Financial Stability and Stress Testing

One important element of enhanced supervision of systemically important financial institutions is the stress testing process, which includes the supervisory stress tests and company-run stress tests. The supervisory stress test assesses whether firms are sufficiently capitalized to absorb losses during stressful conditions while meeting obligations to creditors and counterparties and continuing to be able to lend to households and businesses. The Board integrates the results from the supervisory stress test with its non-stress capital requirements through the stress capital buffer into one forward-looking and risk-sensitive capital framework. Firms must also conduct and publicly disclose the results of their company-run stress tests based on their risk profiles, as defined by the Board’s stress testing rules.

In addition to fostering the safety and soundness of the participating institutions, the stress test program includes macroprudential elements, such as:

  • examination of the loss-absorbing capacity of institutions under a common macroeconomic scenario that has features similar to the strains experienced in a severe recession and which includes, as appropriate, identified salient risks;
  • conducting horizontal testing across large institutions to understand the extent to which those institutions are exposed to similar risks that will generate losses at multiple institutions at the same time; and
  • consideration of the effects of counterparty distress on the largest, most interconnected firms.

The macroeconomic and financial scenarios that are used in the stress testing process have proved to be an important macroprudential tool. The scenarios are not forecasts, but rather represent a hypothetical severe economic downturn and financial market stresses that are designed to assess the resiliency of banks and their capital planning process. The Federal Reserve adjusts the severity of the macroeconomic scenario and global market shock used each year in a way that counteracts the natural tendency for risks to build within the financial system during periods of strong economic activity and for risk appetite to diminish during periods of weak economic activity. The scenarios can also be used to assess the financial system’s vulnerability to particularly significant risks and to highlight certain risks to institutions subject the stress testing process.

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Last Update: December 16, 2021