[Federal Register Volume 78, Number 230 (Friday, November 29, 2013)]
[Rules and Regulations]
[Pages 71435-71448]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2013-27009]
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Rules and Regulations
Federal Register
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Federal Register / Vol. 78, No. 230 / Friday, November 29, 2013 /
Rules and Regulations
[[Page 71435]]
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: Final rule; policy statement.
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SUMMARY: The Board is adopting a final policy statement on the approach
to scenario design for stress testing that will 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: This rule will be effective on January 1, 2014.
FOR FURTHER INFORMATION CONTACT: Tim Clark, Senior Associate Director,
(202) 452-5264, Lisa Ryu, Deputy Associate Director, (202) 263-4833,
David Palmer, Senior Supervisory Financial Analyst, (202) 452-2904, or
Joseph Cox, Financial Analyst, (202) 452-3216, Division of Banking
Supervision and Regulation; Benjamin W. McDonough, Senior Counsel,
(202) 452-2036, or Jeremy Kress, Attorney, (202) 872-7589, Legal
Division; or Andreas Lehnert, Deputy Director, (202) 452-3325, or
Rochelle Edge, Assistant Director, (202) 452-2339, Office of Financial
Stability Policy and Research.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Background
II. Proposed Policy Statement
III. Summary of Comments
A. Design of Stress Test Scenarios
B. Additional Variables
C. Severely Adverse Scenario Development
D. Adverse Scenario Development
E. Market Shock and Additional Scenarios or Components of
Scenarios
F. Transparency and Timing
G. Public Disclosure
IV. 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
financial company measure the sufficiency of capital available to
support the financial company'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 financial company'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, building on its experience during the financial
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 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 financial companies for
measuring capital needs and for managing and allocating capital
resources.
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. This procedure allows the Board to assess
whether the bank holding companies 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--
[[Page 71436]]
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 financial companies 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 has required large
banking organizations with significant trading activities to include
trading and counterparty components (the ``market shock,'' 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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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
financial company's business model, which would also greatly affect
projected revenue, losses, and capital.
II. Proposed Policy Statement
In order to enhance the transparency of the scenario design
process, on November 23, 2012, the Board published for public comment a
proposed policy statement (proposed policy statement) that would be
used to develop scenarios for annual supervisory and company-run stress
tests under the stress testing rules issued under the Dodd-Frank Act
and the capital plan rule.\12\ The proposed policy statement outlined
the characteristics of the supervisory stress test scenarios and
explained the considerations and procedures that underlie the
formulation of these scenarios. The considerations and procedures
described in the proposed 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).
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\12\ 77 FR 70124.
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The proposed policy statement provided a broad description of the
baseline, adverse, and severely adverse scenarios and described the
types of variables that the Board would expect to include in the
macroeconomic scenarios and in the market shock component of the stress
test scenarios applicable to companies with significant trading
activity. The proposed policy statement also described the Board's
approach to developing the macroeconomic scenarios and market shocks,
as well as the relationship between the macroeconomic scenario and the
market shock components. The Board noted that it may determine that
material modifications to the proposed policy statement are appropriate
if the supervisory stress test framework expands materially to include
additional components or other scenarios that are currently not
captured.\13\
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\13\ 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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III. Summary of Comments
The Board received seven comments on the proposed policy statement.
Commenters included financial companies, trade organizations, and
public interest groups. In general, commenters supported the proposed
policy statement and commended the Board for enhancing the transparency
of the scenario design framework. Commenters provided a number of
suggestions for improving the proposed framework, including by
incorporating additional risks into the supervisory scenarios,
providing additional scenarios and variables that would capture salient
risks to financial companies, making the scenarios more predictable,
and further enhancing the transparency of the scenario design process
and stress testing in general. In response to these comments, the Board
has modified certain aspects of the proposed policy statement,
including expanding the information included in the narrative to be
published with the macroeconomic scenarios; adding an historical-based
approach to the adverse scenario; and providing additional information
about the process for designing the path of international variables.
The Board generally has retained the overall principles underlying the
policy statement and its overall organization.
A. Design of Stress Test Scenarios
Commenters suggested a variety of ways for the Board to alter or
improve the design of stress test scenarios, including by making the
process more predictable, using a variety of stress testing approaches
to more fully capture salient risks, tailoring the scenario for nonbank
financial companies, and coordinating with the other federal banking
regulators.
Some commenters advocated for making the scenarios more predictable
by anchoring them more firmly in historical episodes or using a
probabilistic approach with a specified tail percentile for severity.
One commenter asserted that the predictability of the design framework
was diminished by the proposed policy statement noting that scenarios
would vary in relation to changes in the outlook for economic and
financial conditions and changes to specific risks or vulnerabilities.
[[Page 71437]]
The Board believes it is important that scenario development remain
flexible in order to ensure that the stress tests have the ability to
capture emerging risks or elevated systemic risk. Some commenters noted
that it was important for supervisors to retain sufficient discretion
in order to prevent the scenario from becoming stale or irrelevant. For
these reasons, the final policy statement outlines the general range of
scenarios that may be implemented, as well as their overall severity,
but the Board retains the flexibility to incorporate developing risks
and vary the scenario in response to the Board's views regarding the
level of systemic and other risks.
