[Federal Register Volume 84, Number 40 (Thursday, February 28, 2019)]
[Rules and Regulations]
[Pages 6664-6671]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2019-03503]
-----------------------------------------------------------------------
FEDERAL RESERVE SYSTEM
12 CFR Part 252
[Regulation YY; Docket No. R-1649]
RIN 7100-AF 38
Stress Testing Policy Statement
AGENCY: Board of Governors of the Federal Reserve System (Board).
ACTION: Final rule.
-----------------------------------------------------------------------
SUMMARY: The Board is adopting a final policy statement on the approach
to supervisory stress testing conducted under the Board's stress
testing rules and the Board's capital plan rule.
DATES: Effective April 1, 2019.
FOR FURTHER INFORMATION CONTACT: Lisa Ryu, Associate Director, (202)
263-4833, Kathleen Johnson, Assistant Director, (202) 452-3644, Robert
Sarama, Assistant Director, (202) 973-7436, Joseph Cox, Senior
Supervisory Financial Analyst, (202) 452-3216, Aurite Werman, Senior
Financial Analyst, (202) 263-4802, Division of Supervision and
Regulation; Benjamin W. McDonough, Assistant General Counsel, (202)
452-2036, Julie Anthony, Senior Counsel, (202) 475-6682, or Asad
Kudiya, Counsel, (202) 475-6358, Legal Division, Board of Governors of
the Federal Reserve System, 20th Street and Constitution Avenue NW,
Washington, DC 20551. Users of Telecommunication Device for Deaf (TDD)
only, call (202) 263-4869.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Background
II. Description of Stress Testing Policy Statement
III. Summary of Comments Received and Revisions to the Stress
Testing Policy Statement
A. Principles of Supervisory Stress Testing
1. Independence
2. Robustness and Stability
3. Conservatism
B. Supervisory Stress Test Model Policies
1. Disclosure of Information Related to the Supervisory Stress
Test
2. Phasing in of Highly Material Model Changes
3. Limiting Reliance on Past Outcomes
4. Credit Supply Maintenance
C. Principles and Policies of Supervisory Stress Test Model
Validation
IV. Administrative Law Matters
A. Use of Plain Language
B. Paperwork Reduction Act Analysis
C. Regulatory Flexibility Act Analysis
I. Background
Supervisory stress testing is a tool that allows the Board to
assess whether the largest and most complex financial firms are
sufficiently capitalized to absorb losses in stressful economic
conditions while continuing to meet obligations to creditors and other
counterparties and to lend to households and businesses.
The Board's approach to supervisory stress testing has evolved
since the Supervisory Capital Assessment Program (SCAP) in 2009, which
was the first evaluation of capital levels of bank holding companies
(BHCs) on a forward-looking basis under stress. The lessons from SCAP
encouraged the creation, pursuant to the Dodd-Frank Wall Street Reform
and Consumer Protection Act (Dodd-Frank Act),\1\ of the Dodd-Frank Act
Stress Test (DFAST), a forward-looking, quantitative evaluation of the
impact of stressful economic and financial market conditions on firms'
capital. Supervisory stress test models are used to produce estimates
of post-stress capital ratios for covered companies,\2\ pursuant to the
Dodd-Frank Act and the Board's stress test rules.\3\
---------------------------------------------------------------------------
\1\ 77 FR 62377 (October 12, 2012) (Stress Test rules). See 12
CFR part 252, subparts E and F.
\2\ Covered companies are BHCs with average total consolidated
assets of $50 billion or more, U.S. intermediate holding companies
of foreign banking organizations, and any nonbank financial company
supervised by the Board. On July 6, 2018, the Board issued a public
statement regarding the impact of the Economic Growth, Regulatory
Relief, and Consumer Protection Act (EGRRCPA) (Pub. L. 115-174, 132
Stat. 1296 (2018)). The Board stated, consistent with the EGRRCPA,
that it will not take action to require BHCs with total consolidated
assets greater than or equal to $50 billion but less than $100
billion to comply with the Board's capital plan rule (12 CFR 225.8)
or the Board's supervisory stress test and company-run stress test
rules (12 CFR 252, subparts E and F). https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20180706b1.pdf.
\3\ Public Law 111-203, 124 Stat. 1376 (2010); 12 CFR part 252,
subpart E.
---------------------------------------------------------------------------
The supervisory models are also used in the Comprehensive Capital
Analysis and Review (CCAR), a related supervisory program, pursuant to
the Board's capital plan rule.\4\ CCAR focuses on forward-looking
capital planning and the use of stress testing to assess firms' capital
adequacy.\5\ By assessing the capital adequacy of a firm under severe
projected economic and financial stress, the supervisory stress test
complements minimum regulatory capital ratios, which reflect the firm's
current condition.
---------------------------------------------------------------------------
\4\ 12 CFR 225.8.
\5\ Id. CCAR also includes a qualitative assessment of capital
planning practices at the largest and most complex firms, which is
not the subject of this proposed Policy Statement.
---------------------------------------------------------------------------
II. Description of Stress Testing Policy Statement
On December 15, 2017, the Board invited comment on a proposal to
adopt a stress testing policy statement (Policy Statement).\6\ The
proposed Policy Statement would have described the Board's approach to
the development, implementation, use, and validation of the Federal
Reserve's supervisory stress test models, and would have complemented
the Board's policy statement on scenario design.\7\ The proposal would
have included seven principles that have guided decisions regarding
supervisory stress test modeling in the past and that would continue to
guide the development of the modeling framework. In addition, the
proposed Policy Statement would have established procedures and
policies designed to adhere to at least one of the foundational
principles of supervisory stress testing. These policies and procedures
would have included modeling-specific policies and associated
assumptions, such as the policy of credit supply maintenance. Finally,
the proposed Policy Statement would have addressed principles and
policies of supervisory model validation, which is integral to the
credibility of the supervisory stress test. By establishing these
principles, policies, and procedures, the proposed Policy Statement
would have increased transparency around the Federal Reserve's approach
to supervisory modeling.
