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Annual Health Check of Banks - By Fed

As humans go are advised to go a regular health check to track any possible problems, especially in times of stress. In the same way, Banks in the USA go through a financial health check done by Federal Reserve.

In this test, two major scenarios are taken one is called the baseline adverse scenario and the other is called the severely adverse scenario. I’m adding to this global market shock component also checked that detects stress capabilities of banks' trading operations.

But this year an additional component is there, it is called the exploratory market shock component. It is mainly to check firms' resilience in a scenario such as a severe recession with lower inflation or a less severe recession with growing inflation.

The baseline scenario includes a less severe recession with the first two quarters having negative GDP growth with the unemployment rate peaking at 4.8% by year-end. This includes CPI cooling with no adverse impact on an asset class.

The severely adverse scenario includes a long recession that goes into the first quarter of next year with the unemployment rate peaking at 10%. In this also CPI is cooling but all asset classes witness a cut of 30-35%.

The difference between the two scenarios is large indicating that Federal Reserve is only sure about volatility ahead rather than the direction of the economy. But given the dynamics where uncertainty increases every month, they cannot be blamed.

The results of these tests will be released in June 2023. Let’s hope the scenarios do not play out before the results come in as it would result in higher uncertainty ahead.


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