One commenter advocated the use of a variety of approaches to
scenario development, including using sensitivity analysis and
recommended changing the correlations and dependencies between risk
factors given that the relationships between risk factors observed in
normal times may not apply during stressful conditions.
The final policy statement allows for a variety of approaches to
scenario development and for flexibility in changing correlations and
dependencies between risk factors. For example, the final policy
statement allows for the adverse scenario to follow either a recession
approach, a probabilistic approach, or an approach based on historical
experiences, with the possibility of including additional risks that
the Board believes should be understood and monitored. Further, the
final policy statement allows the Board to augment the severely adverse
scenario to reflect salient risks that would not be captured under the
recession approach that is used to develop the severely adverse
scenario. Augmenting the severely adverse scenario to include salient
risks and the possibility of including additional risks in the adverse
scenario allows for correlations and dependencies between risk factors
to be further altered to capture specific stressful outcomes that are
identified by economists, bank supervisors, and financial market
experts as representing particularly relevant risks.
One commenter urged the Board to account in its scenario design
framework for unique risks faced by nonbank financial companies
supervised by the Board. The commenter asserted that the scenarios for
nonbank financial companies should de-emphasize shocks arising from
traditional banking activities, as such risks would be less salient for
nonbank financial companies. The Board expects to take into account
differences among bank holding companies and nonbank covered companies
supervised by the Board when applying the stress testing
requirements.\14\ As the nonbank financial companies implement the
stress testing requirements, the Board may tailor the application for
those companies, including by updating its framework for developing
supervisory scenarios. The Board will continue to consult with other
supervisory authorities, including the Federal Insurance Office, as
appropriate.
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\14\ To date, the Financial Stability Oversight Council has
designated three nonbank financial companies for supervision by the
Board: General Electric Capital Corporation, American International
Group, Inc., and Prudential Financial Inc. These companies will be
subject to the Board's stress testing rules beginning with the
stress cycle that commences in the calendar year after the year in
which the company first becomes subject to the Board's minimum
regulatory capital requirements, unless the Board accelerates or
extends the compliance date.
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Finally, some commenters stressed the importance of coordination
between the Board, the Federal Deposit Insurance Corporation (FDIC),
and the Office of the Comptroller of the Currency (OCC) in developing a
common scenario in order to prevent the stress testing process from
becoming overly complex and burdensome. In addition, commenters
suggested that different scenarios from each agency would make the
public disclosure of company-run stress test results more difficult to
interpret. As noted previously in the stress test rules and in the
proposed policy statement, the Board plans to develop scenarios each
year in close consultation with the primary federal financial
regulatory agencies. The Board, FDIC, and OCC followed this approach
both in 2012 and 2013. This coordinated approach allows a common set of
scenarios to be used for the annual company-run stress tests across
various banking entities within the same organizational structure. The
Board plans to continue to develop the annual set of scenarios in
consultation with the OCC and the FDIC to reduce the burden that could
arise from having the agencies establish inconsistent scenarios.
B. Additional Variables
Several commenters supported adding additional variables to the
supervisory scenarios. A few commenters noted that it would be helpful
for the Board to provide companies with a broader suite of variables.
In particular, one company noted that in order to run its stress tests
under the supervisory scenarios, it had to forecast hundreds of
additional variables. One commenter noted that requiring companies to
project the paths of additional variables could create inconsistency
between the scenarios that companies use in their stress tests,
reducing the industry-wide comparability of the exercise.
Several commenters requested specific variables, including
additional country-specific international variables. Commenters
requested that the Board include variables on more countries and more
scenario variables for each country, including information on
unemployment rates, equity market indexes, and home values. One
commenter provided tables of suggested variables that many companies
use for their own internal processes. Finally, one commenter urged the
Board to provide all the factors used in its own models in the
supervisory stress test to improve macroprudential supervision and
increase the consistency of scenario assumptions and the comparability
of results across companies.
In defining the supervisory scenarios, the Board expects to provide
the variables the Board considers to be the most important descriptors
of the scenarios' economic and financial conditions. However, in
response to comments, the Board will provide a narrative with the
supervisory scenarios each year to aid companies in projecting other
variables based on the variables provided in the scenarios. The
narrative will include descriptions of the paths of many additional
variables companies may need to project for their company-run stress
tests. The Board may add additional variables to the scenarios in the
future if the Board determines that the variables provide additional
information about the conditions in the scenarios that cannot be
inferred from the other variables in the supervisory scenarios. For
example, this year the Board plans to provide two additional interest
rate variables, the yield on 5-year Treasury bonds and the prime rate,
that were specifically requested by one commenter. However, large and
complex financial companies should be able to identify their key risks
and relate them to the external environment by translating the
supervisory scenario into additional variables.
Several commenters suggested that the variables from the market
shock component of the adverse and severely adverse scenarios should be
provided to all companies subject to stress tests. One industry
commenter requested that the market shock to be released to all
companies at the same time as the macroeconomic scenario so the
companies can use variables from the market shock in their company-run
stress tests.