---------------------------------------------------------------------------
\6\ 82 FR 59528 (December 15, 2017).
\7\ See 12 CFR 252, Appendix A.
---------------------------------------------------------------------------
III. Summary of Comments Received and Revisions to the Stress Testing
Policy Statement
The Board received twelve comments in response to the proposal.
Commenters included public interest groups, academics, individual
banking organizations, and trade and industry groups. Commenters
generally supported the elements of the proposed Policy Statement, and
provided alternative views on certain principles and policies
described.
A. Principles of Supervisory Stress Testing
1. Independence
The proposed Policy Statement would have emphasized the use of
independent supervisory models for assessing covered companies' capital
adequacy. Supervisory models developed internally and independently
[[Page 6665]]
rely on detailed portfolio data provided by covered companies, but do
not rely on models or estimates provided by covered companies to the
greatest extent possible.
Commenters were divided in their views on the use of independent
supervisory models. Several commenters expressed the view that the
stress testing program should be tailored to each covered company, and
recommended that the Federal Reserve consider increasing its reliance
on firms' own models. A commenter expressed the view that the Board is
not required to use DFAST stress testing results in the CCAR
quantitative assessment in order to treat firms consistently, and
recommended that the Federal Reserve use its own models for the DFAST
assessment and covered companies' models for the CCAR quantitative
assessment.
Other commenters strongly supported the principle of independence,
and recommended that the Board maintain independently developed models
separate from covered companies' models for use in the supervisory
stress test. One commenter expressed the view that the Federal Reserve
has an effective framework for carrying out stress tests of the largest
firms, and another asserted that the failure of firms' internal models
during the financial crisis showed the need for better model risk
governance and a strong independent check on firm models.
The Board will maintain independence as a central principle of
supervisory stress testing. Supervisory models provide an independent
check on firm risk management, and the use of consistent supervisory
models in both the DFAST assessment and CCAR quantitative assessments
is critical to ensuring that resulting capital requirements are based
on a comparable assessment. Studies have found that covered companies'
own models often produce materially different estimates of expected
losses for the same set of portfolios.\8\ As a result, relying on those
models could result in material differences in the assessment of post-
stress capital ratios across firms with similar risk profiles.
---------------------------------------------------------------------------
\8\ See Financial Services Authority, 2012, ``Results of 2011
Hypothetical Portfolio Exercise for Sovereigns, Banks and Large
Corporates,'' January 25, available at http://www.fsa.gov.uk/static/pubs/international/2011hpe.pdf; and Simon Firestone and Marcelo
Rezende, ``Are Banks' Internal Risk Parameters Consistent? Evidence
From Syndicated Loans,'' Journal of Financial Services Research,
vol. 50, issue 2 (October 2016) pp. 211-242.
---------------------------------------------------------------------------
Independent models that are not specifically tailored to each
individual institution are still appropriate for assessing risk, as
such models do capture differences in risk when estimated on
sufficiently granular data. Many of the supervisory models are
estimated on a pooled set of loan- or securities-level data, and as a
result, can capture differences in portfolio risk characteristics
across firms in a consistent manner. Board staff regularly meets with
covered companies and industry representatives to solicit input on how
best to collect data, and the Board has in the past modified its
information collection requirements based on feedback received.
2. Robustness and Stability
Robustness and stability were described as key principles of
supervisory stress testing in the proposed Policy Statement.
Specifically, supervisory models should be robust and stable, such that
changes in model projections over time are not driven by transitory
factors.
The estimates of post-stress capital produced by the supervisory
stress test provide information regarding covered companies' capital
adequacy to market participants, firms, and the general public.
Adherence to the principle of robustness and stability helps to ensure
that changes in these model projections over time are not driven by
temporary variations in model performance or inputs.
A commenter expressed concern about the inclusion of this
principle, asserting that elevating stability to a central principle is
likely to reinforce a tendency toward an excessively static stress
test, and that incorporating new data in supervisory stress testing
models could be important in capturing new risks.
In response to the comment, the Board is maintaining an emphasis on
robustness and stability as key principles of stress testing. This
emphasis is intended not to limit the dynamism of the stress test as a
supervisory tool, but rather to ensure that any changes in model
projections reflect underlying risk factors, scenarios, and model
enhancements. Supervisory models will continue to be recalibrated with
newly available input data each year, and these data will affect
supervisory model projections, particularly when the data reflect
evolving risks. Generally, however, model recalibrations due to newly
available data should not be the principal driver of year-over-year
changes in results.
3. Conservatism
The proposed Policy Statement would have established conservatism
as a central principle of supervisory stress testing. Commenters
generally supported the principle, asserting that the massive economic
costs of a financial collapse argue for a commitment to erring on the
conservative side. Accordingly, the final Policy Statement will reflect
the Board's commitment, given a reasonable set of assumptions or
approaches, to use those results that result in relatively more
significant losses or lower revenue, all other things being equal.
4. Other Principles of Supervisory Stress Testing
The Board sought comment on several other principles of supervisory
stress testing described in the proposed Policy Statement. The proposed
Policy Statement would have described a system of models designed to
result in projections that are not only independent, robust and stable,
and conservative, but also forward-looking, consistent and comparable
across covered companies, generated from simpler and more transparent
approaches, and able to capture the impact of economic stress. The
Board did not receive comments specific to those proposed principles.
One commenter recommended that the Board incorporate counter-
cyclicality as a stated principle of stress testing, noting that
projected capital losses in the stress tests have improved in recent
years even as economic conditions have improved and scenario severity
has increased. Improvements in projected post-stress capital in recent
stress test cycles do not solely reflect the Board's principles of
supervisory stress test modeling and scenario design. Rather, a number
of factors drive projected capital losses in the supervisory stress
test. Year-over-year changes in the supervisory stress test results
reflect not only the scenarios and supervisory models, but also
portfolio composition and risk characteristics and the starting capital
positions of firms, which tend to be procyclical. The Board already
strives to limit procyclicality in the supervisory stress test through
scenario design, and describes that goal in its policy statement on
scenario design. Accordingly, the final Policy Statement will reflect
the principles of supervisory stress testing as proposed.
