Situation Overview: The Federal Reserve Board (FRB) uses the stress tests as a key supervisory tool to explore risks across large banks. This year’s results quantified the impact to banks under multiple new scenarios, providing capital planning and risk professionals with an expanded range of outcomes for analysis relative to previous years.

What: Firms should use the results to assess risk identification, scenario design and risk management practices, particularly in areas of heightened concern, such as credit card and commercial real estate lending, funding and liquidity forecasting, and hedge fund exposures.

Who: All large banks, as well as banks approaching the Category IV threshold of $100 billion in total assets.

In Depth

Background

Following the 2023 bank failures, the FRB announced that it would introduce multiple exploratory scenarios in future stress testing exercises to estimate the impact of emerging risks to the financial system. The results of these scenarios highlight that severe losses could be realized by the financial system under a variety of severe stress events, and that firms need to have risk management practices to anticipate and prepare for a diverse array of scenarios.

Results of the Stress Test and Exploratory Scenarios

This year’s supervisory analyses included: (1) a supervisory severely adverse scenario, similar to prior years; (2) two macroeconomic exploratory scenarios which evaluated funding stresses in stagflation environments; and (3) two trading book exploratory scenarios, which evaluated exposure to hedge fund counterparties.

The supervisory severely adverse scenario results were more adverse relative to the prior year, due to increased risk in banks’ credit card and corporate credit portfolios, as well as higher expenses and lower fee income as compared to prior years.

The more severe of the two macroeconomic exploratory scenarios had more severe results relative to the 2023 supervisory severely adverse scenario, with an aggregate peak-to-trough CET1 drawdown[1] of 2.7 percentage points, and a comparable severity to the 2.8 percentage points CET1 drawdown under the 2024 supervisory severely adverse scenario.

The trading book exploratory scenarios included differing shocks on interest rates, and the assumed instantaneous default of five hedge funds with the largest counterparty exposures for each of the firms subject to the exploratory market shocks.  These assumptions led to aggregated losses between 1.0 and 1.2 percent of risk weighted assets.[2]

What Firms Should Do

To proactively leverage these results, and prepare for potential supervisory areas of focus, capital planning and risk professionals at banks should take four key steps:

1. Understand the drivers of results in their own portfolios and evaluate whether potential losses are aligned with risk appetite. Specifically, this should involve assessing how pre-provision net revenue (PPNR) and credit losses respond to recessionary and stagflation scenarios, and how recent trends – such as post-COVID retail credit normalization, the credit quality of the corporate loan portfolio, noninterest income and non-interest expenses – are impacting results.  For counterparty exposures, and hedge fund exposures in particular, evaluate how those exposures and associated losses vary under different shocks and how concentrations and contagion impacts might contribute to losses.
2. Evaluate risk management capabilities. Focus on risk management fundamentals, such as monitoring and reporting of exposures, regular reassessments of risk appetite and risk limits, and escalation and governance mechanisms. Given the evolving risk profile in portfolios, it is important to evaluate if any refinement of risk acceptance criteria (such as loan tenors, FICO scores) are needed. For corporate, commercial real estate and hedge fund exposures, assess the sensitivity of internal risk rating processes and underlying analytics to evolving market conditions.
3. Evaluate stress testing capabilities. Use the risk identification framework to periodically modify stress scenarios to reflect emerging risks, and project outcomes under multiple interest rate and macroeconomic environments.  Continue to review data and modeling limitations, particularly associated with the COVID and post-COVID period results. Build out the stress testing infrastructure to be able to forecast multiple scenarios.
4. Assess implications to Recovery Plans. Consider the implications of stress test results on recovery plans. Specifically, evaluate whether the recovery plan includes a range of scenarios with differing macroeconomic and interest rate environments, and whether there are sufficient recovery actions under these various scenarios. Also evaluate the conversion of a capital stress to liquidity stress, and vice versa, by integrating capital and liquidity forecasts.

[1] Defined as the aggregate common equity tier 1 (CET1) capital ratio calculated from 4Q 2023 to the minimum lowpoint over the forecast horizon, in aggregate for participating firms.

[2] Note: Only Globally Systemic Important Banks were subject to the exploratory market shocks.