[[Page 71438]]
In order to enhance the transparency of the supervisory and
company-run stress tests, the Board expects to publish the market shock
component annually.\15\ However, only companies with significant
trading activity, as determined by the Board and specified in the
Capital Assessments and Stress Testing report (FR Y-14) (trading
companies) are subject to the market shock component.\16\ Companies
that are not subject to the market shock should not incorporate the
market shock component into their stress tests or complete the
Securities AFS Market Shock tab on the FR Y-14A Summary Schedule.
Moreover, unlike the scenarios, the market shock is not a time series
but rather is assumed to be an instantaneous event. Companies should
not assume that the risk factor moves in the market shock are
appropriate for inclusion in their stress tests as a complement to the
macroeconomic scenarios.
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\15\ On March 7, 2013 the Board published the market shock
components of the supervisory adverse and severely adverse scenarios
that were used for the stress test cycle commencing on November 15,
2012. The severely adverse market shock is available online at:
http://www.federalreserve.gov/bankinforeg/accessible-2013-ccar-severely-adverse-market-shocks.htm.
\16\ Consistent with the instructions to the FR Y-14A, bank
holding companies with greater than $500 billion in total
consolidated assets that are subject to the amended market risk rule
are considered to have significant trading activity.
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C. Severely Adverse Scenario Development
Several commenters provided feedback on the proposed approach for
developing the severely adverse scenario. Some commenters suggested
alternative frameworks that would limit the variability in the severity
of the scenario. An industry participant suggested that the Board
should avoid volatility in scenario severity based on the economic
conditions at the starting point of the exercise, as variation in the
scenario severity would cause stress losses and capital requirements to
vary considerably. Another commenter supported the historical approach
to designing the severely adverse scenario, asserting that it would
constrain the scenario to a plausible range and make the scenario more
predictable.
One commenter expressed a preference for the probabilistic approach
and advocated for a consistent probabilistic severity (i.e., the same
tail percentile) with idiosyncratic differences in risk factor
movements to reflect existing and emerging concerns. The commenter
acknowledged the drawbacks that the Board identified with the
probabilistic approach but suggested that these problems could be
overcome with rigor in calibration and supervisory discretion in
picking variables and paths of variables. Finally, the commenter
suggested that the supervisory judgment required to use the
probabilistic approach will ensure a proactive and prudential
supervisory scenario design process.
As noted in the proposed policy statement, the Board intends to
offset natural procyclical tendencies in its scenario design framework
by using an approach that ensures the scenarios reach a minimum
severity level. The Board believes that setting a floor for the
severity of the scenario is appropriate in light of cyclical systemic
risks that build up at financial intermediaries during robust
expansions that may be obscured by the strength of the overall
environment. The Board also believes that varying the scenario severity
in response to systemic risks is aligned with the goals of scenario
design and stress testing. As such, the Board believes varying the
severity of the severely adverse scenario based on current
macroeconomic conditions--in the same manner as described in the
proposed policy statement--better meets the goals of scenario design
and stress testing than alternative methods of specifying the severity
of the supervisory scenarios.
D. Adverse Scenario Development
One commenter suggested that the process for designing the adverse
scenario should be constrained, perhaps by historical experience, so
that the scenario does not change drastically from year to year. The
commenter noted that an exception could be granted for cases where the
Board has identified material emerging risks not captured in adverse
historical precedents. The commenter suggested that the Board select
from a menu of historical macroeconomic events or derive the paths of
adverse scenario variables from a combination of the historical events,
which would allow the adverse scenario variables to fluctuate within a
more predictable range.
The Board does not believe that predictability of the scenarios
from year to year should be the overriding factor determining the
specification of the adverse scenario. Other factors are also important
in determining the specification of the adverse scenario, including,
but not limited to, improved understanding of relevant risks to the
banking industry (that may not captured in the severely adverse
scenario), nonlinearities in the effect of macroeconomic conditions on
the companies' financial condition, and risks identified by the
companies in their living wills or in the company-developed scenarios
for the CCAR or mid-cycle company-run stress tests.
The Board believes that adverse scenarios based on historical
experiences represent important stresses to financial companies and has
added this approach to the list of possible approaches used to
formulate the adverse scenario. However, the Board believes that there
are notable benefits from formulating the adverse scenario following
other approaches. Varying the approach the Board uses for the adverse
scenario each year--by incorporating specific risks or by using the
probabilistic approach, for instance--permits flexibility so that the
results of the scenario provide the most value to supervisors, in light
of current economic conditions. Consequently, the adverse scenario
design framework in the final policy statement contains a range of
options and is not limited only to historical episodes.
E. Market Shock and Additional Scenarios or Components of Scenarios
The Board did not receive comments on its proposed framework for
designing the market shock scenario component. However, several
commenters advocated for the inclusion of additional scenarios and
components of scenarios in the stress tests. One commenter urged the
Board to include operational risk because, in the commenter's view,
operational risk failures can allow for the accretion of credit and
market risk. Another commenter focused on the need for a supervisory
scenario that included liquidity risk, even in a capital stress test.
The commenter noted that short-term funding risk was a major
contributor to the financial crisis due to the interrelationship
between capital and liquidity. The commenter advocated for supervisory
scenarios that take into account the potential for asset shocks that
reduce capital to also cause a company to lose access to certain
funding markets. Finally, one commenter suggested that the Board
incorporate all possible risks in a single scenario or combine separate
stress testing exercises appropriately to create a comprehensive and
coherent stress test.
