Keeping Watch: The Bank Stress Test

Maybe it’s just me, but the Winter Olympics seem more interesting this year. Great skiing, hockey and bobsledding, all happening near one of the most dangerous borders in the world. While athletes and spectators are watching the competition, just a few miles away soldiers are keeping watch on over the DMZ.

Meanwhile, back in the U.S. the Federal Reserve is keeping a close watch on the banking industry, as highlighted in the February 1 st release of new and tougher scenarios for the Dodd- Frank Act Stress Test (DFAST).

The banking industry stress test is perhaps the best piece of regulation that came out of the financial crisis. This test forces all major banks to prove they can withstand a severe recession without their capital falling to dangerously low levels. The goal is to have no more large bank failures - ever. The stress test is highly detailed, rigorously applied and consistent across the industry. And these tests are getting even tougher over time!

DFAST has three scenarios: baseline, adverse and severely adverse. Of course, severely adverse is the most difficult scenario, and it really has some teeth. Broadly, the scenario assumes a major global recession accompanied by consistently high long-term interest rates. That is, in this scenario long-term rates do not fall, but stay the same. As a consequence, losses on fixed income assets are even higher than would be expected in a normal recession. Going deeper, U.S. GDP begins to decline sharply and eventually falls 7½ percent, the unemployment rate increases almost 6 percentage points to 10 percent, equity prices fall 65 percent and are accompanied by a surge in equity market volatility, and real estate prices see large declines with house prices and commercial real estate prices falling 30 percent and 40 percent, respectively. Finally, spreads on investment-grade corporate bonds balloon to 575 bps by the start of 2019. The Fed is looking tougher than soldiers on the DMZ!

Related: While the Equity Markets Gyrate, the Corporate Bond Market Remains a Relative Sea of Calm

It is good to know the Federal Reserve is planning for the worst when it comes to bank safety and soundness. This is one of the reasons we like bank fixed income investments at this time. In our opinion bank bonds are safe, liquid and still relatively cheap due to their abundance - and the Fed is standing watch. If only we could win a few more medals!

Sources: The Federal Reserve, Bloomberg, The Financial Times