The Federal Reserve has sought to bolster confidence in the US banking system by stress testing the 31 largest US banks. These banks have been asked to test their loan portfolios against a deep and prolonged recession as concerns over the European sovereign-debt crisis pose significant risks to economic expansion. The aim of stress testing is two-fold to provide:

1. Confidence in the banking sector by demonstrating that US banks can handle a deep downturn
2. Additional transparency to banks’ capital adequacy

The Fed has requested four scenarios be tested, however the worst-case scenario is akin to economic Armageddon. Those assumptions are outlined below:

• The US unemployment rate rises to 13%
• An 8% drop in US GDP
• A 21% decline in US housing prices
• A 52% plunge in US equity markets by 4Q12

This is a very pessimistic scenario under anyone’s reading, especially in relation to US housing and equity markets. However, the Fed clearly believes it is within the realms of possibility if they are asking banks to model the outcome and prepare themselves for it.

The Fed will publish the results for Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley and Wells Fargo in Q1 2012.

By preparing for the worst and hoping for the best, at least the US regulators are making a valiant effort to ensure that US banks can survive the kind of shock the deepening European sovereign debt crisis could deliver.  The same point can’t be made about its European brethren, who, after proudly announcing a clean bill of health for Dexia SA in July 2011, had to bail the French-Belgian lender out in October 2011.