WASHINGTON Risks posed by rising interest rates are once again a top theme in stress test scenarios released by the Federal Reserve Board on Thursday.
The 2015 checkups will include a test of how well institutions could withstand a "rapid increase in both short- and long-term... Treasury rates," brought on by inflation and a "mild recession."
"In the scenario, bank funding costs react strongly to rising short-term rates," the central bank said in describing the "adverse scenario" part of the simulation.
The regulators release three scenarios annually as part of both the stress testing procedures required in the Dodd-Frank Act and a Fed program known as the Comprehensive Capital Analysis and Review. Along with the Fed's release, the Federal Deposit Insurance Corp. and Office of the Comptroller Currency issued similar scenarios for institutions that must conduct "company-run" stress tests.
The tests include a simulation of how banks respond to a "baseline scenario," which typically reflects current economic projections. The baseline environment in the 2015 cycle, the Fed said, envisions a "sustained, moderate expansion in economic activity," with gross domestic product growing at an average rate of 3% per year.
Interest rate risk was a condition envisioned in both the 2012 and 2013 instructions, although last year's "adverse" scenario involved a different cause for rising rates. In the Fed's release Thursday, the scenario envisions weakening global economic activity coupled with heightened inflationary pressures, leading to a rise in rates and "certain risks to banks' funding costs." (Both the adverse and "severely adverse" scenarios are purely hypothetical and not meant as an economic forecast.)
Under the "severely adverse" scenario, which is similar to that issued last year, the pullback in global economic activity is more pronounced and there are significant drops in asset prices. "In the scenario, the U.S. corporate sector experiences increases in financial distress that are even larger than would be expected in a severe recession, together with a widening in corporate bond spreads and a decline in equity prices," the Fed said.
Dodd-Frank requires the Fed to conduct supervisory stress tests for companies with over $50 billion in assets. Such companies must also report the results of their own internal stress tests. Meanwhile, CCAR is used to test the viability of proposed capital plans submitted by large firms to the central bank. Separately, banks with between $10 billion and $50 billion in assets must carry out their own stress tests under the supervision of their federal regulator.