[Federal Register Volume 77, Number 226 (Friday, November 23, 2012)]
[Proposed Rules]
[Pages 70124-70135]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2012-28207]
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FEDERAL RESERVE SYSTEM
12 CFR Part 252
[Regulation YY; Docket No. OP-1452]
RIN 7100-AD-86
Policy Statement on the Scenario Design Framework for Stress
Testing
AGENCY: Board of Governors of the Federal Reserve System (Board).
ACTION: Proposed policy statement with request for public comment.
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SUMMARY: The Board is requesting public comment on a policy statement
on the approach to scenario design for stress testing that would be
used in connection with the supervisory and company-run stress tests
conducted under the Board's Regulations pursuant to the Dodd-Frank Wall
Street Reform and Consumer Protection Act (Dodd-Frank Act or Act) and
the Board's capital plan rule.
DATES: Comments must be received by February 15, 2013.
FOR FURTHER INFORMATION CONTACT: Tim Clark, Senior Associate Director,
(202) 452-5264, Lisa Ryu, Assistant Director, (202) 263-4833, or David
Palmer, Senior Supervisory Financial Analyst, (202) 452-2904, Division
of Banking Supervision and Regulation; Benjamin W. McDonough, Senior
Counsel, (202) 452-2036, or Christine Graham, Senior Attorney, (202)
452-3099, Legal Division; or Andreas Lehnert, Deputy Director, (202)
452-3325, or Rochelle Edge, Adviser, (202) 452-2339, Office of
Financial Stability Policy and Research.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Background
II. Administrative Law Matters
A. Use of Plain Language
B. Paperwork Reduction Act Analysis
C. Regulatory Flexibility Act Analysis
I. Background
Stress testing is a tool that helps both bank supervisors and a
banking organization measure the sufficiency of capital available to
support the banking organization's operations throughout periods of
stress.\1\ The Board and the other federal banking agencies previously
have highlighted the use of stress testing as a means to better
understand the range of a banking organization's potential risk
exposures.\2\
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\1\ A full assessment of a company's capital adequacy must take
into account a range of risk factors, including those that are
specific to a particular industry or company.
\2\ See, e.g., Supervisory Guidance on Stress Testing for
Banking Organizations With More Than $10 Billion in Total
Consolidated Assets, 77 FR 29458 (May 17, 2012), available at http://www.federalreserve.gov/bankinforeg/srletters/sr1207a1.pdf;
Supervision and Regulation Letter SR 10-6, Interagency Policy
Statement on Funding and Liquidity Risk Management (March 17, 2010),
available at http://www.federalreserve.gov/boarddocs/srletters/2010/sr1006a1.pdf; Supervision and Regulation Letter SR 10-1, Interagency
Advisory on Interest Rate Risk (January 11, 2010), available at
http://www.federalreserve.gov/boarddocs/srletters/2010/SR1001.pdf;
Supervision and Regulation Letter SR 09-4, Applying Supervisory
Guidance and Regulations on the Payment of Dividends, Stock
Redemptions, and Stock Repurchases at Bank Holding Companies
(revised March 27, 2009), available at http://www.federalreserve.gov/boarddocs/srletters/2009/SR0904.htm;
Supervision and Regulation Letter SR 07-1, Interagency Guidance on
Concentrations in Commercial Real Estate (Jan. 4, 2007), available
at http://www.federalreserve.gov/boarddocs/srletters/2007/SR0701.htm; Supervision and Regulation Letter SR 12-7, Supervisory
Guidance on Stress Testing for Banking Organizations with More Than
$10 Billion in Total Consolidated Assets (May 14, 2012), available
at http://www.federalreserve.gov/bankinforeg/srletters/sr1207.htm;
Supervision and Regulation Letter SR 99-18, Assessing Capital
Adequacy in Relation to Risk at Large Banking Organizations and
Others with Complex Risk Profiles (July 1, 1999), available at
http://www.federalreserve.gov/boarddocs/srletters/1999/SR9918.htm;
Supervisory Guidance: Supervisory Review Process of Capital Adequacy
(Pillar 2) Related to the Implementation of the Basel II Advanced
Capital Framework, 73 FR 44620 (July 31, 2008); The Supervisory
Capital Assessment Program: SCAP Overview of Results (May 7, 2009),
available at http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20090507a1.pdf; and Comprehensive Capital Analysis and Review:
Objectives and Overview (Mar. 18, 2011), available at http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20110318a1.pdf.
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In particular, as part of its effort to stabilize the U.S.
financial system during the 2007-2009 financial crisis, the Board and
the Federal Reserve banks, along with other federal financial
regulatory agencies, conducted stress tests of large, complex bank
holding companies through the Supervisory Capital Assessment Program
(SCAP). The SCAP was a forward-looking exercise designed to estimate
revenue, losses, and capital needs under an adverse economic and
financial market scenario. By looking at the broad capital needs of the
financial system and the specific needs of individual companies, these
stress tests provided valuable information to market participants,
reduced uncertainty about the financial condition of the participating
bank holding companies under a scenario that was more adverse than that
which was anticipated to occur at the time, and had an overall
stabilizing effect.
Building on the SCAP and other supervisory work coming out of the
crisis, the Board initiated the annual Comprehensive Capital Analysis
and Review (CCAR) in late 2010 to assess the capital adequacy and the
internal capital planning processes of the same large, complex bank
holding companies
[[Page 70125]]
that participated in SCAP and to incorporate stress testing as part of
the Board's regular supervisory program for assessing capital adequacy
and capital planning practices at these large bank holding companies.
The CCAR represents a substantial strengthening of previous approaches
to assessing capital adequacy and promotes thorough and robust
processes at large banking organizations for measuring capital needs
and for managing and allocating capital resources. The CCAR focuses on
the risk measurement and management practices supporting organizations'
capital adequacy assessments, including their ability to deliver
credible inputs to their loss estimation techniques, as well as the
governance processes around capital planning practices. On November 22,
2011, the Board issued an amendment (capital plan rule) to its
Regulation Y to require all U.S. bank holding companies with total
consolidated assets of $50 billion or more to submit annual capital
plans to the Board to allow the Board to assess whether they have
robust, forward-looking capital planning processes and have sufficient
capital to continue operations throughout times of economic and
financial stress.\3\
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\3\ See Capital Plans, 76 FR 74631 (Dec. 1, 2011) (codified at
12 CFR 225.8).
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In the wake of the financial crisis, Congress enacted the Dodd-
Frank Act, which requires the Board to implement enhanced prudential
supervisory standards, including requirements for stress tests, for
covered companies to mitigate the threat to financial stability posed
by these institutions.\4\ Section 165(i)(1) of the Dodd-Frank Act
requires the Board to conduct an annual stress test of each bank
holding company with total consolidated assets of $50 billion or more
and each nonbank financial company that the Council has designated for
supervision by the Board (covered company) to evaluate whether the
covered company has sufficient capital, on a total consolidated basis,
to absorb losses as a result of adverse economic conditions
(supervisory stress tests).\5\ The Act requires that the supervisory
stress test provide for at least three different sets of conditions--
baseline, adverse, and severely adverse conditions--under which the
Board would conduct its evaluation. The Act also requires the Board to
publish a summary of the supervisory stress test results.
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\4\ See section 165(i) of the Dodd-Frank Act; 12 U.S.C. 5365(i).
\5\ See 12 U.S.C. 5365(i)(1).
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In addition, section 165(i)(2) of the Dodd-Frank Act requires the
Board to issue regulations that require covered companies to conduct
stress tests semi-annually and require financial companies with total
consolidated assets of more than $10 billion that are not covered
companies and for which the Board is the primary federal financial
regulatory agency to conduct stress tests on an annual basis
(collectively, company-run stress tests).\6\ The Board issued final
rules implementing the stress test requirements of the Act on October
12, 2012 (stress test rules).\7\
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\6\ 12 U.S.C. 5365(i)(2).
\7\ 77 FR 62398 (October 12, 2012); 12 CFR part 252, subparts F-
H.
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The Board's stress test rules provide that the Board will notify
covered companies, by no later than November 15 of each year of a set
of conditions (each set, a scenario), it will use to conduct its annual
supervisory stress tests.\8\ The rules further establish that the Board
will provide, also by no later than November 15, covered companies and
other banking organizations subject to the final rule the scenarios
they must use to conduct their annual company-run stress tests.\9\
Under the stress test rules, the Board may require certain companies to
use additional components in the adverse or severely adverse scenario
or additional scenarios.\10\ For example, the Board expects to require
large banking organizations with significant trading activities to
include global market shock components (described in the following
sections) in their adverse and severely adverse scenarios. The Board
will provide any additional components or scenarios by no later than
December 1 of each year.\11\ The Board expects that the scenarios it
will require the companies to use will be the same as those the Board
will use to conduct its supervisory stress tests (together, stress test
scenarios).
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\8\ See id.; 12 CFR 252.134(b).
\9\ See id.; 12 CFR 252.144(b), 154(b). The annual company-run
stress tests use data as of September 30 of each calendar year.
\10\ 12 CFR 252.144(b), 154(b).
\11\ Id.
