I, along with many others, have "suggested that the economic forecasts used in the tests are not severe enough." (See also Breathing easier after bank stress tests? You shouldn't.) Here's an opposing view from Ken Beauchemin and Brent Meyer of the Cleveland Fed:
How Realistic Were the Economic Forecasts Used in the Stress Tests?, by Ken Beauchemin and Brent Meyer, FRB Cleveland: The results of the “stress tests” came out last Thursday, and we can now see what three months of intense scrutiny of 19 of the countries largest bank holding companies has revealed about the amount of capital they are likely to need to withstand a worse-than-expected recession. Since the April 24 release of the Federal Reserve white paper describing the process, a number of observers have suggested that the economic forecasts used in the tests are not severe enough, and may result in insufficient capital requirements.
Regulators tested the banks against two sets of assumptions for GDP, unemployment, and housing prices. The “baseline” scenario averaged the February forecasts of real GDP and the unemployment rate from the Blue Chip Survey, Consensus Forecasts, and the Survey of Professional Forecasters. The assumptions for house prices followed a path implied by futures on the Case-Shiller Housing Price Index. The second, “more adverse” scenario represented a longer and deeper recession than the baseline scenario.
In the baseline case, real GDP falls by 2.0 percent in 2009 before rebounding to 2.1 percent in 2010; the unemployment rate averages 8.4 percent in 2009 and 8.8 percent in 2010. House prices decline 14.0 percent in 2009 and fall an additional 4.0 percent in 2010.
The more adverse (but not necessarily “worst-case” scenario) assumes a sharp 3.3 percent real GDP contraction in 2009 followed by scant 0.5 percent growth in 2010; the unemployment rate averages 8.9 percent in 2009 and 10.3 percent in 2010. House prices drop 22.0 percent in 2009 and 7.0 percent in 2010.
At the time the assumptions were determined, the advance estimate on fourth-quarter 2009 real GDP growth was −3.8 percent (annualized), and the February employment figures were not known. Subsequently, the Bureau of Economic Analysis slashed the fourth-quarter growth estimate by a stunning 2.5 percentage points, to −6.3 percent. Given the large downward GDP revision, an exceptionally rapid deterioration in the labor market, and yet another large GDP decline (in the first quarter), it is, of course, natural to question the validity of the bank stress tests. It turns out, however, that the most recent forecasts remain in line with the two stress-test scenarios.
First, the most recent GDP growth forecasts still lie within the range covered by the stress-test scenarios. While both the Blue Chip consensus and Macroeconomic Advisors forecasts dip below the baseline-scenario projection for 2009 growth of −2.0 percent, they are quite close to the 2010 baseline and remain firmly within the range between the baseline and more adverse scenarios in both years. Furthermore, only the Blue Chip pessimists’ forecast hits the lower bound of the stress-test scenarios in 2009, and it is 0.4 percentage point above the more adverse scenario for 2010.
Second, while rapid deterioration in the labor market has led to a near-term path for the unemployment rate that will most likely generate a 2009 average in excess of the 8.4 percent rate assumed by the baseline scenario, both the most recent Macroeconomic Advisors and Blue Chip forecasts predict an unemployment rate slightly lower than the 8.9 percent rate assumed by the more adverse scenario. The forecasts for 2010 are also less dire than assumed by the more adverse scenario. As the Federal Reserve noted in its April 24 white paper, “Although the likelihood that unemployment could average 10.3 percent in 2010 is now higher than had been anticipated when the scenarios were specified, that outcome still exceeds a more recent consensus projection by professional forecasters for an average unemployment rate of 9.3 percent in 2010.”
Finally, recent forecasts for house prices remain consistent with those of the stress-test scenarios and even hold out some hope that house prices may rise faster than the baseline forecast. This result is particularly encouraging since further declines in house prices will be a leading cause of any additional losses. Home prices are an important indicator to consider because the troubled assets that could potentially threaten the 19 tested financial institutions are largely related to residential real estate. The ultimate performance of these assets is partly a function of what happens to home prices in the future.
In summary, notwithstanding further unexpected and dramatic declines in the economy, recent projections by professional forecasters indicate that the stress-test scenarios remain viable and relevant to the task of assessing the potential losses faced by nation’s largest bank holding companies. While the adverse scenario may seem more likely than when it was first drawn up, it is only the near-term outlook for unemployment that has significantly strayed from baseline assumptions. Furthermore, the alternatively adverse scenario looks to be plenty adverse, and exposes the wisdom of planning for a more stressful outcome in the first place.