The time has come to “stress test” America’s largest banks again. Nineteen financial firms will take part. The Federal Reserve has released guidelines for the tests. Some could make bank executives shiver. The Fed said:

The scenarios include baseline, adverse, and severely adverse scenarios, as described in the Federal Reserve’s final rules that implement stress test requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Each scenario includes 26 variables, including economic activity, unemployment, exchange rates, prices, incomes, and interest rates

The worst case scenario is absurd:

In the United States, the severely adverse scenario features a severe recession, with the unemployment rate increasing 4 percentage points from current levels (an amount similar to that in severe contractions over the past half-century). Notably, the unemployment rate remains above any level experienced over the last 70 years from the middle of 2013 to the end of the scenario.

Real GDP declines nearly 5 percent between the third quarter of 2012 and the end of 2013; over this period, the unemployment rate rises to nearly 12 percent, and the four-quarter percent change in the CPI decelerates to 1 percent. Equity prices fall more than 50 percent over the course of the recession and, correspondingly, the equity market volatility index jumps above 70 at the start of the scenario. House prices decline more than 20 percent by the end of 2014, and commercial real estate prices fall by a similar amount.

Actually, that nearly happened in 2008 and 2009.

Douglas A. McIntyre

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