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Stress tests required under the stress test rules and under the
Board's capital plan rule require the Board and financial institutions
to calculate pro-forma capital levels--rather than ``current'' or
actual levels--over a specified planning horizon under baseline and
stressed scenarios. This approach integrates key lessons of the 2007-
2009 financial crisis into the Board's supervisory framework. In the
financial crisis, investor and counterparty confidence in the
capitalization of financial institutions eroded rapidly in the face of
changes in the current and expected economic and financial conditions,
and this loss in market confidence imperiled institutions' ability to
access funding, continue operations, serve as a credit intermediary,
and meet obligations to creditors and counterparties. Importantly, such
a loss in confidence occurred even when a financial institution's
capital ratios exceeded the regulatory minimums. This is because the
institution's capital ratios were perceived as lagging indicators of
its financial condition, particularly when conditions were changing.
The stress tests required under the stress test rules and capital
plan rule are a valuable supervisory tool that provides a forward-
looking assessment of large financial institutions' capital adequacy
under hypothetical economic and financial market conditions. Currently,
these stress tests primarily focus on credit risk and market risk--that
is, risk of mark-to-market losses associated with firms' trading and
counterparty positions--and not on other types of risk, such as
liquidity risk or operational risk unrelated to the macroeconomic
environment. Pressures stemming from these sources are considered in
separate supervisory exercises. No single supervisory tool, including
the stress tests, can provide an assessment of an institution's ability
to withstand every potential source of risk.
Selecting appropriate scenarios is an especially significant
consideration for stress tests required under the capital plan rule,
which ties the review of a bank holding company's performance under
stress scenarios to its ability to make capital distributions. More
severe scenarios, all other things being equal, generally translate
into larger projected declines in a company's capital. Thus, a company
would need more capital today to meet its minimum capital requirements
in more stressful scenarios and have the ability to continue making
capital distributions, such as common dividend payments. This
translation is far from mechanical; it will depend on factors that are
specific to a given company, such as underwriting standards and the
banking organization's business model, which would also greatly affect
projected revenue, losses, and capital.
To enhance the transparency of the scenario design process, the
Board is requesting public comment on a proposed policy statement
(Policy Statement) that would be used to develop scenarios for annual
supervisory and company-run stress tests under the stress testing rules
[[Page 70126]]
issued under the Act and the capital plan rule. The Board plans to
develop the annual set of scenarios, as outlined below, in consultation
with the Office of the Comptroller of the Currency (OCC) and Federal
Deposit Insurance Corporation (FDIC) to reduce the burden that could
arise from having the agencies establish inconsistent scenarios.
The proposed Policy Statement outlines the characteristics of the
stress test scenarios and explains the considerations and procedures
that underlie the formulation of these scenarios. The considerations
and procedures described in this policy statement would apply to the
Board's stress testing framework, including to the stress tests
required under 12 CFR part 252, subparts F, G, and H, as well as the
Board's capital plan rule (12 CFR 225.8). The Board may determine that
material modifications to the Policy Statement would be appropriate if
the supervisory stress test framework expands materially to include
additional components or other scenarios that are currently not
captured.\12\
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\12\ Before requiring a company to include additional components
or other scenarios in its company-run stress tests, the Board would
follow the notice procedures set forth in the stress test rules. See
12 CFR 252.144(b), 154(b).
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Although the Board does not envision that the approach used to
develop scenarios would change from year to year, the characteristics
of the scenarios provided to companies would reflect changes in the
outlook for economic and financial conditions and changes to specific
risks or vulnerabilities that the Board, in consultation with the other
federal banking agencies, determines should be considered in the annual
stress tests. The stress test scenarios should not be regarded as
forecasts; rather, they are hypothetical paths of economic variables
that would be used to assess the strength and resilience of the
companies' capital in various economic and financial environments.
The proposed Policy Statement is organized as follows. Section 1
provides background on the proposed Policy Statement. Section 2 is an
outline of the proposed Policy Statement and describes its scope.
Section 3 provides a broad description of the baseline, adverse, and
severely adverse scenarios and describes the types of variables that
the Board expects to include in the macro scenarios and the market
shock component of the stress test scenarios applicable to firms with
significant trading activity.\13\ The proposed approach for the macro
scenarios differs considerably from that for the market shocks, and,
therefore, they are described separately. Section 4 describes the
Board's proposed approach for developing the macro scenarios, and
section 5 describes the proposed approach for the market shock
components. Section 6 describes the relationship between the macro
scenario and the market shock components. Section 7 provides a timeline
for the formulation and publication of the macroeconomic assumptions
and market shocks.
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\13\ Currently, the firms subject to the market shock component
include the six bank holding companies that are subject to the
market risk rule and have total consolidated assets greater than
$500 billion, as reported on their FR Y-9C. However, the set of
companies subject to the market shock could change over time as the
size, scope, and complexity of the banking organization's trading
activities evolve.
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Consistent with the stress testing rules and the Act, the Board
will issue a minimum of three different scenarios, including baseline,
adverse, and severely adverse scenarios, for use under the stress test
rules. Specific circumstances or vulnerabilities, over which the Board
determines, in any given year, require particular vigilance to ensure
the resilience of the banking sector, will be captured in either the
adverse or severely adverse scenarios. A greater number of scenarios
could be needed in some years--for example, because the Board
identifies a large number of unrelated and uncorrelated but nonetheless
significant risks.
While the Board generally expects to use the same scenarios for all
companies subject to the stress testing rules, it may require a subset
of companies--depending on a company's financial condition, size,
complexity, risk profile, scope of operations, or activities, or risks
to the U.S. economy--to include additional scenario components or
additional scenarios that are designed to capture different effects of
adverse events on revenue, losses, and capital. One example of such
components is the market shock that applies only to trading companies.
Additional components or scenarios may also include other stress
factors that may not necessarily be directly correlated to
macroeconomic or financial assumptions but nevertheless can materially
affect companies' risks, such as the unexpected default of a major
counterparty.
Early in each stress testing cycle, the Board plans to publish the
macro scenarios along with a brief narrative summary that explains how
these scenarios have changed relative to the previous year. In cases
where scenarios are modified to reflect particular risks and
vulnerabilities, the narrative would also explain the underlying
motivation for these changes. The Board also plans to release a broad
description of the market shock component.
The Board seeks comment on all aspects of the proposed Policy
Statement. The Board notes that it will not revise the baseline,
adverse, and severely adverse scenarios or market shock component that
were recently issued under the Board's stress test rules and the
capital plan rule for CCAR 2013 in light of any comments on the
proposed policy statement but will consider the comments in developing
future macro scenarios.
Question 1. In what ways could the Board improve its approach to
scenario design? What additional economic or financial variables should
the Board consider in developing scenarios?
Question 2. In addition to the trading shock, what additional
components should the Board include in its stress testing framework?
What additional scenarios should the Board consider using in connection
with the stress testing framework?
Question 3. The policy statement proposes a number of different
methods for developing the adverse scenarios. What additional ways
might the Board consider specifying the adverse scenario?
Question 4. Does the approach for specifying the severely adverse
scenarios--specifically, that of featuring a severe recession along
with any salient risks to the economic and financial outlook--capture
the relevant macroeconomic risks that firms face? Should there be
additional features added to the scenario, either in specific
circumstances or more generally?
II. Administrative Law Matters
A. Use of Plain Language
Section 722 of the Gramm-Leach-Bliley Act (Pub. L. 106-102, 113
Stat. 1338, 1471, 12 U.S.C. 4809) requires the Federal banking agencies
to use plain language in all proposed and final rules published after
January 1, 2000. The Board has sought to present the proposed rule in a
simple and straightforward manner, and invites comment on the use of
plain language.
B. Paperwork Reduction Act Analysis
In accordance with the requirements of the Paperwork Reduction Act
of 1995 (44 U.S.C. 3506), the Board has reviewed the proposed policy
statement to assess any information collections. There are no
collections of information as defined by the Paperwork Reduction Act in
the proposal.
[[Page 70127]]
C. Regulatory Flexibility Act Analysis
In accordance with section 3(a) of the Regulatory Flexibility Act
(RFA), the Board is publishing an initial regulatory flexibility
analysis of the proposed policy statement. The RFA, 5 U.S.C. 601 et
seq., requires each federal agency to prepare an initial regulatory
flexibility analysis in connection with the promulgation of a proposed
rule, or certify that the proposed rule will not have a significant
economic impact on a substantial number of small entities.\14\ The RFA
requires an agency either to provide an initial regulatory flexibility
analysis with a proposed rule for which a general notice of proposed
rulemaking is required or to certify that the proposed rule will not
have a significant economic impact on a substantial number of small
entities. Based on its analysis and for the reasons stated below, the
Board believes that the proposed policy statement will not have a
significant economic impact on a substantial number of small entities.
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\14\ See 5 U.S.C. 603, 604 and 605.
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Under regulations issued by the Small Business Administration
(SBA), a ``small entity'' includes those firms within the ``Finance and
Insurance'' sector with asset sizes that vary from $7 million or less
in assets to $175 million or less in assets.\15\ The Board believes
that the Finance and Insurance sector constitutes a reasonable universe
of firms for these purposes because such firms generally engage in
actives that are financial in nature. Consequently, bank holding
companies or nonbank financial companies with assets sizes of $175
million or less are small entities for purposes of the RFA.
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\15\ 13 CFR 121.201.