B. Supervisory Stress Test Model Policies
The proposed Policy Statement would have established policies and
procedures to guide the development, implementation, and use of all
models used in supervisory stress test projections. These policies
would have
[[Page 6666]]
facilitated adherence to at least one of the governing principles
described in the Supervisory Stress Test Model Policies section.
1. Disclosure of Information Related to the Supervisory Stress Test
The proposed Policy Statement included a policy of information
parity, such that the Board does not disclose information related to
the supervisory stress test or firm-specific results to covered
companies if that information is not also publicly disclosed. The
proposed Policy Statement noted that increasing public disclosure can
help the public understand and interpret the results of the supervisory
stress test by facilitating evaluation of the quality of the Board's
assessment, while promoting equitable treatment of covered companies.
Commenters were divided on the Board's proposed policy. A commenter
recommended that the Board engage in a confidential supervisory
dialogue with individual covered companies in specific instances, such
as when the results of the supervisory stress test deviate from the
results of the firm's company-run stress test. This commenter also
requested that the Board share information about data deficiencies with
firms. Another commenter supported the Board's proposed approach to
disclosure of information related to the supervisory stress test.
The final Policy Statement retains the proposed policy of not
disclosing information to covered companies that the Board does not
also share with the public. This approach ensures that no single
institution has access to information about the supervisory stress test
that is not also publicly accessible by other institutions. For
example, under this approach, firms newly subject to the supervisory
stress test would have the same information as firms that have been
subject to the supervisory stress test since its inception.
The Board will maintain its current practice of notifying covered
companies of deficient data identified by the Federal Reserve, and
providing covered companies with the opportunity to remedy those
deficient data. In addition, the Board plans to provide the public with
more information about conservative assumptions applied to deficient
data than it has in prior disclosures. The Board intends to provide in
the annual disclosure of DFAST results the conservative loss rates that
are applied to portfolios that cannot be modeled because of missing
data.
2. Phasing in of Highly Material Model Changes
The proposed Policy Statement would have established the policy
that the Board phase in the most material model changes over two years,
in the interest of reducing model-driven volatility in stress testing
results. Commenters were divided on the proposed policy. One commenter
asserted that phasing in highly material model changes could delay
incorporation of material new data into the modeling process. Another
commenter requested that the Board phase in all material model changes
over two years, as opposed to phasing in the most material model
changes over two years.
In response to comments, the Board will continue to phase in the
most material model changes over two years, so as not to introduce
excess volatility to supervisory results. The Board has revised the
final Policy Statement to include a description of the materiality
threshold that generally determines the model changes subject to phase-
in over two years. Specifically, in assessing the materiality of a
model change, the Federal Reserve calculates the impact of using an
enhanced model on post-stress capital ratios using data and scenarios
from prior years' supervisory stress test exercises. Under the final
Policy Statement, the use of an enhanced model is considered a highly
material change if its use results in a change in the CET1 ratio of 50
basis points or more for one or more firms, relative to the model used
in prior years' supervisory exercises. In general, the phase-in
threshold for highly material model changes applies only to conceptual
changes to models. Model changes related to changes in accounting or
regulatory capital rules and model parameter re-estimation based on
newly available data are implemented with immediate effect. The Board
will continue to evaluate the appropriateness of the threshold for the
model phase-in, including the cumulative effect of all model changes in
a given year.
3. Limiting Reliance on Past Outcomes
The proposed Policy Statement would have established a policy of
limiting reliance on past outcomes, and minimizing the use of firm-
specific fixed effects in supervisory models, to allow for the
incorporation of events that have not occurred historically in
supervisory stress test modeling. A commenter requested that, where
applicable, the Board provide detail on, and examples of, firm-specific
fixed effects. The Board is finalizing the policy as described in the
proposed Policy Statement. In finalizing the notice of enhanced model
disclosure,\9\ the Board intends to expand its description of
supervisory models that use firm-specific fixed effects in its enhanced
model disclosure.
---------------------------------------------------------------------------
\9\ 82 FR 59547 (December 15, 2017).
---------------------------------------------------------------------------
4. Credit Supply Maintenance
The Board invited comment on its policy of credit supply
maintenance, described in Section 2.7 of the proposed Policy Statement,
as the assumption that firms' balance sheets would remain consistent or
would increase in magnitude. Commenters generally supported the
proposed policy. A commenter asserted that it is not sufficient to
assume that firms maintain their asset size throughout the projection
horizon, and that it is conservative and safer to assume some increase
in firms' asset size. Another commenter expressed the view that the
assumption of a flat or growing balance sheet is pivotal, as it
reflects the role of banks in providing additional credit in a troubled
economy.
Several commenters encouraged the Board to assume that firms'
balance sheets and risk-weighted assets (RWAs) stay constant, rather
than grow, over the projection horizon.\10\ Other commenters asserted
that the flat-to-rising balance sheet assumption is not consistent with
historical patterns, and requested that the Federal Reserve make the
more realistic assumption that firms' balance sheets and RWAs grow
smaller in a stressed environment, in order to reflect likely bank
behavior.
---------------------------------------------------------------------------
\10\ On April 25, 2018, the Board issued a notice of proposed
rulemaking, which would revise the Board's stress test rules and
capital plan rule to use the results of the supervisory stress test
to size a firm's stress capital buffer and stress leverage buffer.
As part of the proposal, the Board proposed to revise section 2.7 of
the Policy Statement relating to credit supply maintenance to
provide that, in projecting a firm's balance sheet, the Federal
Reserve will assume that the firm takes actions to maintain a
constant level of assets, including loans, trading assets, and
securities over the planning horizon. The proposal would also add a
new section 3.4 to the Policy Statement regarding a simple approach
for projecting risk-weighted assets (RWAs). In projecting RWAs under
this proposed section, the Federal Reserve would generally assume
that a covered company's RWAs remain unchanged over the planning
horizon. Those changes are still being proposed and are not being
finalized as part of this notice.
