Fed Stress Tests keep Big Banks on the Straight and Narrow

While the economic intelligentsia is still ruminating on the possibilities of a recession, the Federal Reserve Board is looking ahead to what comes after that.

Earlier this month the central bank released the hypothetical situations for its stress tests of large banks. The annual exercise is mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act, enacted in 2010 following the Great Recession. The stress tests analyze the ability of large banks to weather a severe economic downturn by estimating potential losses, net revenue and capital levels in a recession lasting two years.

According to the Fed announcement, 32 banks are participating in the 2024 tests in a recessionary scenario with “heightened stress” in commercial and residential real estate markets, as well as corporate debt markets. In this year’s tests, the hypothetical unemployment rate hits double digits, accompanied by stock market volatility and a collapse in asset prices.

In addition, banks will be tested on a global market shock that puts pressure on their trading and related positions.

All in all, a pretty serious examination for systemically important financial institutions, also known as banks “too big to fail.” But what about companies that aren’t too big to fail?

The annual stress tests may be for large financial institutions, but businesses of any size should take note of what the exercise can offer them. Small businesses aren’t considered too big to fail, but the Covid-19 pandemic showed in stark relief how important those local employers are to the vitality of a community and the financial health of its residents. With a spike in unemployment a key metric in the hypothetical scenarios the Fed puts together for large banks, a measure of the potential impact of significant job losses across the board, is a concern for local governments and business owners alike. Not to mention the residents that could find themselves unemployed in the midst of a financial crisis.

Adopting the mindset of Fed policymakers to examine the potential impacts of a severe economic downturn that identifies key metrics necessary to survive the bad times should be an essential tool of local governments and businesses alike. There may not be much some companies can do in the event of a severe recession other than to hold on for dear life. But recognizing how a financial panic or market crash might have ripple effects at the local level – and some steps business owners can take to mitigate the impact – can only help.

It is unlikely federal regulators will extend the stress tests beyond the too-big-to-fail club and nobody wants to see more bureaucrats telling them what to do. But the preventative perspective the stress tests embrace – based on a worst-case scenario of economic instability – is something business owners should include in their operating plans.

Nobody can predict when the next recession will hit, despite the chorus of doom-and-gloom that saw economic woes around every corner last year. But thinking proactively rather than reactively is a business posture that can only help companies stay on the path to success.