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As discussed in the SUPPLEMENTARY INFORMATION, the proposed policy
statement generally would affect the scenario design framework used in
regulations that apply to bank holding companies with $50 billion or
more in total consolidated assets and nonbank financial companies that
the Council has determined under section 113 of the Dodd-Frank Act must
be supervised by the Board and for which such determination is in
effect. Companies that are affected by the proposed policy statement
therefore substantially exceed the $175 million asset threshold at
which a banking entity is considered a ``small entity''' under SBA
regulations.\16\ The proposed policy statement would affect a nonbank
financial company designated by the Council under section 113 of the
Dodd-Frank Act regardless of such a company's asset size. Although the
asset size of nonbank financial companies may not be the determinative
factor of whether such companies may pose systemic risks and would be
designated by the Council for supervision by the Board, it is an
important consideration.\17\ It is therefore unlikely that a financial
firm that is at or below the $175 million asset threshold would be
designated by the Council under section 113 of the Dodd-Frank Act
because material financial distress at such firms, or the nature,
scope, size, scale, concentration, interconnectedness, or mix of its
activities, are not likely to pose a threat to the financial stability
of the United States.
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\16\ The Dodd-Frank Act provides that the Board may, on the
recommendation of the Council, increase the $50 billion asset
threshold for the application of certain of the enhanced standards.
See 12 U.S.C. 5365(a)(2)(B). However, neither the Board nor the
Council has the authority to lower such threshold.
\17\ See 76 FR 4555 (January 26, 2011).
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As noted above, because the proposed policy statement is not likely
to apply to any company with assets of $175 million or less, if adopted
in final form, it is not expected to affect any small entity for
purposes of the RFA. The Board does not believe that the proposed
policy statement duplicates, overlaps, or conflicts with any other
Federal rules. In light of the foregoing, the Board does not believe
that the proposed policy statement, if adopted in final form, would
have a significant economic impact on a substantial number of small
entities supervised. Nonetheless, the Board seeks comment on whether
the proposed policy statement would impose undue burdens on, or have
unintended consequences for, small organizations, and whether there are
ways such potential burdens or consequences could be minimized in a
manner consistent its purpose.
List of Subjects in 12 CFR Part 252
Administrative practice and procedure, Banks, Banking, Federal
Reserve System, Holding companies, Nonbank Financial Companies
Supervised by the Board, Reporting and recordkeeping requirements,
Securities, Stress Testing.
Authority and Issuance
For the reasons stated in the SUPPLEMENTARY INFORMATION, the Board
of Governors of the Federal Reserve System proposes to add the Policy
Statement as set forth at the end of the SUPPLEMENTARY INFORMATION as
part 252 to 12 CFR chapter II as follows:
PART 252--ENHANCED PRUDENTIAL STANDARDS (Regulation YY)
1. The authority citation for part 252 would continue to read as
follows:
Authority: 12 U.S.C. 321-338a, 1467a(g), 1818, 1831p-1, 1844(b),
1844(c), 5361, 5365, 5366.
2. Appendix A to part 252 would be added to read as follows:
Appendix A--Policy Statement on the Scenario Design Framework for
Stress Testing
1. Background
The Board has imposed stress testing requirements through its
regulations implementing section 165(i) of the Dodd-Frank Act
(stress test rules) and through its capital plan rule (12 CFR
225.8). Under the stress test rules issued under section 165(i)(1)
of the Dodd-Frank Wall Street Reform and Consumer Protection Act
(Dodd-Frank Act or Act), the Board conducts an annual stress test
(supervisory stress tests), on a consolidated basis, of each bank
holding company with total consolidated assets of $50 billion or
more and each nonbank financial company that the Financial Stability
Oversight Council has designated for supervision by the Board
(together, covered companies).\18\ In addition, under the stress
test rules issued under section 165(i)(2) of the Act, covered
companies must conduct stress tests semi-annually and other
financial companies with total consolidated assets of more than $10
billion and for which the Board is the primary regulatory agency
must conduct stress tests on an annual basis (together company-run
stress tests).\19\ The Board will provide for at least three
different sets of conditions (each set, a scenario), including
baseline, adverse, and severely adverse scenarios for both
supervisory and company-run stress tests.\20\
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\18\ 12 U.S.C. 5365(i)(1); 77 FR 62378 (October 12, 2012), to be
codified at 12 CFR part 252, subpart F.
\19\ 12 U.S.C. 5365(i)(2); 77 FR 62378, 62396 (October 12,
2012), to be codified at 12 CFR part 252, subparts G and H.
\20\ The stress test rules define scenarios as ``those sets of
conditions that affect the U.S. economy or the financial condition
of a [company] that the Board annually determines are appropriate
for use in stress tests, including, but not limited to, baseline,
adverse, and severely adverse scenarios.'' The stress test rules
define baseline scenario as a ``set of conditions that affect the
U.S. economy or the financial condition of a company and that
reflect the consensus views of the economic and financial outlook.''
The stress test rules define adverse scenario a ``set of conditions
that affect the U.S. economy or the financial condition of a company
that are more adverse than those associated with the baseline
scenario and may include trading or other additional components.''
The stress test rules define severely adverse scenario as a ``set of
conditions that affect the U.S. economy or the financial condition
of a company and that overall are more severe than those associated
with the adverse scenario and may include trading or other
additional components.'' See 12 CFR 252.132(a), (d), (m), and (n);
12 CFR 252.142(a), (d), (o), and (p); 12 CFR 252.152(a), (e), (o),
and (p).
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[[Page 70128]]
The stress test rules provide that the Board will notify covered
companies by no later than November 15 of each year scenarios it
will use to conduct its annual supervisory stress tests and provide,
also by no later than November 15, covered companies and other
banking organizations subject to the final rules the set of
scenarios they must use to conduct their annual company-run stress
tests.\21\ Under the stress test rules, the Board may require
certain companies to use additional components in the adverse or
severely adverse scenario or additional scenarios.\22\ For example,
the Board expects to require large banking organizations with
significant trading activities to include a global market shock
component (described in the following sections) in their adverse and
severely adverse scenarios. The Board will provide any additional
components or scenario by no later than December 1 of each year.\23\
The Board expects that the scenarios it will require the companies
to use will be the same as those the Board will use to conduct its
supervisory stress tests (together, stress test scenarios).
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\21\ 12 CFR 252.144(b), 12 CFR 252.154(b). The annual company-
run stress tests use data as of September 30 of each calendar year.
\22\ 12 CFR 252.144(b), 154(b).
\23\ Id.
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In addition, section 225.8 of the Board's Regulation Y (capital
plan rule) requires all U.S. bank holding companies with total
consolidated assets of $50 billion or more to submit annual capital
plans, including stress test results, to the Board to allow the
Board to assess whether they have robust, forward-looking capital
planning processes and have sufficient capital to continue
operations throughout times of economic and financial stress.\24\
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\24\ See Capital plans, 76 FR 74631 (Dec. 1, 2011) (codified at
12 CFR 225.8).
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Stress tests required under the stress test rules and under the
capital plan rule require the Board and banking organizations to
calculate pro-forma capital levels--rather than ``current'' or
actual levels--over a specified planning horizon under baseline and
stressful scenarios. This approach integrates on key lessons of the
2007-2009 financial crisis into the Board's supervisory framework.
During the financial crisis, investor and counterparty confidence in
the capitalization of financial institutions eroded rapidly in the
face of changes in the current and expected economic and financial
conditions, and this loss in market confidence imperiled
institutions' ability to access funding, continue operations, serve
as a credit intermediary, and meet obligations to creditors and
counterparties. Importantly, such a loss in confidence occurred even
when a financial institution's capital ratios were in excess of
regulatory minimums. This is because the institution's capital
ratios were perceived as lagging indicators of its financial
condition, particularly when conditions were changing.
The stress tests required under the stress test rules and
capital plan rule are a valuable supervisory tool that provides a
forward-looking assessment of large financial institutions' capital
adequacy under hypothetical economic and financial market
conditions. Currently, these stress tests primarily focus on credit
risk and market risk--that is, risk of mark-to-market losses
associated with firms' trading and counterparty positions--and not
on other types of risk, such as liquidity risk or operational risk
unrelated to the macroeconomic environment. Pressures stemming from
these sources are considered in separate supervisory exercises. No
single supervisory tool, including the stress tests, can provide an
assessment of an institution's ability to withstand every potential
source of risk.
Selecting appropriate scenarios is an especially significant
consideration, for stress tests required under the capital plan
rule, which ties the review of a bank holding company's performance
under stress scenarios to its ability to make capital distributions.
More severe scenarios, all other things being equal, generally
translate into larger projected declines in banks' capital. Thus, a
company would need more capital today to meet its minimum capital
requirements in more stressful scenarios and have the ability to
continue making capital distributions, such as common dividend
payments. This translation is far from mechanical; it will depend on
factors that are specific to a given company, such as underwriting
standards and the company's business model, which would also greatly
affect projected revenue, losses, and capital.
2. Overview and Scope
This policy statement provides more detail on the
characteristics of the stress test scenarios and explains the
considerations and procedures that underlie the approach for
formulating these scenarios. The considerations and procedures
described in this policy statement apply to the Board's stress
testing framework, including to the stress tests required under 12
CFR part 252, subparts F, G, and H, as well as the Board's capital
plan rule (12 CFR 225.8).\25\
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\25\ The Board may determine that modifications to the approach
are appropriate, for instance, to address a broader range of risks,
such as, operational risk.