---------------------------------------------------------------------------
The Board is finalizing the credit supply maintenance assumption as
described in the proposed Policy Statement. The assumption that
aggregate credit supply does not contract during the stress period is
key to the aim of supervisory stress testing, which is to assess
whether firms are sufficiently capitalized to both absorb
[[Page 6667]]
losses during times of economic stress and continue to lend to
households and businesses and meet their obligations.
5. Other Supervisory Stress Test Model Policies
The Board sought comment on several other supervisory stress test
model policies described in the proposed Policy Statement. The proposed
Policy Statement described policies and procedures related to soundness
in model design, the treatment of the global market shock,
incorporation of business plan changes, firm-specific overlays,
treatment of missing or deficient data, and treatment of immaterial
portfolios. The Board did not receive additional comments specific to
those proposed policies and procedures.
C. Principles and Policies of Supervisory Model Validation
Models used in the supervisory stress test are subject to ongoing
review and validation by an independent unit within the Federal
Reserve. The proposed Policy Statement described principles of model
validation, central to the credibility of supervisory models and of the
stress test exercise. The Board did not receive comments on its
principles of supervisory model validation and is adopting the
principles without change.
IV. Administrative Law Matters
A. Use of Plain Language
Section 722 of the Gramm-Leach-Bliley Act (Pub. L. No 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 received no comments on these matters and
believes 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 final policy
statement to assess any information collections. There are no
collections of information as defined by the Paperwork Reduction Act in
the final policy statement.
C. Regulatory Flexibility Act Analysis
The Regulatory Flexibility Act (RFA), 5 U.S.C. 601 et seq.,
generally requires that, in connection with a proposed rulemaking, an
agency prepare and make available for public comment an initial
regulatory flexibility analysis (IRFA).\11\ The Board solicited public
comment on this policy statement in a notice of proposed rulemaking
\12\ and has since considered the potential impact of this policy
statement on small entities in accordance with section 604 of the RFA.
Based on the Board's analysis, and for the reasons stated below, the
Board believes the final rule will not have a significant economic
impact on a substantial number of small entities.
---------------------------------------------------------------------------
\11\ See 5 U.S.C. 603, 604 and 605.
\12\ 82 FR 59533 (December 15, 2017).
---------------------------------------------------------------------------
The RFA requires an agency to prepare a final regulatory
flexibility analysis (FRFA) unless the agency certifies that the rule
will not, if promulgated, have a significant economic impact on a
substantial number of small entities. The FRFA must contain: (1) A
statement of the need for, and objectives of, the rule; (2) a statement
of the significant issues raised by the public comments in response to
the IRFA, a statement of the agency's assessment of such issues, and a
statement of any changes made in the proposed rule as a result of such
comments; (3) the response of the agency to any comments filed by the
Chief Counsel for Advocacy of the Small Business Administration in
response to the proposed rule, and a detailed statement of any changes
made to the proposed rule in the final rule as a result of the
comments; (4) a description of an estimate of the number of small
entities to which the rule will apply or an explanation of why no such
estimate is available; (5) a description of the projected reporting,
recordkeeping and other compliance requirements of the rule, including
an estimate of the classes of small entities which will be subject to
the requirement and type of professional skills necessary for
preparation of the report or record; and (6) a description of the steps
the agency has taken to minimize the significant economic impact on
small entities, including a statement for selecting or rejecting the
other significant alternatives to the rule considered by the agency.
The final policy statement outlines the key principles and policies
governing the Board's approach to models used in supervisory stress
testing. The final policy statement is intended to increase
transparency around the development, implementation, and validation of
these models. Commenters did not raise any issues in response to the
IRFA. In addition, the Chief Counsel for Advocacy of the Small Business
Administration did not file any comments in response to the proposed
policy statement.
Under regulations issued by the Small Business Administration
(SBA), a ``small entity'' includes a depository institution, bank
holding company, or savings and loan holding company with assets of
$550 million or less (small banking organizations).\13\ As discussed in
the SUPPLEMENTARY INFORMATION, the final policy statement generally
would apply to bank holding companies with total consolidated assets of
$100 billion or more and U.S. intermediate holding companies of foreign
banking, which generally have at least total consolidated assets of $50
billion or more. Companies that are subject to the final policy
statement therefore substantially exceed the $550 million asset
threshold at which a banking entity is considered a ``small entity''
under SBA regulations. Because the final policy statement does not
apply to any company with assets of $550 million or less, the final
policy statement does not apply to any ``small entity'' for purposes of
the RFA.
---------------------------------------------------------------------------
\13\ See 13 CFR 121.201.
---------------------------------------------------------------------------
There are no projected reporting, recordkeeping, or other
compliance requirements associated with the final policy statement. As
discussed above, the final policy statement does not apply to small
entities.
The Board does not believe that the final policy statement
duplicates, overlaps, or conflicts with any other Federal Rules. In
addition, the Board does not believe there are significant alternatives
to the final policy statement that have less economic impact on small
entities. In light of the foregoing, the Board does not believe the
final 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 preamble, 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 6668]]
0
2. Appendix B to part 252 is added to read as follows:
Appendix B--Stress Testing Policy Statement
This Policy Statement describes the principles, policies, and
procedures that guide the development, implementation, and
validation of models used in the Federal Reserve's supervisory
stress test.
1. Principles of Supervisory Stress Testing
The system of models used in the supervisory stress test is
designed to result in projections that are (i) from an independent
supervisory perspective; (ii) forward-looking; (iii) consistent and
comparable across covered companies; (iv) generated from simpler and
more transparent approaches, where appropriate; (v) robust and
stable; (vi) conservative; and (vii) able to capture the impact of
economic stress. These principles are further explained below.
