Mega lenders with more than $10 billion in assets will have to perform their next stress test using a "severe" scenario that factors in the capital-reserve impact of a 20% home-price drop.
While this severe test is only an experiment used to gauge the capital safety of banks under Dodd-Frank rules, it does show how critical home prices are to the overall health of a financial firm's capital reserves. The tests are being coordinated by the Federal Reserve, the Federal Deposit Insurance Corp. and the Office of the Comptroller of Currency.
The next stress test for capital reserves features three scenarios. The first two scenarios examine how banks will fare with mild to moderate economic growth over the next two years, while the remaining test considers the impact of a severe recession. The point is to see how the bank's capital reserves function in each situation.
The more severe test examines the impact of a 5% decline in gross domestic product within the next year, an unemployment rate of 12%, a 50% drop in equity prices and a 20% decline in home prices by 2014.
The baseline stress test will examine a bank's capital performance in a scenario where unemployment edges down to just above 6% in the next three years. It also factors in nominal GDP increases of just over 2% a year and nominal home price increases.
The medium-level test forces big banks to examine their capital reserves in the midst of a moderate recession that begins in the fourth quarter and lasts for two years. Real GDP in this medium-level test declines 2%, while unemployment rises above 9% and home prices decline another 6% by 2013.
Click here to read more on all three stress tests.