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Although the Board does not envision that the broad approach
used to develop scenarios will change from year to year, the stress
test scenarios will reflect changes in the outlook for economic and
financial conditions and changes to specific risks or
vulnerabilities that the Board, in consultation with the other
federal banking agencies, determines should be considered in the
annual stress tests. The stress test scenarios should not be
regarded as forecasts; rather, they are hypothetical paths of
economic variables that will be used to assess the strength and
resilience of the companies' capital in various economic and
financial environments.
The remainder of this policy statement is organized as follows.
Section 3 provides a broad description of the baseline, adverse, and
severely adverse scenarios and describes the types of variables that
the Board expects to include in the macro scenarios and the market
shock component of the stress test scenarios applicable to firms
with significant trading activity. Section 4 describes the Board's
approach for developing the macro scenarios, and section 5 describes
the approach for the market shocks. Section 6 describes the
relationship between the macro scenario and the market shock
components. Section 7 provides a timeline for the formulation and
publication of the macroeconomic assumptions and market shocks.
3. Content of the Stress Test Scenarios
The Board will publish a minimum of three different scenarios,
including baseline, adverse, and severely adverse conditions, for
use in stress tests required in the stress test rules.\26\ In
general, the Board anticipates that it will not issue additional
scenarios. Specific circumstances or vulnerabilities that in any
given year the Board determines require particular vigilance to
ensure the resilience of the banking sector will be captured in
either the adverse or severely adverse scenarios. A greater number
of scenarios could be needed in some years--for example, because the
Board identifies a large number of unrelated and uncorrelated but
nonetheless significant risks.
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\26\ 12 CFR 252.134(b), 12 CFR 252.144(b), 12 CFR 252.154(b).
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While the Board generally expects to use the same scenarios for
all companies subject to the final rule, it may require a subset of
companies--depending on a company's financial condition, size,
complexity, risk profile, scope of operations, or activities, or
risks to the U.S. economy--to include additional scenario components
or additional scenarios that are designed to capture different
effects of adverse events on revenue, losses, and capital. One
example of such components is the market shock that applies only to
companies with significant trading activity. Additional components
or scenarios may also include other stress factors that may not
necessarily be directly correlated to macroeconomic or financial
assumptions but nevertheless can materially affect companies' risks,
such as the unexpected default of a major counterparty.
Early in each stress testing cycle, the Board plans to publish
the macro scenarios along with a brief narrative summary that
explains how these scenarios have changed relative to the previous
year. In cases where scenarios are changed to reflect particular
risks and vulnerabilities, the narrative will also explain the
underlying motivation for these changes. The Board also plans to
release a broad description of the market shock components.
3.1 Macro Scenarios
The macro scenarios will consist of the future paths of a set of
economic and financial variables.\27\ The economic and financial
variables included in the scenarios will likely comprise those
included in the 2012 Comprehensive Capital Analysis and Review
(CCAR).\28\ The domestic U.S.
[[Page 70129]]
variables provided for in the 2012 CCAR included:
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\27\ The future path of a variable refers to its specification
over a given time period. For example, the path of unemployment can
be described in percentage terms on a quarterly basis over the
stress testing time horizon.
\28\ See Appendix III of the 2012 CCAR Instructions and Guidance
(www.federalreserve.gov/newsevents/press/bcreg/bcreg20111122d1.pdf).
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Five measures of economic activity and prices: real and
nominal gross domestic product (GDP) growth, the unemployment rate
of the civilian non-institutional population aged 16 and over,
nominal disposable personal income growth, and the Consumer Price
Index (CPI) inflation rate;
Four measures of developments in equity and property
markets: The Core Logic National House Price Index, the National
Council for Real Estate Investment Fiduciaries Commercial Real
Estate Price Index, the Dow Jones Total Stock Market Index, and the
Chicago Board Options Exchange Market Volatility Index; and
Four measures of interest rates: the rate on the three-
month Treasury bill, the yield on the 10-year Treasury bond, the
yield on a 10-year BBB corporate security, and the interest rate
associated with a conforming, conventional, fixed-rate, 30-year
mortgage.
The international variables provided for in the 2012 CCAR
included, for the euro area, the United Kingdom, developing Asia,
and Japan:
Percent change in real GDP;
Percent change in the Consumer Price Index or local
equivalent; and
The U.S./foreign currency exchange rate.\29\
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\29\ The Board may increase the range of countries or regions
included in future scenarios, as appropriate.
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The economic variables included in the scenarios influence key
items affecting banking organizations' net income, including pre-
provision net revenue and credit losses on loans and securities.
Moreover, these variables exhibit fairly typical trends in adverse
economic climates that can have unfavorable implications for banks'
net income and, thus, capital positions.
The economic variables included in the scenario may change over
time. For example, the Board may add variables to a scenario if the
international footprint of companies that are subject to the stress
testing rules changed notably over time such that the variables
already included in the scenario no longer sufficiently capture the
material risks of these companies. Alternatively, historical
relationships between macroeconomic variables could change over time
such that one variable (e.g., disposable personal income growth)
that previously provided a good proxy for another (e.g., light
vehicle sales) in modeling banks' pre-provision net revenue or
credit losses ceases to do so, resulting in the need to create a
separate path, or alternative proxy, for the other variable.
However, recognizing the amount of work required for companies to
incorporate the scenario variables into their stress testing models,
the Board expects to eliminate variables from the scenarios only in
rare instances.
The Board expects that the company may not use all of the
variables provided in the scenario, if those variables are not
appropriate to the company's line of business, or may add additional
variables, as appropriate.\30\ The Board expects the companies will
ensure that the paths of such additional variables are consistent
with the scenarios the Board provided. For example, the companies
may use, as part of their internal stress test models, local-level,
such as state-level unemployment rates or city-level house prices.
While the Board does not plan to include local-level macro variables
in the stress test scenarios it provides, it expects the companies
to evaluate the paths of local-level macro variables as needed for
their internal models, and ensure internal consistency between these
within-country variables and their aggregate, macro-economic
counterparts. The Board will provide the macro scenario component of
the stress test scenarios for a period that spans a minimum of 13
quarters. The scenario horizon reflects the supervisory stress test
approach that the Board plans to use. Under the stress test rules,
the Board will assess the effect of different scenarios on the
consolidated capital of each company over a forward-looking planning
horizon of at least nine quarters.
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\30\ The Board expects banking organizations will ensure that
the paths of such additional variables are consistent with the
scenarios the Board provided.
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3.2 Market Shock Component
The market shock component of the stress test scenarios will
only apply to companies with significant trading activity and their
subsidiaries.\31\ The component consists of large moves in market
prices and rates that would be expected to generate losses. Market
shocks differ from macro scenarios in a number of ways, both in
their design and application. For instance, market shocks that might
typically be observed over an extended period (e.g., 6 months) are
assumed to be an instantaneous event which immediately affects the
market value of the companies' trading assets and liabilities. In
addition, under the stress test rules, the as-of date for market
shocks will differ from the quarter-end, and the Board will provide
the as-of date for market shocks no later than December 1 of each
year. Finally, as described in section 4, market shocks include a
much larger set of risk factors than the set of economic and
financial variables included in macro scenarios. Broadly, these risk
factors include shocks to financial market variables that affect
asset prices, such as a credit spread or the yield on a bond, and,
in some cases, the value of the position itself (e.g., the market
value of private equity positions).
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\31\ Currently, companies with significant trading activity
include the six bank holding companies that are subject to the
market risk rule and have total consolidated assets greater than
$500 billion, as reported on their FR Y-9C. The Board may also
subject a state member bank subsidiary of any such bank holding
company to the market shock component. The set of companies subject
to the market shock component could change over time as the size,
scope, and complexity of banking organization's trading activities
evolve.
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The Board envisions that the market shocks will include shocks
to a broad range of risk factors that are similar in granularity to
those risk factors trading companies use internally to produce
profit and loss estimates, under stressful market scenarios, for all
asset classes that are considered trading assets, including
equities, credit, interest rates, foreign exchange rates, and
commodities. For example, risk factor shocks for interest rates
would capture changes in the level, correlation, and volatility, by
country and maturity. Risk factors will be specified separately by
currency or geographic region, and include key sub-categories
relevant to each asset class. For example, the risk factor shocks
applied to credit spreads will differ by risk category and the risk
factor shocks for spot oil prices will vary by grade and type of
crude oil.
Examples of risk factors include, but are not limited to:
Equity indices of all developed markets, and of
developing and emerging market nations to which companies with
significant trading activity may have exposure, along with term
structures of implied volatilities;
Cross-currency FX rates of all major and many minor
currencies, along term structures of implied volatilities;
Term structures of government rates (e.g., U.S.
Treasuries), interbank rates (e.g., swap rates) and other key rates
(e.g., commercial paper) for all developed markets and for
developing and emerging market nations to which banks may have
exposure;
Term structures of implied volatilities that are key
inputs to the pricing of interest rate derivatives;
Term structures of futures prices for energy products
including crude oil (differentiated by country of origin), natural
gas, and power;
Term structures of futures prices for metals and
agricultural commodities;
``Value-drivers'' (credit spreads or instrument prices
themselves) for credit-sensitive product segments including:
Corporate bonds, credit default swaps, and collateralized debt
obligations by risk; non-agency residential mortgage-backed
securities and commercial mortgage-backed securities by risk and
vintage; sovereign debt; and, municipal bonds; and
Shocks to the values of private equity positions.