1.1. Independence
(a) In the supervisory stress test, the Federal Reserve uses
supervisory models that are developed internally and independently
(i.e., separate from models used by covered companies). The
supervisory models rely on detailed portfolio data provided by
covered companies but do not rely on models or estimates provided by
covered companies to the greatest extent possible.
(b) The Federal Reserve's stress testing framework is unique
among regulators in its use of independent estimates of losses and
revenues under stress. These estimates provide a perspective that is
not formed in consultation with covered companies or influenced by
firm-provided estimates and that is useful to the public in its
evaluation of covered companies' capital adequacy. This perspective
is also valuable to covered companies, who may benefit from external
assessments of their own losses and revenues under stress, and from
the degree of credibility that independence confers upon supervisory
stress test results.
(c) The independence of the supervisory stress test allows
stress test projections to adhere to the other key principles
described in the Policy Statement. The use of independent models
allows for consistent treatment across firms. Losses and revenues
under stress are estimated using the same modeling assumptions for
all covered companies, enabling comparisons across supervisory
stress test results. Differences in covered companies' results
reflect differences in firm-specific risks and input data instead of
differences in modeling assumptions. The use of independent models
also ensures that stress test results are produced by stress-focused
models, designed to project the performance of covered companies in
adverse economic conditions.
(d) In instances in which it is not possible or appropriate to
create a supervisory model for use in the stress test, including
when supervisory data are insufficient to support a modeled estimate
of losses or revenues, the Federal Reserve may use firm-provided
estimates or third-party models or data. For example, in order to
project trading and counterparty losses, sensitivities to risk
factors and other information generated by covered companies'
internal models are used. In the cases where firm-provided or third-
party model estimates are used, the Federal Reserve monitors the
quality and performance of the estimates through targeted
examination, additional data collection, or benchmarking. The Board
releases a list of the providers of third-party models or data used
in the stress test exercise in the annual disclosure of quantitative
results.
1.2. Forward-Looking
(a) The Federal Reserve has designed the supervisory stress test
to be forward-looking. Supervisory models are tools for producing
projections of potential losses and revenue effects based on each
covered company's portfolio and circumstances.
(b) While supervisory models are specified using historical
data, they should generally avoid relying solely on extrapolation of
past trends in order to make projections, and instead should be able
to incorporate events or outcomes that have not occurred. As
described in Section 2.4, the Federal Reserve implements several
supervisory modeling policies to limit reliance on past outcomes in
its projections of losses and revenues. The incorporation of the
macroeconomic scenario and global market shock component also
introduces elements outside of the realm of historical experience
into the supervisory stress test.
1.3. Consistency and Comparability
The Federal Reserve uses the same set of models and assumptions
to produce loss projections for all covered companies participating
in the supervisory stress test. A standard set of scenarios,
assumptions, and models promotes equitable treatment of firms
participating in the supervisory stress test and comparability of
results, supporting cross-firm analysis and providing valuable
information to supervisors and to the public. Adhering to a
consistent modeling approach across covered companies means that
differences in projected results are due to differences in input
data, such as instrument type or portfolio risk characteristics,
rather than differences in firm-specific assumptions made by the
Federal Reserve.
1.4. Simplicity
The Federal Reserve uses simple approaches in supervisory
modeling, where possible. Given a range of modeling approaches that
are equally conceptually sound, the Federal Reserve will select the
least complex modeling approach. In assessing simplicity, the
Federal Reserve favors those modeling approaches that allow for a
more straightforward interpretation of the drivers of model results
and that minimize operational challenges for model implementation.
1.5. Robustness and Stability
The Federal Reserve maintains supervisory models that aim to be
robust and stable, such that changes in model projections over time
reflect underlying risk factors, scenarios, and model enhancements,
rather than transitory factors. The estimates of post-stress capital
produced by the supervisory stress test provide information
regarding a covered company's capital adequacy to market
participants, covered companies, and the public. Adherence to this
principle helps to ensure that changes in these model projections
over time are not driven by temporary variations in model
performance or inputs. Supervisory models are recalibrated with
newly available input data each year. These data affect supervisory
model projections, particularly in times of evolving risks. However,
these changes generally should not be the principal driver of a
change in results, year over year.
1.6. Conservatism
Given a reasonable set of assumptions or approaches, all else
equal, the Federal Reserve will opt to use those that result in
larger losses or lower revenue. For example, given a lack of
information about the true risk of a portfolio, the Federal Reserve
will compensate for the lack of data by using a high percentile loss
rate.
1.7. Focus on the Ability To Evaluate the Impact of Severe Economic
Stress
In evaluating whether supervisory models are appropriate for use
in a stress testing exercise, the Federal Reserve places particular
emphasis on supervisory models' abilities to project outcomes in
stressed economic environments. In the supervisory stress test, the
Federal Reserve also seeks to capture risks to capital that arise
specifically in times of economic stress, and that would not be
prevalent in more typical economic environments. For example, the
Federal Reserve includes losses stemming from the default of a
covered company's largest counterparty in its projections of post-
stress capital for firms with substantial trading or processing and
custodian operations. The default of a company's largest
counterparty is more likely to occur in times of severe economic
stress than in normal economic conditions.
2. Supervisory Stress Test Model Policies
To be consistent with the seven principles outlined in Section
1, the Federal Reserve has established policies and procedures to
guide the development, implementation, and use of all models used in
supervisory stress test projections, described in more detail below.
Each policy facilitates adherence to at least one of the modeling
principles that govern the supervisory stress test, and in most
cases facilitates adherence to several modeling principles.
2.1. Soundness in Model Design
(a) During development, the Federal Reserve (i) subjects
supervisory models to extensive review of model theory and logic and
general conceptual soundness; (ii) examines and evaluates
justifications for modeling assumptions; and (iii) tests models to
establish the accuracy and stability of the estimates and forecasts
that they produce.
(b) After development, the Federal Reserve continues to subject
supervisory models to scrutiny during implementation to ensure that
the models remain appropriate for use in the stress test exercise.