While operational risk and funding risk are material risks to some
financial companies, no single stress test can incorporate all risks
that affect a financial company. Companies should supplement stress
tests conducted pursuant to the Dodd-Frank Act and capital plan rule
with other stress tests and other risk measurement tools. For
[[Page 71439]]
example, as part of its supervisory process, the Board evaluates
liquidity risk, including through stress testing, and the Board has
proposed a rule that would require large bank holding companies and
nonbank financial companies supervised by the Board to conduct
liquidity stress tests.\17\ Companies should conduct additional stress
testing, as needed, to ensure that all risks and vulnerabilities,
including funding and operational risk, are addressed--as described in
the stress testing guidance issued by the agencies in May 2012.\18\ If
the Board requires companies to apply additional scenarios or
components of scenarios on a regular basis--including for operational
risk or the relationship between liquidity and capital risk--then the
Board may update the final policy statement to include the process for
designing those scenarios or components of scenarios.
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\17\ See Notice of Proposed Rulemaking on Enhanced Prudential
Standards and Early Remediation Requirements for Covered Companies,
(January 5, 2012) (77 FR 594).
\18\ See Supervisory Guidance on Stress Testing for Banking
Organizations With More Than $10 Billion in Total Consolidated
Assets, (May 17, 2012) (codified at 77 FR 29458).
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F. Transparency and Timing
The Board received several comments on enhancing the transparency
of the scenario design process, improving communication about the
scenarios, and on the timing of when the scenarios are provided to the
companies. Several commenters requested additional information about
how the Board develops the scenarios or specific aspects of the
scenarios. For instance, some commenters requested additional
clarification on the process and assumptions for developing the
international variables in the macroeconomic scenarios. In response to
these comments, the final policy statement contains additional
information on how the Board develops the scenarios. Section 4.2.3 of
the final policy statement includes a description of the process and
assumptions for developing the paths of international variables in the
supervisory scenarios.
Some commenters requested that the Board include additional
narrative information in its scenario release. One commenter requested
the Board provide more description around the adverse and severely
adverse scenarios, especially in cases where the scenarios do not
derive from observable historical events, to aid companies in
developing a deeper understanding of the economic situation that the
data describes and the relationships between and among variables. The
commenter suggested that without a fuller narrative it is difficult for
companies to project additional variables in a manner that is
consistent with the scenario, leading to inconsistent assumptions and
variables across companies. More narrative information on the
international variables was specifically requested, including
information on whether the international scenarios are intended to
reflect global conditions or whether they are designed to reflect
idiosyncratic stresses at the country level.
Each year, to accompany the release of its supervisory scenarios,
the Board has published a brief narrative summary of the macroeconomic
scenarios. This narrative describes the supervisory scenarios and
explains how they have changed relative to the previous year. In
response to comments, the Board will also provide in the narrative a
description of the economic situation underlying the scenario,
including for the international environment in the scenarios.
In addition, to assist companies in projecting the paths of
additional variables in a manner consistent with the scenario, the
narrative accompanying the supervisory scenarios will also provide
descriptions of the general path of some additional variables. These
descriptions will be general--that is, they will describe developments
for broad classes of variables rather than for specific variables--and
will specify the intensity and direction of variable changes but not
numeric magnitudes. These descriptions should provide guidance that
will be useful to companies in specifying the paths of the additional
variables for their company-run stress tests. In practice, it will not
be possible for the narrative to include descriptions on all of the
additional variables that companies may need to for their company-run
stress tests.
One commenter requested that the Board communicate, in advance of
the scenario release, any additional risks or vulnerabilities that
would cause the scenario to vary due to changes in the outlook for
economic and financial conditions. The Board expects that if a scenario
varies in response to additional risks or vulnerabilities identified by
the Board, then those risks and vulnerabilities would be communicated
through the narrative that accompanies the supervisory scenarios.
Several commenters addressed the timeline for supervisory scenario
development. A few commenters requested that the Board provide the
supervisory scenarios to the companies earlier in order to provide
adequate time for companies to evaluate the scenarios, develop
additional required variables, and initiate the stress testing and
capital planning processes. One commenter noted that providing the
supervisory scenarios two weeks before November 15 would extend the
time to companies have to conduct stress tests by 25 to 30 percent.
Another commenter felt the current timetable is extremely aggressive
and precludes companies from performing more comprehensive due
diligence. One commenter acknowledged the concern that a scenario may
become dated if it is released too early, but the commenter asserted
that this concern is mitigated because only five quarters of the
planning horizon will elapse before there is another annual stress test
and capital planning exercise.
The Board recognizes the importance of providing covered companies
adequate time to implement the company-run stress tests. The Board
intends to release the scenarios as soon as it is possible to
incorporate the relevant data on economic and financial conditions as
of the end of the third quarter, but no later than November 15 of each
year.
One commenter requested that the market shock and the macroeconomic
scenarios be released concurrently. The commenter asserted that delays
in processing the effect of the scenarios on capital markets positions
affects all other processes downstream in the stress tests, including
calculation of the company's capital position.
Because the market shock component is an instantaneous shock
layered onto the stress test conducted under the macroeconomic
scenario, it should not affect most other aspects of a company's stress
test. However, in recognition of companies' constraints in conducting
the company-run stress tests, the Board will seek to release the market
shock before the deadline of December 1 of each year.
