UPDATE 1-U.S. Federal Reserve releases scenarios for bank stress tests
* Toughest scenario includes a slowdown in China
* Banks must submit capital plans by Jan. 7
WASHINGTON, Nov 15 (Reuters) - The U.S. Federal Reserve released on Thursday the economic scenarios, including a hypothetical sharp slowdown in China, that the biggest banks will use in the next round of stress tests to determine how they would withstand a financial shock.
Regular stress tests are part of a more rigorous regime required by the 2010 Dodd-Frank financial oversight law. They are designed to that ensure banks have enough capital cushions and are not being overly aggressive in returning cash to shareholders.
In the toughest of the three scenarios, banks would face a severe recession in the United States, with the unemployment rate spiking up to about 12 percent, and recessions in Europe and Japan. The Fed said this is similar to last year's test.
In addition, a sharp weakening of economic activity in China would spill over into the rest of developing Asia under the severely adverse scenario this year, the Fed said.
Analysts said the test scenarios should come as no surprise to banks.
"If the U.S. and China have a recession, so goes the world. It's not unexpected," said Walter Young, a director with Deloitte's governance, regulatory and risk strategies group.
"There's really no curveball thrown to the banks from the Fed here."
In addition to testing for economic stress scenarios, six big bank holding companies with significant trading activities will be checked for their ability to withstand a specific global market shock.
Those banks are Bank of America Corp, Citigroup Inc , Goldman Sachs Group Inc, JPMorgan Chase & Co , Morgan Stanley and Wells Fargo & Co.
The market shock scenario features a broad increase in interest rates, particularly long-term rates, which would knock down the value of bank holdings of investment grade bonds, such as Treasury securities.
Unlike last year, banks will get one opportunity to adjust plans to repurchase stock or boost dividends after the regulator's initial assessment of the capital plan, the Fed said last week.
Citigroup ran into trouble after last year's stress tests when the Federal Reserve turned down its plan to return capital to shareholders. The firm had been expected to be able to raise its quarterly dividend.
Experts said banks now have a better sense of what the Fed is looking for, and the chance to revise capital plans should help banks avoid failing this time around.
"The Fed is going to have a much more open dialogue than they have had in the past when it was just pass-fail," said Paul Miller, an analyst at FBR Capital Markets. "I am not expecting anybody to fail."
Young said regulators are giving banks a boost by offering them a shot at revising their plans, but he said the Fed has also asked for more documentation of the assumptions banks use in their stress test models.
The Fed said it worked with the Federal Deposit Insurance Corp and the Office of the Comptroller of the Currency to craft the scenarios.
Banks with more than $50 billion in assets must conduct tests this year. Smaller banks will have another year.
The banks must submit their capital plans to regulators by Jan. 7.