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Federal Reserve sets bank stress test scenarios

November 1, 2013: 2:18 PM ET

In the Fed's worst case scenario test, the nation's unemployment rate leaps to 11.3%, house prices fall by 25%, and the Dow Jones industrial average plunges nearly 50%.

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FORTUNE -- The Federal Reserve released on Friday the economic scenarios it will use in its annual test of the health of the U.S.'s largest banks.

The scenarios range from mildly bad to catastrophic, and map how the economy could perform in the next three years. In the Fed's worst case, the nation's unemployment rate leaps to 11.3%, house prices fall by 25%, and the Dow Jones Industrial Average (INDU) plunges nearly 50%, to just under 9,000. It also factors in a recession in Europe and Asia.

But even the mildly adverse scenario the Fed has chosen this year could point out significant weaknesses in the banks. In that scenario, the U.S. falls into recession, with GDP dropping 2%, but long-term interest rates spike. That would be a one-two punch for banks, which would see a drop-off in business but also steep losses in their bond and loan portfolios.

The Fed had been criticized in the past for not looking closely enough at how banks could perform if interest rates were to rise. The inclusion of this scenario for the first time could signal that the central bank is more worried about interest rate risk, now that the economy is improving.

MORE: Wells Fargo now most profitable bank in U.S.

Also, for the first time, the Fed will try to measure what would happen to each of the nation's largest banks if that bank's largest trading partner were to fail. In the past, the Fed has looked more generally at how financial market stress could cause losses in the largest banks' trading portfolios.

Still, the stress tests exclude some events that could be pretty disastrous for banks. For instance, Fed officials said they didn't specifically test the banks for what would happen if the U.S. government were to default. In early October, the Treasury Department predicted that a U.S. debt default would cause a financial crisis as bad or worse than what happened in 2008. The federal government will have to raise the debt ceiling again by February in order to avoid a default.

Releasing the economic scenarios that the banks will be tested on is the first step in the annual bank stress tests that were mandated by Dodd-Frank, the financial reform law written in the wake of the 2008 financial crisis that brought down Bear Stearns and Lehman Brothers. The actual results of the tests for each individual bank won't be released until next March.

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About This Author
Stephen Gandel
Stephen Gandel

Stephen Gandel has covered Wall Street and investing for over 15 years. He joins Fortune from sister publication TIME, where he was a senior business writer and lead blogger for The Curious Capitalist. He has also held positions at Money and Crain's New York Business. Stephen is a four-time winner of the Henry R. Luce Award. His work has also been recognized by the National Association of Real Estate Editors, the New York State Society of CPA and the Association of Area Business Publications. He is a graduate of Washington University, and lives in Brooklyn with his wife and two children.

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