4. Approach for Formulating the Macroeconomic Assumptions for Scenarios
This section describes the Board's approach for formulating
macroeconomic assumptions for each scenario. The methodologies for
formulating this part of each scenario differ by scenario, so these
methodologies for the baseline, severely adverse, and the adverse
scenarios are described separately in each of the following
subsections.
In general, the baseline scenario will reflect the most recently
available consensus views of the macroeconomic outlook expressed by
professional forecasters, government agencies, and other public-
sector organizations as of the beginning of the annual stress-test
cycle. The severely adverse scenario will consist of a set of
economic and financial conditions that reflect the conditions of
post-war U.S. recessions. The adverse scenario will consist of a set
of economic and financial conditions that are more adverse than
those associated with the baseline scenario but less severe than
those associated with the severely adverse scenario.
[[Page 70130]]
Each of these scenarios is described further in sections below
as follows: Baseline (subsection 4.1), severely adverse (subsection
4.2), and adverse (subsection 4.3).
4.1 Approach for Formulating Macroeconomic Assumptions in the Baseline
Scenario
The stress test rules define the baseline scenario as a set of
conditions that affect the U.S. economy or the financial condition
of a banking organization, and that reflect the consensus views of
the economic and financial outlook. Projections under a baseline
scenario are used to evaluate how companies would perform in more
likely economic and financial conditions. The baseline serves also
as a point of comparison to the severely adverse and adverse
scenarios, giving some sense of how much of the company's capital
decline could be ascribed to the scenario as opposed to the
company's capital adequacy under expected conditions.
The baseline scenario will be developed around a macroeconomic
projection that captures the prevailing views of private-sector
forecasters (e.g. Blue Chip Consensus Forecasts and the Survey of
Professional Forecasters), government agencies, and other public-
sector organizations (e.g., the International Monetary Fund and the
Organization for Economic Co-operation and Development) near the
beginning of the annual stress-test cycle. The baseline scenario is
designed to represent a consensus expectation of certain economic
variables over the time period of the tests and it is not the
Board's internal forecast for those economic variables. For example,
the baseline path of short-term interest rates is constructed from
consensus forecasts and may differ from that implied by the FOMC's
Summary of Economic Projections.
For some scenario variables--such as U.S. real GDP growth, the
unemployment rate, and the consumer price index--there will be a
large number of different forecasts available to project the paths
of these variables in the baseline scenario. For others, a more
limited number of forecasts will be available. If available
forecasts diverge notably, the baseline scenario will reflect an
assessment of the forecast that is deemed to be most plausible. In
setting the paths of variables in the baseline scenario, particular
care will be taken to ensure that, together, the paths present a
coherent and plausible outlook for the U.S. and global economy,
given the economic climate in which they are formulated.
4.2 Approach for Formulating the Macroeconomic Assumptions in the
Severely Adverse Scenario
The stress test rules define a severely adverse scenario as a
set of conditions that affect the U.S. economy or the financial
condition of a banking organization and that overall are more severe
than those associated with the adverse scenario. The banking
organization will be required to publicly disclose a summary of the
results of its stress test under the severely adverse scenario, and
the Board intends to publicly disclose the results of its analysis
of the banking organization under the severely adverse scenario.
4.2.1 General Approach: The Recession Approach
The Board intends to use a recession approach to develop the
severely adverse scenario. In the recession approach, the Board will
specify the future paths of variables to reflect conditions that
characterize post-war U.S. recessions, generating either a typical
or specific recreation of a post-war U.S. recession. The Board chose
this approach because it has observed that the conditions that
typically occur in recessions--such as increasing unemployment,
declining asset prices, and contracting loan demand--can put
significant stress on companies' balance sheets. This stress can
occur through a variety of channels, including higher loss
provisions due to increased delinquencies and defaults; losses on
trading positions through sharp moves in market prices; and lower
bank income through reduced loan originations. For these reasons,
the Board believes that the paths of economic and financial
variables in the severely adverse scenario should, at a minimum,
resemble the paths of those variables observed during a recession.
This approach requires consideration of the type of recession to
feature. All post-war U.S. recessions have not been identical: some
recessions have been associated with very elevated interest rates,
some have been associated with sizable asset price declines, and
some have been relatively more global. The most common features of
recessions, however, are increases in the unemployment rate and
contractions in aggregate incomes and economic activity. For this
and the following reasons, the Board intends to use the unemployment
rate as the primary basis for specifying the severely adverse
scenario. First, the unemployment rate is likely the most
representative single summary indicator of adverse economic
conditions. Second, in comparison to GDP, labor market data have
traditionally featured more prominently than GDP in the set of
indicators that the National Bureau of Economic Research reviews to
inform its recession dates.\32\ Third and finally, the growth rate
of potential output can cause the size of the decline in GDP to vary
between recessions. While changes in the unemployment rate can also
vary over time due to demographic factors, this seems to have more
limited implications over time relative to changes in potential
output growth. The unemployment rate used in the severely adverse
scenario will reflect an unemployment rate that has been observed in
severe post-war U.S. recessions, measuring severity by the absolute
level of and relative increase in the unemployment rate.\33\
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\32\ More recently, a monthly measure of GDP has been added to
the list of indicators.
\33\ Even though all recessions feature increases in the
unemployment rate and contractions in incomes and economic activity,
the size of this change has varied over post-war U.S. recessions.
Table 1 documents the variability in the depth of post-war U.S.
recessions. Some recessions--labeled mild in Table 1--have been
relatively modest with GDP edging down just slightly and the
unemployment rate moving up about a percentage point. Other
recessions--labeled severe in Table 1--have been much harsher with
GDP dropping 3\3/4\ percent and the unemployment rate moving up a
total of about 4 percentage points.
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After specifying the unemployment rate, the Board will specify
the paths of other macroeconomic variables based on the paths of
unemployment, income, and activity. However, many of these other
variables have taken wildly divergent paths in previous recessions
(e.g., house prices), requiring the Board to use its informed
judgment in selecting appropriate paths for these variables. In
general, the path for these other variables will be based on their
underlying structure at the time that the scenario is designed
(e.g., the relative fragility of the housing finance system).
The Board considered alternative methods for scenario design of
the severely adverse scenario, including a probabilistic approach.
The probabilistic approach constructs a baseline forecast from a
large-scale macroeconomic model and identifies a scenario that would
have a specific probabilistic likelihood given the baseline
forecast. The Board believes that, at this time, the recession
approach is better suited for developing the severely adverse
scenario than a probabilistic approach because it guarantees a
recession of some specified severity. In contrast, the probabilistic
approach requires the choice of an extreme tail outcome--relative to
baseline--to characterize the severely adverse scenario (e.g., a 5
percent or a 1 percent. tail outcome). In practice, this choice is
difficult as adverse economic outcomes are typically thought of in
terms of how variables evolve in an absolute sense rather than how
far away they lie in the probability space away from the baseline.
In this sense, a scenario featuring a recession may be somewhat
clearer and more straightforward to communicate. Finally, the
probabilistic approach relies on estimates of uncertainty around the
baseline scenario and such estimates are in practice model-
dependent.
4.2.2 Setting the Unemployment Rate Under the Severely Adverse
Scenario
The Board anticipates that the severely adverse scenario will
feature an unemployment rate that increases between 3 to 5
percentage points from its initial level over the course of 6 to 8
calendar quarters.\34\ The initial level will be set based on the
conditions at the time that the scenario is designed. However, if a
3 to 5 percentage point increase in the unemployment rate does not
raise the level of the unemployment rate to at least 10 percent--the
average level to which it has increased in the most recent three
severe recessions--the path of the unemployment rate in most cases
will be specified so as to raise the unemployment rate to at least
10 percent.
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\34\ Six to eight quarters is the average number of quarters for
which a severe recession lasts plus the average number of subsequent
quarters over which the unemployment rate continues to rise. The
variable length of the timeframe reflects the different paths to the
peak unemployment rate depending on the severity of the scenario.
---------------------------------------------------------------------------
This methodology is intended to generate scenarios that feature
stressful outcomes but
[[Page 70131]]
do not induce greater procyclicality in the financial system and
macroeconomy. When the economy is in the early stages of a recovery,
the unemployment rate in a baseline scenario generally trends
downward, resulting in a larger difference between the path of the
unemployment rate in the severely adverse scenario and the baseline
scenario and a severely adverse scenario that is relatively more
intense. Conversely, in a sustained strong expansion--when the
unemployment rate may be below the level consistent with full
employment--the unemployment in a baseline scenario generally trends
upward, resulting in a smaller difference between the path of the
unemployment rate in the severely adverse scenario and the baseline
scenario and a severely adverse scenario that is relatively less
intense. Historically, a 3 to 5 percentage point increase in
unemployment rate is reflective of stressful conditions. As
illustrated in Table 1, over the last half-century, the U.S. economy
has experienced four severe post-war recessions. In all four of
these recessions the unemployment rate increased 3 to 5 percentage
points and in the three most recent of these recessions the
unemployment rate reached a level between 9 percent and 11 percent.
Under this method, if the initial unemployment rate were low--as
it would be after a sustained long expansion--the unemployment rate
in the scenario would increase to a level as high as what has been
seen in past severe recessions. However, if the initial unemployment
rate were already high--as would be the case in the early stages of
a recovery--the unemployment rate would exhibit a change as large as
what has been seen in past severe recessions.
