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The Fed Will Stress Test U.S. Banks to Ensure Their Resilience

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January 30
3:13 AM 2016

The Federal Reserve Bank will analyze the resilience of 33 large U.S. banks against the worse-case hypothetical scenario in its annual stress test. The test aims to prevent recurrence of 2008 crisis.

In Thursday's official release, the Federal Reserve Bank anounced supervisory scenarios for the 2016 Comprehensive Capital Analysis and Review (CCAR) and Dodd-Frank Act stress test exercises. Both are the components used by the Fed to conduct annnual financial health-check of U.S. financial institutions.

CCAR are sets of analysis to evaluate capital adequacy and planning process of U.S. banks. While Dodd-Frank Act stress tests are set of testing tools used to assess sufficiency of banks capital. Banks with strong capital are able to absorb losses and ensure its lending ability even in financial and economic stress.

This year, CCAR and the stress test will include 33 bank holding companies with total consolidated assets of $50 billion and more. According to Reuters, the stress test is a part of the 2010 Dodd-Frank Wall Street reform law. This is intended to push banks to shore up their finances, in a hope to avoid another financial crisis such as in 2008.

In the release, the Fed required financial institutions to use the supervisory scenarios in both CCAR and Dodd-Frank stress test. The results are measured based on three scenarios: severely adverse, adverse, and baseline.

One of the Fed governor Daniel K. Tarullo said in a statement, "In adjusting the scenarios for our yearly stress testing program, we strive to assess the resilience of the nation's largest banks in a variety of potential adverse environments." He also emphasized the importance to increase the level of unpredictability, "It is important that the tests not to be too predictable from year to year."

Severely adverse scenario will include a severe global recession and a high increase of U.S. unemployment rate to 10%. While the adverse scenario will have a moderate recession and mild deflation, along with weakening economic activities all across the United States. Both of scenarios describe a series of hypothetical events to assess the strength and resilience of banking organizations.

Whereas the baseline scenario uses a similar profile to average projections from economic forecasts, but it does not represent the forecast of the Federal Reserve. All scenarios have 28 variables including gross domestic product, unemployment rate, stock market prices, and interest rates.

This year's test is much tougher than previous one. Analyst at Guggenheim Securitiesm Jaret Seiberg wrote in a research note to Bloomberg, "The 2016 CCAR is tougher than the 2015 test, which means the hurdle that big banks must clear to boost capital returns is even greater than what was expected."

The Fed issued a tougher stress test in this year to 33 large U.S. banks in order to ensure their resilience against unexpected situation. The test aims to prevent recurrence of 2008 crisis, as the 2016 condition is more challenging than last year.

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