Surprise! Did we scare you? Or are you excited? While we probably didn’t catch you off guard, science says true surprise causes your brain to freeze for about 1/25th of a second. Surprise and shock can also amplify your emotions up to 400%, meaning that positive emotions will be intensified if the surprise is a good thing. Unfortunately, it also works the same for negative emotions, meaning unhappiness, anger, or fear as a response to the surprise will be much more powerful than you’d normally feel.In the case of the Federal Reserve’s 2025 stress test results, they also came as a surprise — the good kind. Capital losses were smaller than expected, due to three primary factors: a less severe recession scenario, revised private equity exposure measurements, and higher net revenues from better bank performance.These changes signal a shift in how the Fed assesses banking resilience and offer valuable insights into the future of stress testing — insights that CFIs can use to anticipate how upcoming regulatory changes might affect their operations.1. Less Severe Scenario Due to Countercyclical DesignThe 2025 stress scenario was less severe than last year’s, which had a significant impact on the capital ratios of banks tested. The unemployment rate bump was also smaller for the 2025 scenario (5.9% vs. 6.3% in 2024), and both commercial real estate and housing price declines were moderate. The Fed’s decision to apply a countercyclical design to this year’s stress test was meant to align the test scenario with current economic realities, rather than assuming a worst-case scenario.
- Impact on test results. The less severe scenario resulted in fewer loan losses. More banks were able to absorb stress without falling below minimum capital requirements. In fact, the aggregate common equity tier 1 (CET1) capital ratio for the 22 banks in the stress test fell by just 1.8% — much less than in previous years.
- Regulatory implications. The new approach indicates that the Fed is shifting to a more balanced and flexible stress test framework that takes into account evolving economic conditions. The countercyclical nature of the 2025 test may be here to stay, which would make future test results more predictable and less volatile.
- Why it matters to CFIs. While CFIs are not subject to the Fed’s annual stress test for big banks, understanding how countercyclical design is shaping regulatory frameworks can help CFIs align internal scenario planning and capital buffer strategies with broader regulatory trends.
2. Revised Measurement of Private Equity ExposuresThis year’s revised treatment of private equity exposures was also notable. Previously, private equity losses were included in the global market shock component of the stress test. This year, the Fed removed private equity from this component, projecting losses in the most adverse macroeconomic scenario instead. This change was designed to reflect the long holding periods of private equity, which is generally managed in banking book positions, not actively traded.
- Impact on test results. The revised treatment resulted in lower projected losses from private equity, contributing to the smaller-than-expected capital decline. By moving exposures into more relevant scenarios, the Fed ensured that the annual stress test more accurately reflects the real risk profiles of private equity investments.
- Regulatory implications. By aligning the annual stress test with the actual characteristics of different investments, the Fed is aiming for more accurate capital planning and scenario analysis models across the US banking system.
- Why it matters to CFIs. CFIs with exposure to private equity or considering investments in PE or other long-term illiquid assets may benefit from understanding the Fed’s refined risk modeling. While the rule applies to large banks, it offers helpful guidance that CFIs can use to sharpen their internal assessments.
3. Higher Net Revenue from Improved Bank PerformanceThe 2025 stress test also revealed a stronger banking environment, with many banks showing improved profitability, driven by higher net interest and capital market activity. This uptick meant banks entered this year’s stress test with more pre-provision net revenue (PPNR), which helped absorb losses and contributed to the smaller capital decline.
- Impact on test results. With a more profitable baseline, the stress test revealed that banks were well-prepared to withstand losses. Stronger performance was observed in sectors such as credit cards and commercial real estate, where banks had improved risk management and were better positioned to handle defaults.
- Regulatory implications. The Fed’s models are clearly becoming more sensitive to recent performance trends, rewarding banks that maintain consistent profitability. This suggests future regulatory frameworks may place more emphasis on recent earnings, making profitability an even more important factor in future stress tests.
- Why it matters to CFIs. By focusing on enhancing net revenue, CFIs can build stronger capital foundations to withstand economic headwinds, especially as regulators place more weight on performance trends.
Key Takeaways for CFIsWith a less severe recession scenario, revised treatment of private equity exposures, and stronger bank performance, this year’s smaller-than-expected capital declines are a welcome reprieve. For CFIs, there are several key insights to consider:
- Benchmarking and strategic planning. CFIs can use insights from the stress test results to benchmark their risk management practices, especially in capital planning and economic scenario analysis.
- Anticipating regulatory direction. Stress tests offer a window into how the Federal Reserve thinks about risk and capital resilience. Even if CFIs are not subject to these specific rules, new guidance often trickles down.
- Better competitive positioning. This year’s results will influence the behavior of larger competitors. Stress test results can signal near-term market dynamics that CFIs need to anticipate, such as capital availability, loan pricing, or investor sentiment.
By proactively incorporating these insights, CFIs can strengthen their strategic planning and remain resilient in a rapidly changing economic and regulatory landscape.