The Board has sought to improve the transparency around its stress
testing practices, for example by releasing the stress scenarios with
an accompanying narrative in advance of the stress test, publicly
disclosing a detailed description of the framework and methodology
employed in its supervisory stress test, and publishing for comment
this policy statement on its framework for scenario design. In the
future, the Board will continue to look for opportunities to provide
additional transparency around its stress testing processes, while
balancing the need to not reduce the incentives for companies to
develop better internal stress test models that factor in their
idiosyncratic risks and to consider the results of such
[[Page 71440]]
models in their capital planning process.
G. Public Disclosure
One commenter requested a broader disclosure of the methods and
data that are used in stress tests to enhance the public's
understanding of the process and results. The commenter recommended
disclosure of the specification, statistical fit, and out-of-sample
forecasting properties of the risk models used in stress testing. As
noted previously, the Board has sought to improve the transparency of
its supervisory stress testing methodologies and practices, and has
required companies subject to Dodd-Frank Act stress tests to publicly
disclose some information about their company-run stress tests. The
Board expects to revisit the scope of stress testing disclosure from
time to time.
Another commenter suggested that public disclosure of the results
of stress tests conducted by nonbank financial companies may not
provide the marketplace with useful information concerning a company's
overall risk profile or response to stressed conditions. The Board
notes that section 165(i) of the Dodd-Frank Act requires the
publication of a summary of the results of supervisory and company-run
stress tests of each company, including nonbank financial companies.
Moreover, the Board believes that public disclosure is a key component
of stress testing that helps to provide valuable information to market
participants, enhance transparency, and promote market discipline.
As noted above, the final policy statement will be effective on
January 1, 2014. The scenarios for the stress test cycle that commenced
on October 1, 2013, which the Board recently published, were designed
in a manner generally consistent with the final policy statement. The
final policy statement will be effective for supervisory scenarios that
govern the resubmission of any stress tests for the cycle that
commenced on October 1, 2013, as the Board may require.
IV. 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 invited comment on whether the proposed
policy statement was written plainly and clearly, or whether there were
ways the Board could make the rule easier to understand. The Board
received no comment on these matters and believes that the final policy
statement is written plainly and clearly.
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 policy statement
to assess any information collections. There are no collections of
information as defined by the Paperwork Reduction Act in this policy
statement.
C. Regulatory Flexibility Act Analysis
In accordance with the Regulatory Flexibility Act, 5 U.S.C. 601 et
seq. (``RFA''), the Board is publishing a final regulatory flexibility
analysis for this policy statement. Based on its analysis and for the
reasons stated below, the Board believes that the policy statement will
not have a significant economic impact on a substantial number of small
entities. Nevertheless, the Board is publishing a regulatory
flexibility analysis.
The Board is adopting a policy statement on the approach to
scenario design for stress testing that will be used in connection with
the supervisory and company-run stress tests conducted under the
Board's Regulation YY (12 CFR part 252, subparts F, G, and H) pursuant
to the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-
Frank Act or Act) and the Board's capital plan rule (12 CFR 225.8). To
enhance the transparency of the scenario design process, the policy
statement outlines the characteristics of the supervisory stress test
scenarios and explains the considerations and procedures that underlie
the formulation of these scenarios.
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 $35 million or
less to $500 million or less.\19\ As discussed in the Supplementary
Information, the policy statement generally would affect the scenario
design framework used in regulations that apply to bank holding
companies with $10 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 policy statement therefore substantially exceed the $500 million
total asset threshold at which a company is considered a ``small
entity'' under SBA regulations.
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\19\ 13 CFR 121.201.
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The 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.\20\ It is therefore unlikely that a financial firm that
is at or below the $500 million asset threshold would be designated by
the Council under section 113 of the Dodd-Frank Act because material
financial distress at such companies, or the nature, scope, size,
scale, concentration, interconnectedness, or mix of it activities, is
not likely to pose a threat to the financial stability of the United
States.
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\20\ See 76 FR 4555 (January 26, 2011).
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Because the final policy statement is not likely to apply to any
company with assets of $500 million or less, it is not expected to
affect any small entity for purposes of the RFA. The Board does not
believe that the policy statement duplicates, overlaps, or conflicts
with any other Federal rules. The policy statement is unlikely to
impose any new recordkeeping, reporting, or other compliance
requirements or otherwise affect a small banking entity. In light of
the foregoing, the Board does not believe that the policy statement
will have a significant economic impact on a substantial number of
small entities.
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 amends 12 CFR chapter II as
follows:
PART 252--ENHANCED PRUDENTIAL STANDARDS (REGULATION YY)
0
1. The authority citation for part 252 continues to read as follows:
Authority: 12 U.S.C. 321-338a, 1467a(g), 1818, 1831p-1,
1844(b), 1844(c), 5361, 5365, 5366.
[[Page 71441]]
0
2. Appendix A to part 252 is added to read as follows:
Appendix A to Part 252--Policy Statement on the Scenario Design
Framework for Stress Testing
1. Background
a. The Board has imposed stress testing requirements through its
regulations (stress test rules) implementing section 165(i) of the
Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-
Frank Act or Act) and through its capital plan rule (12 CFR 225.8).