The Board believes that the typical increase in the unemployment
rate in the severely adverse scenario would be about 4 percentage
points. However, the Board would calibrate the increase in
unemployment based on its views of the status of cyclical systemic
risk. The Board intends to set the unemployment rate at the higher
end of the range if the Board believed that cyclical systemic risks
were high (as it would be after a sustained long expansion), and to
the lower end of the range if cyclical systemic risks were low (as
it would be in the earlier stages of a recovery). This may result in
a scenario that is slightly more intense than normal if the Board
believed that cyclical systemic risks were increasing in a period of
robust expansion.\35\ Conversely, it would allow the Board to
specify a scenario that is slightly less intense than normal in an
environment where systemic risks appeared subdued, such as in the
early stages of an expansion. However, even at the lower end of the
range of unemployment-rate increases, the scenario would still
feature an increase in the unemployment rate similar to what has
been seen in about half of the severe recessions of the last 50
years.
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\35\ Note, however, that the severity of the scenario would not
exceed an implausible level: even at the upper end of the range of
unemployment-rate increases, the path of the unemployment rate would
still be consistent with severe post-war U.S. recessions.
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As indicated previously, if a 3 to 5 percentage point increase
in the unemployment rate does not raise the level of the
unemployment rate to 10 percent--the average level to which it has
increased in the most recent three severe recessions--the path of
the unemployment rate will be specified so as to raise the
unemployment rate to 10 percent. Setting a floor for the
unemployment rate at 10 percent recognizes the fact that not only do
cyclical systemic risks build up at financial intermediaries during
robust expansions but that these risks are also easily obscured by
the buoyant environment.
In setting the increase in the unemployment rate, the Board
would consider the extent to which analysis by economists,
supervisors, and financial market experts finds cyclical systemic
risks to be elevated (but difficult to be captured more precisely in
one of the scenario's other variables). In addition, the Board--in
light of impending shocks to the economy and financial system--would
also take into consideration the extent to which a scenario of some
increased severity might be necessary for the results of the stress
test and the associated supervisory actions to sustain confidence in
financial institutions.
While the approach to specifying the severely adverse scenario
is designed to avoid adding sources of procyclicality to the
financial system, it is not designed to explicitly offset any
existing procyclical tendencies in the financial system. The purpose
of the stress test scenarios is to make sure that the banks are
properly capitalized to withstand severe economic and financial
conditions, not to serve as an explicit countercyclical offset to
the financial system.
In developing the approach to the unemployment rate, the Board
also considered a method that would increase the unemployment rate
to some fairly elevated fixed level over the course of 6 to 8
quarters. This would result in scenarios being more severe in robust
expansions (when the unemployment rate is low) and less severe in
the early stages of a recovery (when the unemployment rate is high)
and so would not result in pro-cyclicality. Depending on the initial
level of the unemployment rate, this approach could lead to only a
very modest increase in the unemployment rate--or even a decline. As
a result, this approach--while not procyclical--could result in
scenarios not featuring stressful macroeconomic outcomes.
4.2.3 Setting the Other Variables in the Severely Adverse Scenario
Generally, all other variables in the severely adverse scenario
will be specified to be consistent with the increase in the
unemployment rate. The approach for specifying the paths of these
variables in the scenario will be a combination of (1) how economic
models suggest that these variables should evolve given the path of
the unemployment rate, (2) how these variables have typically
evolved in past U.S. recessions, and (3) and evaluation of these and
other factors.
Economic models--such as medium-scale macroeconomic models--
should be able to generate plausible paths consistent with the
unemployment rate for a number of scenario variables, such as real
GDP growth, CPI inflation and short-term interest rates, which have
relatively stable (direct or indirect) relationships with the
unemployment rate (e.g., Okun's Law, the Phillips Curve, and
interest rate feedback rules). For some other variables, specifying
their paths will require a case-by-case consideration. For example,
declining house prices, which are an important source of stress to a
bank's balance sheet, are not a steadfast feature of recessions, and
the historical relationship of house prices with the unemployment
rate or any other variable that deteriorates in recessions is not
strong. Simply adopting their typical path in a severe recession
would likely underestimate risks stemming from the housing sector.
In this case, some modified approach--in which perhaps recessions in
which house prices declined were judgmentally weighted more
heavily--would be appropriate.
4.2.4 Adding Salient Risks to the Severely Adverse Scenario
The severely adverse scenario will be developed to reflect
specific risks to the economic and financial outlook that are
especially salient but would feature minimally in the scenario if
the Board were only to use approaches that looked to past recessions
or relied on historical relationships between variables.
There are some important instances when it would be appropriate
to augment the recession approach with salient risks. For example,
if an asset price were especially elevated and thus potentially
vulnerable to an abrupt and potentially destabilizing decline, it
would be appropriate to include such a decline in the scenario even
if such a large drop were not typical in a severe recession.
Likewise, if economic developments abroad were particularly
unfavorable, assuming a weakening in international conditions larger
than what typically occurs in severe U.S. recessions would likely
also be appropriate.
Clearly, while the recession component of the severely adverse
scenario is within some predictable range, the salient risk aspect
of the scenario is far less so, and therefore, needs an annual
assessment. Each year, the Board will identify the risks to the
financial system and the domestic and international economic
outlooks that appear more elevated than usual, using its internal
analysis and supervisory information and in consultation with the
FDIC and the OCC. Using the same information, the Board will then
calibrate the paths of the macroeconomic and financial variables in
the scenario to reflect these risks.
Detecting risks that have the potential to weaken the banking
sector is particularly difficult when economic conditions are
buoyant, as a boom can obscure the weaknesses present in the system.
In sustained robust expansions, therefore, the selection of salient
risks to augment the scenario will err on the side of including
risks of uncertain significance.
The Board will factor in particular risks to the domestic and
international macroeconomic outlook identified by its
[[Page 70132]]
economists, bank supervisors, and financial market experts and make
appropriate adjustments to the paths of specific economic variables.
These adjustments will not be reflected in the general severity of
the recession and, thus, all macroeconomic variables; rather, the
adjustments will apply to a subset of variables to reflect co-
movements in these variables that are historically less typical. The
Board plans to discuss the motivation for the adjustments that it
makes to variables to highlight systemic risks in the narrative
describing the scenarios.\36\
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\36\ The means of effecting an adjustment to the severely
adverse scenario to address salient systemic risks differs from the
means used to adjust the unemployment rate. For example, in
adjusting the scenario for an increased unemployment rate, the Board
would modify all variables such that the future paths of the
variables are similar to how these variables have moved
historically. In contrast, to address salient risks, the Board may
only modify a small number of variables in the scenario and, as
such, their future paths in the scenario would be somewhat more
atypical, albeit not implausible, given existing risks.
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4.3 Approach for Formulating Macroeconomic Assumptions in the Adverse
Scenario
The adverse scenario can be developed in a number of different
ways, and the selected approach will depend on a number of factors,
including how the Board intends to use the results of the adverse
scenario.\37\ Generally, the Board believes that the companies
should consider multiple adverse scenarios for their internal
capital planning purposes, and likewise, it is appropriate that the
Board consider more than one adverse scenario to assess a company's
ability to withstand stress. Accordingly, the Board does not
identify a single approach for specifying the adverse scenario.
Rather, the adverse scenario will be formulated according to one of
the possibilities listed below. The Board may vary the approach it
uses for the adverse scenario each year so that the results of the
scenario provide the most value to supervisors, in light of current
condition of the economy and the financial services industry.
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\37\ For example, in the context of CCAR, the Board currently
uses the adverse scenario as one consideration in evaluating a bank
holding company's capital adequacy.
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The simplest method to specify the adverse scenario is to
develop a less severe version of the severely adverse scenario. For
example, the adverse scenario could be formulated such that the
deviations of the paths of the variables relative to the baseline
were simply one-half of or two-thirds of the deviations of the paths
of the variables relative to the baseline in the severely adverse
scenario. A priori, specifying the adverse scenario in this way may
appear unlikely to provide the greatest possible informational value
to supervisors--given that it is just a less severe version of the
severely adverse scenario. However, to the extent that the effect of
macroeconomic variables on bank loss positions and incomes are
nonlinear, there could be potential value from this approach.
Another method to specify the adverse scenario is to capture
risks in the adverse scenario that the Board believes should be
understood better or should be monitored, but does not believe
should be included in the severely adverse scenario, perhaps because
these risks would render the scenario implausibly severe. For
instance, the adverse scenario could feature sizable increases in
oil or natural gas prices or shifts in the yield curve that are
atypical in a recession. The adverse scenario might also feature
less acute, but still consequential, adverse outcomes, such as a
disruptive slowdown in growth from emerging-market economies.
Under the Board's stress test rules, covered companies are
required to develop their own scenarios for mid-cycle company-run
stress tests.\38\ A particular combination of risks included in
these scenarios may inform the design of the adverse scenario for
annual stress tests. In this same vein, another possibility would be
to use modified versions of the circumstances that firms describe in
their living wills as being able to cause their failures.
---------------------------------------------------------------------------
\38\ 12 CFR 252.145.
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It might also be informative to periodically use a stable
adverse scenario, at least for a few consecutive years. Even if the
scenario used for the stress test does not change over the credit
cycle, if companies tighten and relax lending standards over the
cycle, their loss rates under the adverse scenario--and indirectly
the projected changes to capital--would decrease and increase,
respectively. A consistent scenario would allow the direct
observation of how capital fluctuates to reflect growing cyclical
risks.
