The Federal Reserve provided the country's 19 biggest banks with its the guidelines for the 2013 stress test. For next year, banks will be stressed under three scenarios, the most severe incorporating a slowdown in China, along with severe recessions in the U.S. and Europe.
As mandated by Dodd-Frank, banks will test how their capital levels would be impacted under three different scenarios: a baseline scenario based on forecasts by private economists along with hypothetical adverse and severely adverse scenarios.
Like last year, the central bank uses 26 different variables to depict the different scenarios including the unemployment rate, the impact on equity prices, the CPI and the expected change in GDP.
The tests assist the Federal Reserve in deciding whether a bank can distribute capital through dividends and or stock buyback programs. For the banks, it's an annual assessment of whether or not they might survive a significant and sudden downturn in the economy.
The primary difference in the 2013 stress test from 2012's is the inclusion of a hypothetical slowdown in Asia's developing economies spurred by weakness in China. According to the severely adverse scenario, weakness in that region of the world, along with severe recessions in the U.S and Europe, would result in a 50 percent decline in equity prices, a jump in the U.S unemployment rate to 12.1 percent and a 20 percent decline in home prices by the end of 2014.
Under the adverse scenario, the new addition mandated by Dodd-Frank, the Fed projects a weaker global economy with a sudden spike in inflation here in the U.S. Banks will stress test their balances sheets to see how they would be impacted by a 25 percent decline in equities and a spike in the CPI to 4 percent by mid-2013.
The baseline scenario is more along the lines of what economists expect in the coming two years, average annual GDP growth of 2 percent through 2015 and an average annual increase in equity prices of 5 percent.
-By CNBC's Mary Thompson