The Federal Reserve monitors changes in the economic environment,
the structure of covered
[[Page 6669]]
companies and their portfolios, and the structure of the stress
testing exercise, if applicable, to verify that a model in use
continues to serve the purposes for which it was designed.
Generally, the same principles, rigor, and standards for evaluating
the suitability of supervisory models that apply in model
development and design will apply in ongoing monitoring of
supervisory models.
2.2. Disclosure of Information Related to the Supervisory Stress
Test
(a) In general, the Board does not disclose information related
to the supervisory stress test or firm-specific results to covered
companies if that information is not also publicly disclosed.
(b) The Board has increased the breadth of its public disclosure
since the inception of the supervisory stress test to include more
information about model changes and key risk drivers, in addition to
more detail on different components of projected net revenues and
losses. Increasing public disclosure can help the public understand
and interpret the results of the supervisory stress test,
particularly with respect to the condition and capital adequacy of
participating firms. Providing additional information about the
supervisory stress test allows the public to make an evaluation of
the quality of the Board's assessment. This policy also promotes
consistent and equitable treatment of covered companies by ensuring
that institutions do not have access to information about the
supervisory stress test that is not also accessible publicly,
corresponding to the principle of consistency and comparability.
2.3. Phasing in of Highly Material Model Changes
(a) The Federal Reserve may revise its supervisory stress test
models to include advances in modeling techniques, enhancements in
response to model validation findings, incorporation of richer and
more detailed data, public comment, and identification of models
with improved performance, particularly under adverse economic
conditions. Revisions to supervisory stress models may at times have
material impact on modeled outcomes.
(b) In order to mitigate sudden and unexpected changes to the
supervisory stress test results, the Federal Reserve follows a
general policy of phasing highly material model changes into the
supervisory stress test over two years. The Federal Reserve assesses
whether a model change would have a highly significant impact on the
projections of losses, components of revenue, or post-stress capital
ratios for covered companies. In these instances, in the first year
when the model change is first implemented, estimates produced by
the enhanced model are averaged with estimates produced by the model
used in the previous stress test exercise. In the second and
subsequent years, the supervisory stress test exercise will reflect
only estimates produced by the enhanced model. This policy
contributes to the stability of the results of the supervisory
stress test. By implementing highly material model changes over the
course of two stress test cycles, the Federal Reserve seeks to
ensure that changes in model projections primarily reflect changes
in underlying risk factors and scenarios, year over year.
(c) In general, phase-in thresholds for highly material model
changes apply only to conceptual changes to models. Model changes
related to changes in accounting or regulatory capital rules and
model parameter re-estimation based on newly available data are
implemented with immediate effect.
(d) In assessing the materiality of a model change, the Federal
Reserve calculates the impact of using an enhanced model on post-
stress capital ratios using data and scenarios from prior years'
supervisory stress test exercises. The use of an enhanced model is
considered a highly material change if its use results in a change
in the CET1 ratio of 50 basis points or more for one or more firms,
relative to the model used in prior years' supervisory exercises.
2.4. Limiting Reliance on Past Outcomes
(a) Models should not place undue emphasis on historical
outcomes in predicting future outcomes. The Federal Reserve aims to
produce supervisory stress test results that reflect likely outcomes
under the supervisory scenarios. The supervisory scenarios may
potentially incorporate events that have not occurred historically.
It is not necessarily consistent with the purpose of a stress
testing exercise to assume that the future will be like the past.
(b) In order to model potential outcomes outside the realm of
historical experience, the Federal Reserve generally does not
include variables that would capture unobserved historical patterns
in supervisory models. The use of industry-level models, restricted
use of firm-specific fixed effects (described below), and minimized
use of dummy variables indicating a loan vintage or a specific year,
ensure that the outcomes of the supervisory models are forward-
looking, consistent and comparable across firms, and robust and
stable.
(c) Firm-specific fixed effects are variables that identify a
specific firm and capture unobserved differences in the revenues,
expenses or losses between firms. Firm-specific fixed effects are
generally not incorporated in supervisory models in order to avoid
the assumption that unobserved firm-specific historical patterns
will continue in the future. Exceptions to this policy are made
where appropriate. For example, if granular portfolio-level data on
key drivers of a covered company's performance are limited or
unavailable, and firm-specific fixed effects are more predictive of
a covered company's future performance than are industry-level
variables, then supervisory models may be specified with firm-
specific fixed effects.
(d) Models used in the supervisory stress test are developed
according to an industry-level approach, calibrated using data from
many institutions. In adhering to an industry-level approach, the
Federal Reserve models the response of specific portfolios and
instruments to variations in macroeconomic and financial scenario
variables. In this way, the Federal Reserve ensures that differences
across firms are driven by differences in firm-specific input data,
as opposed to differences in model parameters or specifications. The
industry approach to modeling is also forward-looking, as the
Federal Reserve does not assume that historical patterns will
necessarily continue into the future for individual firms. By
modeling a portfolio or instrument's response to changes in economic
or financial conditions at the industry level, the Federal Reserve
ensures that projected future losses are a function of that
portfolio or instrument's own characteristics, rather than the
historical experience of the covered company. This policy helps to
ensure that two firms with the same portfolio receive the same
results for that portfolio in the supervisory stress test.
(e) The Federal Reserve minimizes the use of vintage or year-
specific fixed effects when estimating models and producing
supervisory projections. In general, these types of variables are
employed only when there are significant structural market shifts or
other unusual factors for which supervisory models cannot otherwise
account. Similar to the firm-specific fixed effects policy, and
consistent with the forward-looking principle, this vintage
indicator policy is in place so that projections of future
performance under stress do not incorporate assumptions that
patterns in unmeasured factors from brief historical time periods
persist. For example, the loans originated in a particular year
should not be assumed to continue to default at a higher rate in the
future because they did so in the past.
2.5. Treatment of Global Market Shock and Counterparty Default
Component
(a) Both the global market shock and counterparty default
components are exogenous components of the supervisory stress
scenarios that are independent of the macroeconomic and financial
market environment specified in those scenarios, and do not affect
projections of risk-weighted assets or balances. The global market
shock, which specifies movements in numerous market factors,\14\
applies only to covered companies with significant trading exposure.
