role as head of Citi.
In addition, two other bank regulators, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency, both also agreed to conduct stress tests on some large institutions under their oversight using the scenarios. Cumulatively, more than 100 large financial institutions that each have more than $10 billion in capital will conduct stress tests.
The regulators also clarified guidance that community banks with under $10 billion in assets are not required to conduct the types of stress testing required by big banks.