Finally, the Board may consider specifying the adverse scenario
using the probabilistic approach described in section 3.2.1 (that
is, with a specified lower probability of occurring than the
severely adverse scenario but a greater probability of occurring
than the baseline scenario). The approach has some intuitive appeal
despite its shortcomings. For example, using this approach for the
adverse scenario could allow the Board to explore an alternative
approach to develop stress testing scenarios and their effect on a
company's net income and capital.
With the exception of cases in which the probabilistic approach
is used to generate the adverse scenario, the adverse scenario would
at a minimum contain a mild to moderate recession. This is because
most of the value from investigating the implications of the risks
described above is likely to be obtained from considering them in
the context of balance sheets of covered companies and large banks
that are under some stress.
5. Approach for Formulating Scenario Market Price and Rate Shocks
This section discusses the approach the Board proposes to adopt
for developing the stress scenario component appropriate for
companies with significant trading activities. The design and
specification of the stress components for trading differ from that
of the macro scenarios because profits and losses from the trading
are measured in mark-to-market terms, while revenues and losses from
traditional banking are generally measured using the accrual method.
As noted above, another critical difference is the time-evolution of
the trading stress tests. The trading stress component consists of
an instantaneous ``shock'' to a large number of risk factors that
determine the mark-to-market value of trading positions, while the
macro scenarios supply a projected path of economic variables that
affect traditional banking activities over the entire planning
period.
The development of the scenarios in the final rules that are
detailed in this section are as follows: baseline (subsection 5.1),
severely adverse (subsection 5.2), and adverse (subsection 5.3).
5.1 Approach for Formulating the Scenario for Trading Variables Under
the Baseline Scenario
By definition, market shocks are large, previously unanticipated
moves in asset prices and rates. Because asset prices should,
broadly speaking, reflect consensus opinions about the future
evolution of the economy, large price movements, as envisioned in
the market shock, should not occur along the baseline path. As a
result, market shocks will not be included in the baseline scenario.
5.2 Approach for Formulating the Market Shock Component Under the
Severely Adverse Scenario
This section addresses possible approaches to designing market
shocks in the severely adverse scenario, including important
considerations for scenario design, possible approaches to designing
scenarios, and a development strategy for implementing the preferred
approach.
5.2.1 Design Considerations for Market Shocks
The general market practice for stressing a trading portfolio is
to specify market shocks either in terms of extreme moves in
observable, broad market indicators and risk factors or directly as
large changes to the mark-to-market values of financial instruments.
These moves can be specified either in relative terms or absolute
terms. Supplying values of risk factors after a ``shock'' is roughly
equivalent to the macro scenarios, which supply values for a set of
economic and financial variables; however, trading stress testing
differs from macroeconomic stress testing in several critical ways.
In the past, the Board used one of two approaches to specify
market shocks. During SCAP and CCAR in 2011, the Board used a very
general approach to market shocks and required companies to stress
their trading positions using changes in market prices and rates
experienced during the second half of 2008, without specifying risk
factor shocks. This broad guidance resulted in inconsistency across
companies both in terms of the severity and the application of
shocks. In certain areas companies were permitted to use their own
experience during the second half of 2008 to define shocks. This
resulted in significant variation in shock severity across
companies.
To enhance the consistency and comparability in market shocks
for CCAR in 2012, the Board provided to each trading company more
than 35,000 specific risk
[[Page 70133]]
factor shocks, primarily based on market moves in the second half of
2008. While the number of risk factors used in companies' pricing
and stress-testing models still typically exceed that provided in
the Board's scenarios, the greater specificity resulted in more
consistency in the scenario across companies. The benefit of the
comprehensiveness of risk factor shocks is at least partly offset by
potential difficulty in creating shocks that are coherent and
internally consistent, particularly as the framework for developing
market shocks deviates from historical events.
Also importantly, the ultimate losses associated with a given
market shock will depend on a company's trading positions, which can
make it difficult to rank order, ex ante, the severity of the
scenarios. In certain instances, market shocks that include large
market moves may not be particularly stressful for a given company.
Aligning the market shock with the macro scenario for consistency
may result in certain companies actually benefiting from risk factor
moves of larger magnitude in the market scenario if the companies
are hedging against salient risks to other parts of their business.
Thus, the severity of market shocks must be calibrated to take into
account how a complex set of risks, such as directional risks and
basis risks, interacts with each other, given the companies' trading
positions at the time of stress. For instance, a large depreciation
in a foreign currency would benefit companies with net short
positions in the currency while hurting those with net long
positions. In addition, longer maturity positions may move
differently from shorter maturity positions, adding further
complexity.
The instantaneous nature of market shocks and the immediate
recognition of mark-to-market losses add another element to the
design of market shocks, and to determining the appropriate severity
of shocks. For instance, in both SCAP and CCAR, the Board assumed
that market moves that occurred over the six-month period in late
2008 would occur instantaneously. The design of the market shocks
must factor in appropriate assumptions around the period of time
during which market events would unfold and any associated market
responses.
5.2.2 Approaches to Trading Stress Component Design
For each scenario, the Board plans to use a standardized set of
market shocks that apply to all companies with significant trading
activity. The market shocks could be based on a single historical
episode, multiple historical periods, hypothetical (but plausible)
events, or some combination of historical episodes and hypothetical
events (hybrid approach). Depending on the type of hypothetical
events, a scenario based on such events may result in changes in
risk factors that were not previously observed. In 2012 CCAR, the
shocks were largely based on relative moves in asset prices and
rates during the second half of 2008, but also included some
additional considerations to factor in the widening of spreads for
European sovereigns and financial companies based on actual
observation during the latter part of 2011.
For the severely adverse scenario, the Board plans to use the
hybrid approach to develop shocks. The hybrid approach allows the
Board to maintain certain core elements of consistency in market
shocks each year while providing flexibility to add hypothetical
elements based on market conditions at the time of the stress tests.
In addition, this approach will help ensure internal consistency in
the scenario because of its basis in historical episodes; however,
combining the historical episode and hypothetical events may require
tweaks to ensure mutual consistency of the joint moves. In general,
the hybrid approach provides considerable flexibility in developing
scenarios that are relevant each year, and by introducing variations
in the scenario, the approach will also reduce the ability of
companies with significant trading activity to modify or shift their
portfolios to minimize expected losses in the severely adverse
scenario.
The Board has considered a number of alternative approaches for
the design of market shocks. For example, the Board explored an
option of providing tailored market shocks for each trading company,
using information on the companies' portfolio gathered through
ongoing supervision or other means. By specifically targeting known
or potential vulnerabilities in a company's trading position, this
approach would be useful in assessing each company's capital
adequacy as it relates to the company's idiosyncratic risk. However,
the Board does not believe this approach to be well-suited for the
stress tests required by regulation. Consistency and comparability
are key features of annual supervisory stress tests and annual
company-run stress tests required in the stress test rules. It would
be difficult to use the information on the companies' portfolio to
design a common set of shocks that are universally stressful for all
covered companies. As a result, this approach would be better suited
to more customized, tailored stress tests that are part of the
company's internal capital planning process or to other supervisory
efforts outside of the stress tests conducted under the stress test
rules.
5.2.3 Development of the Trading Stress Scenario
Consistent with the approach describe above, the market shock
component for the severely adverse scenario will incorporate key
elements of market developments during the second half of 2008, but
also incorporate observations from other periods or price and rate
movements in certain markets that the Board deems to be plausible
though such movements may not have been observed historically. The
Board also expects to rely less on market events of the second half
of 2008 and more on hypothetical events or other historical episodes
to develop the market shock, particularly as the bank holding
company's portfolio changes over time and a different combination of
events would better capture material risk in bank holding company's
portfolio in the given year.
The developments in the credit markets during the second half of
2008 were unprecedented, providing a reasonable basis for market
shocks in the severely adverse scenario. During this period, key
risk factors in virtually all asset classes experienced extremely
large shocks; the collective breadth and intensity of the moves have
no parallels in modern financial history and, on that basis, it
seems likely that this episode will continue to be the dominant
historical scenario, although experience during other historical
episodes may also guide the severity of the market shock component
of the severely adverse scenario. Moreover, the risk factor moves
during this episode are directly consistent with the ``recession''
approach that underlies the macroeconomic assumptions. However,
market shocks based only on historical events could become stale and
less relevant over time as the company's positions change,
particularly if more salient features are not added each year.
While the market shocks based on the second half of 2008 are of
unparalleled magnitude, the shocks may become less relevant over
time as the companies' trading positions change. In addition, more
recent events could highlight the companies' vulnerability to
certain market events. For example, in 2011, Eurozone credit spreads
in the sovereign and financial sectors surpassed those observed
during the second half of 2008, necessitating the modification of
the stress scenario for the CCAR 2012 to reflect a salient source of
stress to trading positions. As a result, it is important to
incorporate both historical and hypothetical outcomes in market
shocks for the severely adverse scenario. For the time being, the
development of market shocks in the severely adverse scenario will
begin with the risk factor movements in the particular historical
period, such as the second half of 2008. The Board will then
consider hypothetical but plausible outcomes, based on financial
stability reports, supervisory information, and internal and
external assessments of market risks and potential flash points. The
hypothetical outcomes could originate from major geopolitical,
economic, or financial market events with potentially significant
impacts on market risk factors. The severity of these hypothetical
moves will likely be guided by similar historical events,
assumptions embedded in the companies' internal stress tests or
market participants, and other available information.