Under the stress test rules issued under section 165(i)(1) of the
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).\21\ 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).\22\ 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
(macroeconomic scenarios).\23\
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\21\ 12 U.S.C. 5365(i)(1); 12 CFR part 252, subpart F.
\22\ 12 U.S.C. 5365(i)(2); 12 CFR part 252, subparts G and H.
\23\ 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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b. The stress test rules provide that the Board will notify
covered companies by no later than November 15 of each year of the
scenarios it will use to conduct its annual supervisory stress tests
and provide, also by no later than November 15, covered companies
and other financial companies subject to the final rules the set of
scenarios they must use to conduct their annual company-run stress
tests.\24\ 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.\25\ For example,
the Board expects to require large banking organizations with
significant trading activities to include a trading and counterparty
component (market shock, 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.\26\ 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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\24\ 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.
\25\ 12 CFR 252.144(b), 154(b).
\26\ Id.
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c. In addition, Sec. 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.\27\
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\27\ See Capital plans, 76 FR 74631 (Dec. 1, 2011) (codified at
12 CFR 225.8).
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d. Stress tests required under the stress test rules and under
the capital plan rule require the Board and financial companies 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 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 companies eroded rapidly in the face
of changes in the current and expected economic and financial
conditions, and this loss in market confidence imperiled companies'
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.
e. 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 companies' 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 companies' trading and counterparty positions--and
not on other types of risk, such as liquidity risk. Pressures
stemming from these sources are considered in separate supervisory
exercises. No single supervisory tool, including the stress tests,
can provide an assessment of a company's ability to withstand every
potential source of risk.
f. 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, however; 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
a. 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).\28\
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\28\ 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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b. 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.
c. 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 macroeconomic
scenarios and the market shock component of the stress test
scenarios applicable to companies with significant trading activity.
Section 4 describes the Board's approach for developing the
macroeconomic scenarios, and section 5 describes the approach for
the market shocks. Section 6 describes the relationship between the
macroeconomic scenario and the market shock components. Section 7
provides a timeline for the formulation and publication of the
[[Page 71442]]
macroeconomic assumptions and market shocks.
3. Content of the Stress Test Scenarios
a. 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.\29\ 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.
---------------------------------------------------------------------------
\29\ 12 CFR 252.134(b), 12 CFR 252.144(b), 12 CFR 252.154(b).
---------------------------------------------------------------------------
b. 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.
c. Early in each stress testing cycle, the Board plans to
publish the macroeconomic scenarios along with a brief narrative
summary that provides a description of the economic situation
underlying the scenario and explains how the scenarios have changed
relative to the previous year. In addition, to assist companies in
projecting the paths of additional variables in a manner consistent
with the scenario, the narrative will also provide descriptions of
the general path of some additional variables. These descriptions
will be general--that is, they will describe developments for broad
classes of variables rather than for specific variables--and will
specify the intensity and direction of variable changes but not
numeric magnitudes. These descriptions should provide guidance that
will be useful to companies in specifying the paths of the
additional variables for their company-run stress tests. Note that
in practice it will not be possible for the narrative to include
descriptions on all of the additional variables that companies may
need to for their company-run stress tests. In cases where scenarios
are designed to reflect particular risks and vulnerabilities, the
narrative will also explain the underlying motivation for these
features of the scenario. The Board also plans to release a broad
description of the market shock components.
3.1 Macroeconomic Scenarios
a. The macroeconomic scenarios will consist of the future paths
of a set of economic and financial variables.\30\ The economic and
financial variables included in the scenarios will likely comprise
those included in the ``2014 Supervisory Scenarios for Annual Stress
Tests Required under the Dodd-Frank Act Stress Testing Rules and the
Capital Plan Rule'' (2013 supervisory scenarios). The domestic U.S.
variables provided for in the 2013 supervisory scenarios included:
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\30\ 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.
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i. Six 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, real
and nominal disposable personal income growth, and the Consumer
Price Index (CPI) inflation rate;
ii. 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
iii. Six measures of interest rates: the rate on the three-month
Treasury bill, the yield on the 5-year Treasury bond, the yield on
the 10-year Treasury bond, the yield on a 10-year BBB corporate
security, the prime rate, and the interest rate associated with a
conforming, conventional, fixed-rate, 30-year mortgage.
b. The international variables provided for in the 2014
supervisory scenarios included, for the euro area, the United
Kingdom, developing Asia, and Japan:
i. Percent change in real GDP;
ii. Percent change in the Consumer Price Index or local
equivalent; and
iii. The U.S./foreign currency exchange rate.\31\
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\31\ The Board may increase the range of countries or regions
included in future scenarios, as appropriate.
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c. The economic variables included in the scenarios influence
key items affecting financial companies' 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
companies' net income and, thus, capital positions.
d. 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 companies' 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.
e. 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. 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
variables, 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 variables and their aggregate, macro-economic
counterparts. The Board will provide the macroeconomic 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.
3.2 Market Shock Component
a. The market shock component of the adverse and severely
adverse scenarios will only apply to companies with significant
trading activity and their subsidiaries.\32\ The component consists
of large moves in market prices and rates that would be expected to
generate losses. Market shocks differ from macroeconomic 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
[[Page 71443]]
described in section 4, the market shock includes a much larger set
of risk factors than the set of economic and financial variables
included in macroeconomic 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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\32\ 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 financial company's trading activities
evolve.