The counterparty default scenario component applies only to covered
companies with substantial trading or processing and custodian
operations. Though these stress factors may not be directly
correlated to macroeconomic or financial assumptions, they can
materially affect covered companies' risks. Losses from both
components are therefore considered in addition to the estimates of
losses under the macroeconomic scenario.
---------------------------------------------------------------------------
\14\ See 12 CFR part 252, appendix A, ``Policy Statement on the
Scenario Design Framework for Stress Testing,'' for a detailed
description of the global market shock.
---------------------------------------------------------------------------
(b) Counterparty credit risk on derivatives and repo-style
activities is incorporated in supervisory modeling in part by
assuming the default of the single counterparty to which the covered
firm would be most exposed in the global market shock event.\15\
[[Page 6670]]
Requiring covered companies subject to the large counterparty
default component to estimate and report the potential losses and
effects on capital associated with such an instantaneous default is
a simple method for capturing an important risk to capital for firms
with large trading and custodian or processing activities.
Engagement in substantial trading or custodial operations makes the
covered companies subject to the counterparty default scenario
component particularly vulnerable to the default of their major
counterparty or their clients' counterparty, in transactions for
which the covered companies act as agents. The large counterparty
default component is consistent with the purpose of a stress testing
exercise, as discussed in the principle about the focus on the
ability to evaluate the impact of severe economic stress. The
default of a covered company's largest counterparty is a salient
risk in a macroeconomic and financial crisis, and generally less
likely to occur in times of economic stability. This approach seeks
to ensure that covered companies can absorb losses associated with
the default of any counterparty, in addition to losses associated
with adverse economic conditions, in an environment of economic
uncertainty.
---------------------------------------------------------------------------
\15\ In addition to incorporating counterparty credit risk by
assuming the default of the covered company's largest counterparty,
the Federal Reserve incorporates counterparty credit risk in the
supervisory stress test by estimating mark-to-market losses, credit
valuation adjustment (CVA) losses, and incremental default risk
(IDR) losses associated with the global market shock.
---------------------------------------------------------------------------
(c) The full effect of the global market shock and counterparty
default components is realized in net income in the first quarter of
the projection horizon in the supervisory stress test. The Board
expects covered companies with material trading and counterparty
exposures to be sufficiently capitalized to absorb losses stemming
from these exposures that could occur during times of general
macroeconomic stress.
2.6. Incorporation of Business Plan Changes
(a) The Federal Reserve incorporates material changes in the
business plans of covered companies, including mergers,
acquisitions, and divestitures over the projection horizon, in the
supervisory stress test projections. The incorporation of business
plan changes in the supervisory stress test is a requirement of the
capital plan rule,\16\ and captures a risk to the capital of covered
companies. Allowing for the inclusion of mergers, acquisitions, and
divestitures is forward-looking, as the Federal Reserve seeks to
capture material impacts on a covered company's post-stress capital
that may arise from a business plan change in the course of the
projection horizon.
---------------------------------------------------------------------------
\16\ 12 CFR 225.8(e)(2).
---------------------------------------------------------------------------
(b) The incorporation of business plan changes in supervisory
projections is consistent with the purpose of a stress testing
exercise, corresponding to the principle about the focus on the
ability to evaluate the impact of severe economic stress. In CCAR
specifically, the Board evaluates whether covered companies have the
ability to complete firm-projected capital actions in the
supervisory stress test, while remaining above post-stress minimum
capital and leverage ratios. Business plan changes, such as mergers,
acquisitions, or divestitures, may have material impacts on these
firm-projected capital actions and on the projected ability of a
covered company to make planned capital distributions and maintain
capital ratios above regulatory minima.
(c) A consistent methodology for modeling of business plan
changes is applied across covered companies. The data that are
available about characteristics of assets being acquired or divested
are generally limited and less granular than other data collected by
the Board in the Capital Assessments and Stress Testing (FR Y-14)
information collection. Projections of the effects of business plan
changes may rely on less granular information and may result in a
simpler modeling approach than supervisory projections for legacy
portfolios or businesses.
2.7. Credit Supply Maintenance
(a) The supervisory stress test incorporates the assumption that
aggregate credit supply does not contract during the stress period.
The aim of supervisory stress testing is to assess whether firms are
sufficiently capitalized to absorb losses during times of economic
stress, while also meeting obligations and continuing to lend to
households and businesses. The assumption that a balance sheet of
consistent or increasing magnitude is maintained allows supervisors
to evaluate the health of the banking sector assuming firms continue
to lend during times of stress.
(b) In order to implement this policy, the Federal Reserve must
make assumptions about new loan balances. To predict losses on new
originations over the planning horizon, newly originated loans are
assumed to have the same risk characteristics as the existing
portfolio, where applicable, with the exception of loan age and
delinquency status. These newly originated loans would be part of a
covered company's normal business, even in a stressed economic
environment. While an individual firm may assume that it reacts to
rising losses by sharply restricting its lending (e.g., by exiting a
particular business line), the banking industry as a whole cannot do
so without creating a ``credit crunch'' and substantially increasing
the severity and duration of an economic downturn. The assumption
that the magnitude of firm balance sheets will be fixed or growing
in the supervisory stress test ensures that covered companies cannot
assume they will ``shrink to health,'' and serves the Federal
Reserve's goal of helping to ensure that major financial firms
remain sufficiently capitalized to accommodate credit demand in a
severe downturn. In addition, by precluding the need to make
assumptions about how underwriting standards might tighten or loosen
during times of economic stress, the Federal Reserve follows the
principle of consistency and comparability and promotes consistency
across covered companies.