For the time being, the development of market shocks in the
severely adverse scenario will begin with the risk factor movements
in the particular historical period, such as the second half of
2008. The Board will then develop hypothetical but plausible
scenarios, based on financial stability reports, supervisory
information, and internal and external assessments of market risks
and potential flash points. Once broad market scenarios are agreed
upon, specific risk factor groups will be targeted as the source of
the trading stress. For example, a scenario involving the failure of
a large, interconnected globally active financial institution could
begin with a sharp increase in credit default swaps spreads and a
precipitous decline in asset prices across multiple markets, as
investors become more risk averse and market liquidity evaporates.
[[Page 70134]]
These broad market movements would be extrapolated to the granular
level for all risk factors by examining transmission channels and
the historical relationships between variables, though in some
cases, the movement in particular risk factors may be amplified
based on theoretical relationships, market observations, or the
saliency to company trading books. If there is a disagreement
between the risk factor movements in the historical event used in
the scenario and the hypothetical event, the Board will reconcile
the differences by assessing consistency with the macro scenario, a
priori expectation based on financial and economic theory, and the
importance of the risk factors to the trading positions of the
covered companies.
5.3 Approach for Formulating the Scenario for Trading Variables Under
the Adverse Scenario
The market shock component included in the adverse scenario will
be designed to be generally less severe than the severely adverse
scenario while providing useful information to supervisors. As in
the case of the macro scenario, the market shock component in the
adverse scenario can be developed in a number of different ways.
The adverse scenario could be differentiated from the severely
adverse scenario by the absolute size of the shock, the scenario
design process (e.g., historical events versus hypothetical events),
or some other criteria. As discussed above, due to differences in
companies' trading positions, it can be difficult to know ex ante
whether the adverse scenario or severely adverse scenario would
result in greater losses for a given company. However, the Board
anticipates that the adverse scenario would generally result in
lower aggregate trading losses than the severely adverse scenario,
particularly given the importance of credit-related losses. The
Board expects that as the market shock component of the adverse
scenario may differ qualitatively from the market shock component of
the severely adverse scenario, the results of adverse scenarios may
be useful in identifying a particularly vulnerable area in a trading
company's positions.
There are several possibilities for the adverse scenario and the
Board may use a different approach each year to better explore the
vulnerabilities of companies with significant trading activity. One
approach is to use a scenario based on some combination of
historical events. This approach is similar to the one used for 2012
CCAR, where the market shock component was largely based on the
second half of 2008, but also included a number of risk factor
shocks that reflected the significant widening of spreads for
European sovereigns and financials in late 2011. This approach would
provide some consistency each year and provide an internally
consistent scenario with minimal implementation burden. Having a
relatively consistent adverse scenario may be useful as it
potentially serves as a benchmark against the results of the
severely adverse scenario and can be compared to past stress tests.
Another approach is to have an adverse scenario that is
identical to the severely adverse scenario, except that the shocks
are smaller in magnitude (e.g., 100 basis points for adverse versus
200 basis points for severely adverse). This ``scaling approach''
generally fits well with an intuitive interpretation of ``adverse''
and ``severely adverse.'' Moreover, since the nature of the moves
will be identical between the two classes of scenarios, there will
be at least directional consistency in the risk factor inputs
between scenarios. While under this approach the adverse scenario
would be superficially identical to the severely adverse, the logic
underlying the severely adverse scenario may not be applicable. For
example, if the severely adverse scenario was based on a historical
scenario, the same could not be said of the adverse scenario. It is
also remains possible, although unlikely, that a scaled adverse
scenario actually would result in greater losses, for some
companies, than the severely adverse scenario with similar moves of
greater magnitude. For example, if some companies are hedging
against tail outcomes then the more extreme trading book dollar
losses may not correspond to the most extreme market moves.
Alternatively, the market shock component of an adverse scenario
could differ substantially from the severely adverse scenario with
respect to the sizes and nature of the shocks. Under this approach,
the market shock component could be constructed using some
combination of historical and hypothetical events, similar to the
severely adverse scenario. As a result, the market shock component
of the adverse scenario could be viewed more as an alternative to
the severely adverse scenario and, therefore, it is possible that
the adverse scenario could have larger losses for some companies
than the severely adverse scenario. However, this approach would
provide valuable information to supervisors, by focusing on
different facets of potential vulnerabilities.
Finally, the design of the adverse scenario for annual stress
tests could be informed by the companies' own market shock
components used for their mid-cycle company-run stress tests.\39\
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\39\ 12 CFR 252.145.
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6. Consistency Between the Economic and Financial Variable Scenarios
and the Market Price and Rate Shock Scenarios
As discussed earlier, the market shock comprises a set of
movements in a very large number of risk factors that are realized
instantaneously. Among the risk factors specified in the market
shock are several variables also specified in the macro scenarios,
such as short- and long-maturity interest rates on Treasury and
corporate debt, the level and volatility of U.S. stock prices, and
exchange rates.
Generally, the market shock scenario will be directionally
consistent with the macro scenario, though the magnitude of moves in
broad risk factors, such as interest rates, foreign exchange rates,
and prices, may differ. Because the market shock is designed, in
part, to mimic the effects of a sudden market dislocation, while the
macro scenarios are designed to provide a description of the
evolution of the real economy over two or more years, assumed
economic conditions can move in significantly different ways.
However, such differences should not be viewed as inconsistency in
scenarios as long as the macro scenario and the market shock
component of the scenario are directionally consistent. In effect,
the market shock can simulate a market panic, during which financial
asset prices move rapidly in unexpected directions, and the
macroeconomic assumptions can simulate the severe recession that
follows. Indeed, the pattern of a financial crisis, characterized by
a short period of wild swings in asset prices followed by a
prolonged period of moribund activity, and a subsequent severe
recession is familiar and plausible.
As discussed in section 4.2.4, the Board may feature a
particularly salient risk in the macroeconomic assumptions for the
severely adverse scenario, such as a fall in an elevated asset
price. In such instances, the Board would also seek to reflect the
same risk in one of the market shocks. For example, if the macro
scenario were to feature a substantial decline in house price, it
would seem plausible for the market shock to also feature a
significant decline in market values of any securities that are
closely tied to the housing sector or residential mortgages.
In addition, as discussed in section 4.3, the Board may specify
the macroeconomic assumptions in the adverse scenario in such a way
as to explore risks qualitatively different from those in the
severely adverse scenario. Depending on the nature and type of such
risks, the Board may also seek to reflect these risks in one of the
market shocks as appropriate.
7. Timeline for Scenario Publication
The Board will provide a description of the macro scenarios by
no later than November 15 of each year. During the period
immediately preceding the publication of the scenarios, the Board
will collect and consider information from academics, professional
forecasters, international organizations, domestic and foreign
supervisors, and other private-sector analysts that regularly
conduct stress tests based on U.S. and global economic and financial
scenarios, including analysts at the covered companies. In addition,
the Board will consult with the FDIC and the OCC on the salient
risks to be considered in the scenarios. The Board expects to
conduct this process in July and August of each year and to update
the scenarios based on incoming macroeconomic data releases and
other information through the end of October.
Currently, the Board does not plan to publish the details of the
market shock component. The Board expects to provide a broad
overview of the market shock component.
[[Page 70135]]
Table 1--Classification of U.S. Recessions
--------------------------------------------------------------------------------------------------------------------------------------------------------
Total change in
Change in the the
Decline in unemployment unemployment
Peak Trough Severity Duration (quarters) real GDP rate during the rate (incl.
recession after the
recession)
--------------------------------------------------------------------------------------------------------------------------------------------------------
1957Q3............................. 1958Q2............... Severe............... 4 (Medium)........... -3.1 3.2 3.2
1960Q2............................. 1961Q1............... Typical.............. 4 (Medium)........... -0.5 1.6 1.8
1969Q4............................. 1970Q4............... Typical.............. 5 (Medium)........... -0.1 2.2 2.4
1973Q4............................. 1975Q1............... Severe............... 6 (Long)............. -3.1 3.4 4.1
1980Q1............................. 1980Q3............... Typical.............. 3 (Short)............ -2.2 1.4 1.4
1981Q3............................. 1982Q4............... Severe............... 6 (Long)............. -2.6 3.3 3.3
1990Q3............................. 1991Q1............... Mild................. 3 (Short)............ -1.3 0.9 1.9
2001Q1............................. 2001Q4............... Mild................. 4 (Medium)........... 0.7 1.3 2.0
2007Q4............................. 2009Q2............... Severe............... 7 (Long)............. [-4.7] 4.5 5.1
Average............................ ..................... Severe............... 6.................... -3.8 3.7 3.9
Average............................ ..................... Moderate............. 4.................... -1.0 1.8 1.8
Average............................ ..................... Mild................. 3.................... -0.3 1.1 1.9
--------------------------------------------------------------------------------------------------------------------------------------------------------
By order of the Board of Governors of the Federal Reserve
System, November 15, 2012.
Margaret McCloskey Shanks,
Deputy Secretary of the Board.
[FR Doc. 2012-28207 Filed 11-21-12; 8:45 am]
BILLING CODE 6210-01-P