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b. 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. Examples of risk factors include, but are not
limited to:
i. 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;
ii. Cross-currency FX rates of all major and many minor
currencies, along term structures of implied volatilities;
iii. 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 companies may have
exposure;
iv. Term structures of implied volatilities that are key inputs
to the pricing of interest rate derivatives;
v. Term structures of futures prices for energy products
including crude oil (differentiated by country of origin), natural
gas, and power;
vi. Term structures of futures prices for metals and
agricultural commodities;
vii. ``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
viii. Shocks to the values of private equity positions.
4. Approach for Formulating the Macroeconomic Assumptions for Scenarios
a. 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.
b. 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.
c. 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
a. 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.
b. 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.
c. 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 financial company and that overall are more severe
than those associated with the adverse scenario. The financial
company 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 financial company under the adverse scenario and the severely
adverse scenario.
4.2.1 General Approach: The Recession Approach
a. 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.
b. 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.\33\ 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
[[Page 71444]]
severity by the absolute level of and relative increase in the
unemployment rate.\34\
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\33\ More recently, a monthly measure of GDP has been added to
the list of indicators.
\34\ 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[frac34] percent and the unemployment rate moving up a
total of about 4 percentage points.
---------------------------------------------------------------------------
c. 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).
d. 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
a. 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.\35\ 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.
---------------------------------------------------------------------------
\35\ 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.
---------------------------------------------------------------------------
b. This methodology is intended to generate scenarios that
feature stressful outcomes but 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.
c. 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.
d. The Board believes that the typical increase in the
unemployment rate in the severely adverse scenario will be about 4
percentage points. However, the Board will 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.\36\ Conversely, it will 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 will 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.
---------------------------------------------------------------------------
\36\ 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.
---------------------------------------------------------------------------
e. 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.
f. In setting the increase in the unemployment rate, the Board
will 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--will
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.
g. 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 companies are
properly capitalized to withstand severe economic and financial
conditions, not to serve as an explicit countercyclical offset to
the financial system.
h. 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 will 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
a. 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
[[Page 71445]]
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.
b. 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
company'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--will be appropriate.
c. In addition, judgment is necessary in projecting the path of
a scenario's international variables. Recessions that occur
simultaneously across countries are an important source of stress to
the balance sheets of companies with notable international exposures
but are not an invariable feature of the international economy. As a
result, simply adopting the typical path of international variables
in a severe U.S. recession would likely underestimate the risks
stemming from the international economy. Consequently, an approach
like that used for projecting house prices is followed where
judgment and economic models together inform the path of
international variables.
4.2.4 Adding Salient Risks to the Severely Adverse Scenario
a. The severely adverse scenario will be developed to reflect
specific risks to the economic and financial outlook that are
especially salient but will 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.
b. There are some important instances when it will 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.
c. 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
Federal Deposit Insurance Corporation (FDIC) and the Office of the
Comptroller of the Currency (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.
d. 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.
e. The Board will factor in particular risks to the domestic and
international macroeconomic outlook identified by its 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.\37\
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\37\ 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.
---------------------------------------------------------------------------
4.3 Approach for Formulating Macroeconomic Assumptions in the
Adverse Scenario
a. 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.\38\ 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.
---------------------------------------------------------------------------
\38\ 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.
---------------------------------------------------------------------------
b. 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 company loss positions and incomes are
nonlinear, there could be potential value from this approach.
c. 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.
d. Under the Board's stress test rules, covered companies are
required to develop their own scenarios for mid-cycle company-run
stress tests.\39\ 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 companies
describe in their living wills as being able to cause their
failures.
---------------------------------------------------------------------------
\39\ 12 CFR 252.145.
---------------------------------------------------------------------------
e. 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.
f. The Board may consider specifying the adverse scenario using
the probabilistic approach described in section 4.2.1 (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
[[Page 71446]]
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.
g. Finally, the Board could design the adverse scenario based on
a menu of historical experiences--such as, a moderate recession
(e.g., the 1990-1991 recession); a stagflation event (e.g.,
stagflation during 1974); an emerging markets crisis (e.g., the
Asian currency crisis of 1997-1998); an oil price shock (e.g., the
shock during the run up to the 1990-1991 recession); or high
inflation shock (e.g., the inflation pressures of 1977-1979). The
Board believes these are important stresses that should be
understood; however, there may be notable benefits from formulating
the adverse scenario following other approaches--specifically, those
described previously in this section--and consequently the Board
does not believe that the adverse scenario should be limited to
historical episodes only.
h. With the exception of cases in which the probabilistic
approach is used to generate the adverse scenario, the adverse
scenario will 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 companies
that are under some stress.
5. Approach for Formulating the Market Shock Component
a. This section discusses the approach the Board proposes to
adopt for developing the market shock component of the adverse and
severely adverse scenarios appropriate for companies with
significant trading activities. The design and specification of the
market shock component differs from that of the macroeconomic
scenarios because profits and losses from 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
market shock component. The market shock 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
macroeconomic scenarios supply a projected path of economic
variables that affect traditional banking activities over the entire
planning period.
b. The development of the market shock component 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 Market Shock Component 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, the market shock 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 the
market shock component 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
a. 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 macroeconomic 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.
b. 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.
c. To enhance the consistency and comparability in market shocks
for the stress tests in 2012 and 2013, the Board provided to each
trading company more than 35,000 specific risk 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.
d. 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 macroeconomic 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.
e. 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 previous stress tests, 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 will unfold and any associated market
responses.