2.8. Firm-Specific Overlays and Additional Firm-Provided Data
(a) The Federal Reserve does not make firm-specific overlays to
model results used in the supervisory stress test. This policy
ensures that the supervisory stress test results are determined
solely by the industry-level supervisory models and by firm-specific
input data. The Federal Reserve has instituted a policy of not using
additional input data submitted by one or some of the covered
companies unless comparable data can be collected from all the firms
that have material exposure in a given area. Input data necessary to
produce supervisory stress test estimates is collected via the FR Y-
14 information collection. The Federal Reserve may request
additional information from covered companies, but otherwise will
not incorporate additional information provided as part of a firm's
CCAR submission or obtained through other channels into stress test
projections.
(b) This policy curbs the use of data only from firms that have
incentives to provide it, as in cases in which additional data would
support the estimation of a lower loss rate or a higher revenue
rate, and promotes consistency across the stress test results of
covered companies.
2.9. Treatment of Missing or Erroneous Data
(a) Missing data, or data with deficiencies significant enough
to preclude the use of supervisory models, create uncertainty around
estimates of losses or components of revenue. If data that are
direct inputs to supervisory models are not provided as required by
the FR Y-14 information collection or are reported erroneously, then
a conservative value will be assigned to the specific data based on
all available data reported by covered companies, depending on the
extent of data deficiency. If the data deficiency is severe enough
that a modeled estimate cannot be produced for a portfolio segment
or portfolio, then the Federal Reserve may assign a conservative
rate (e.g., 10th or 90th percentile PPNR or loss rate, respectively)
to that segment or portfolio.
(b) This policy promotes the principle of conservatism, given a
lack of information sufficient to produce a risk-sensitive estimate
of losses or revenue components using information on the true
characteristics of certain positions. This policy ensures consistent
treatment for all covered companies that report data deemed
insufficient to produce a modeled estimate. Finally, this policy is
simple and transparent.
2.10. Treatment of Immaterial Portfolio Data
(a) The Federal Reserve makes a distinction between insufficient
data reported by covered companies for material portfolios and
immaterial portfolios. To limit regulatory burden, the Federal
Reserve allows covered companies not to report detailed loan-level
or portfolio-level data for loan types that are not material as
defined in the FR Y-14 reporting instructions. In these cases, a
loss rate representing the median rates among covered companies for
whom the rate is calculated will be applied to the immaterial
portfolio. This approach is consistent across covered companies,
simple, and transparent, and promotes the principles of consistency
and comparability and simplicity.
3. Principles and Policies of Supervisory Model Validation
(a) Independent and comprehensive model validation is key to the
credibility of
[[Page 6671]]
supervisory stress tests. An independent unit of validation staff
within the Federal Reserve, with input from an advisory council of
academic experts not affiliated with the Federal Reserve, ensures
that stress test models are subject to effective challenge, defined
as critical analysis by objective, informed parties that can
identify model limitations and recommend appropriate changes.
(b) The Federal Reserve's supervisory model validation program,
built upon the principles of independence, technical competence, and
stature, is able to subject models to effective challenge, expanding
upon efforts made by supervisory modeling teams to manage model risk
and confirming that supervisory models are appropriate for their
intended uses. The supervisory model validation program produces
reviews that are consistent, thorough, and comprehensive. Its
structure ensures independence from the Federal Reserve's model
development function, and its prominent role in communicating the
state of model risk to the Board of Governors assures its stature
within the Federal Reserve.
3.1. Structural Independence
(a) The management and staff of the internal model validation
program are structurally independent from the model development
teams. Validators do not report to model developers, and vice versa.
This ensures that model validation is conducted and overseen by
objective parties. Validation staff's performance criteria include
an ability to review all aspects of the models rigorously,
thoroughly, and objectively, and to provide meaningful and clear
feedback to model developers and users.
(b) In addition, the Model Validation Council, a council of
external academic experts, provides independent advice on the
Federal Reserve's process to assess models used in the supervisory
stress test. In biannual meetings with Federal Reserve officials,
members of the council discuss selective supervisory models, after
being provided with detailed model documentation for and non-public
information about those models. The documentation and discussions
enable the council to assess the effectiveness of the models used in
the supervisory stress tests and of the overarching model validation
program.
3.2. Technical Competence of Validation Staff
(a) The model validation program is designed to provide
thorough, high-quality reviews that are consistent across
supervisory models.
(b) First, the model validation program employs technically
expert staff with knowledge across model types. Second, reviews for
every supervisory model follow the same set of review guidelines,
and take place on an ongoing basis. The model validation program is
comprehensive, in the sense that validators assess all models
currently in use, expand the scope of validation beyond basic model
use, and cover both model soundness and performance.
(c) The model validation program covers three main areas of
validation: (1) Conceptual soundness; (2) ongoing monitoring; and
(3) outcomes analysis. Validation staff evaluates all aspects of
model development, implementation, and use, including but not
limited to theory, design, methodology, input data, testing,
performance, documentation standards, implementation controls
(including access and change controls), and code verification.
3.3. Stature of Validation Function
(a) The validation program informs the Board of Governors about
the state of model risk in the overall stress testing program, along
with ongoing practices to control and mitigate model risk.
(b) The model validation program communicates its findings and
recommendations regarding model risk to relevant parties within the
Federal Reserve System. Validators provide detailed feedback to
model developers and provide thematic feedback or observations on
the overall system of models to the management of the modeling
teams. Model validation feedback is also communicated to the users
of supervisory model output for use in their deliberations and
decisions about supervisory stress testing. In addition, the
Director of the Division of Supervision and Regulation approves all
models used in the supervisory stress test in advance of each
exercise, based on validators' recommendations, development
responses, and suggestions for risk mitigants. In several cases,
models have been modified or implemented differently based on
validators' feedback. The Model Validation Council also contributes
to the stature of the Federal Reserve's validation program, by
providing an external point of view on modifications to supervisory
models and on validation program governance.
By order of the Board of Governors of the Federal Reserve
System, February 22, 2019.
Ann Misback,
Secretary of the Board.
[FR Doc. 2019-03503 Filed 2-27-19; 8:45 am]
BILLING CODE 6210-01-P