5.2.2 Approaches to Market Shock Design
a. As an additional component of the adverse and severely
adverse scenarios, 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 the supervisory
scenarios for 2012 and 2013, 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.
b. For the market shock component in 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 small
adjustments 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 market shock.
c. 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
[[Page 71447]]
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, the tailored approach will 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 will 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 capital rule
and the stress test rules.
5.2.3 Development of the Market Shock
a. Consistent with the approach described 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. Over time 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.
b. 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 most relevant
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.
c. 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 severely adverse market shock in 2012 and 2013 to reflect a
salient source of stress to trading positions. As a result, it is
important to incorporate both historical and hypothetical outcomes
into 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 a 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.
d. 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 swap spreads and a
precipitous decline in asset prices across multiple markets, as
investors become more risk averse and market liquidity evaporates.
These broad market movements will 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 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 Market Shock Under the Adverse
Scenario
a. The market shock component included in the adverse scenario
will feature risk factor movements that are generally less
significant than the market shock component of the severely adverse
scenario. However, the adverse market shock may also feature risk
factor shocks that are substantively different from those included
in the severely adverse scenario, in order to provide useful
information to supervisors. As in the case of the macroeconomic
scenario, the market shock component in the adverse scenario can be
developed in a number of different ways.
b. 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. 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.
c. 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 for
the market shock in 2012, 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 will 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.
d. 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
will 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 will 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. The market shock
component of the adverse scenario in 2013 was largely based on the
scaling approach where a majority of risk factor shocks were smaller
in magnitude than the severely adverse scenario, but it also
featured long-term interest rate shocks that were not part of the
severely adverse market shock.
e. 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 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.
[[Page 71448]]
f. Finally, the design of the adverse scenario for annual stress
tests could be informed by the companies' own trading scenarios used
for their BHC-designed scenarios in CCAR and in their mid-cycle
company-run stress tests.\40\
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\40\ 12 CFR 252.145.
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6. Consistency Between the Macroeconomic Scenarios and the Market Shock
a. 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 macroeconomic
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.
b. The market shock component is an add-on to the macroeconomic
scenarios that is applied to a subset of companies, with no assumed
effect on other aspects of the stress tests such as balances,
revenues, or other losses. As a result, the market shock component
may not be always directionally consistent with the macroeconomic
scenario. Because the market shock is designed, in part, to mimic
the effects of a sudden market dislocation, while the macroeconomic
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. 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.
c. 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 may also seek to reflect the
same risk in one of the market shocks. For example, if the
macroeconomic scenario were to feature a substantial decline in
house prices, it may 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.
d. 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
a. The Board will provide a description of the macroeconomic
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.
b. The Board expects to provide a broad overview of the market
shock component along with the macroeconomic scenarios. The Board
will publish the market shock templates by no later than December 1
of each year, and intends to publish the market shock earlier in the
stress test and capital plan cycles to allow companies more time to
conduct their stress tests.
Table 1--Classification of U.S. Recessions
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Total change
Change in the in the
Decline in Unemployment Unemployment
Peak Trough Severity Duration (quarters) Real GDP Rate during rate (incl.
the Recession after the
Recession)
--------------------------------------------------------------------------------------------------------------------------------------------------------
1957Q3..................... 1958Q2..................... Severe................ 4 (Medium)............ -3.6 3.2 3.2
1960Q2..................... 1961Q1..................... Moderate.............. 4 (Medium)............ -1.0 1.6 1.8
1969Q4..................... 1970Q4..................... Moderate.............. 5 (Medium)............ -0.2 2.2 2.4
1973Q4..................... 1975Q1..................... Severe................ 6 (Long).............. -3.1 3.4 4.1
1980Q1..................... 1980Q3..................... Moderate.............. 3 (Short)............. -2.2 1.4 1.4
1981Q3..................... 1982Q4..................... Severe................ 6 (Long).............. -2.8 3.3 3.3
1990Q3..................... 1991Q1..................... Mild.................. 3 (Short)............. -1.3 0.9 1.9
2001Q1..................... 2001Q4..................... Mild.................. 4 (Medium)............ 0.2 1.3 2.0
2007Q4..................... 2009Q2..................... Severe................ 7 (Long).............. -4.3 4.5 5.1
Average.................... ........................... Severe................ 6..................... -3.5 3.7 3.9
Average.................... ........................... Moderate.............. 4..................... -1.1 1.8 1.8
Average.................... ........................... Mild.................. 3..................... -0.6 1.1 1.9
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Source: Bureau of Economic Analysis, National Income and Product Accounts, Comprehensive Revision on July 31, 2013.
By order of the Board of Governors of the Federal Reserve
System, November 6, 2013.
Robert deV. Frierson,
Secretary of the Board.
[FR Doc. 2013-27009 Filed 11-27-13; 8:45 am]
BILLING CODE 6210-01-P