Federal Register, Volume 84 Issue 40 (Thursday, February 28, 2019)

[Federal Register Volume 84, Number 40 (Thursday, February 28, 2019)]
[Rules and Regulations]
[Pages 6651-6664]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2019-03504]

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Rules and Regulations
Federal Register
________________________________________________________________________

This section of the FEDERAL REGISTER contains regulatory documents
having general applicability and legal effect, most of which are keyed
to and codified in the Code of Federal Regulations, which is published
under 50 titles pursuant to 44 U.S.C. 1510.

The Code of Federal Regulations is sold by the Superintendent of Documents.

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Federal Register / Vol. 84, No. 40 / Thursday, February 28, 2019 /
Rules and Regulations

[[Page 6651]]

FEDERAL RESERVE SYSTEM

12 CFR Part 252

[Regulation YY; Docket No. R-1650]
RIN 7100-AF 39

Amendments to Policy Statement on the Scenario Design Framework
for Stress Testing

AGENCY: Board of Governors of the Federal Reserve System (Board).

ACTION: Final rule.

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SUMMARY: The Board is adopting amendments to its policy statement on
the scenario design framework for stress testing. As revised, the
policy statement clarifies that the Board may adopt a change in the
unemployment rate in the severely adverse scenario of less than 4
percentage points under certain economic conditions and institutes a
guide that limits procyclicality in the stress test for the change in
the house price index in the severely adverse scenario.

DATES: Effective: April 1, 2019.

FOR FURTHER INFORMATION CONTACT: William Bassett, Senior Associate
Director, (202) 736-5644, Luca Guerrieri, Deputy Associate Director,
(202) 452-2550, or Bora Durdu, Chief, (202) 452-3755, Division of
Financial Stability; or Lisa Ryu, Associate Director, (202) 263-4833,
Joseph Cox, Senior Supervisory Financial Analyst, (202) 452-3216, or
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.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Background

II. Description of Policy Statement on the Scenario Design Framework
for Stress Testing
III. Summary of Comments Received and Revisions to the Policy
Statement on the Scenario Design Framework for Stress Testing
A. Unemployment Rate in the Severely Adverse Scenario
B. House Prices in the Severely Adverse Scenario
C. Incorporating Short-Term Wholesale Funding Costs in the
Adverse and Severely Adverse Scenarios
D. Scenario Design Framework and Process for Scenario
Publication
1. Inclusion of Salient Risks in Scenarios
2. Scenario Severity
3. Release Date of Scenarios
4. Transparency of Scenario Variables
5. Publication of Scenarios for Notice and Comment
E. Impact Analysis
IV. Administrative Law Matters
A. Use of Plain Language
B. Paperwork Reduction Act Analysis
C. Regulatory Flexibility Act Analysis

I. Background

The Board conducts supervisory stress tests of covered companies
and requires those companies to conduct company-run stress tests
pursuant to the Dodd-Frank Wall Street Reform Act (Dodd-Frank Act) and
the Board's stress test rules.\1\ Section 165(i)(1) of the Dodd-Frank
Act requires the Board to conduct its evaluation of covered companies'
post-stress capital under different sets of economic conditions (each
set, a scenario). The Board's stress test rules provide that the Board
will notify covered companies, by no later than February 15 of each
year, of the scenarios that the Board will apply to conduct its annual
supervisory stress test and that covered companies must use to conduct
their company-run stress tests.\2\
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\1\ 12 CFR part 252, subparts E and F. Covered companies are
defined as bank holding companies 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. No. 115-174,
132 Stat. 1296 (2018)). In this document, the Board stated,
consistent with EGRRCPA, that it will not take action to require
bank holding companies 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
part 252, subparts E and F). https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20180706b1.pdf.
\2\ 12 CFR 252.44(b); 12 CFR 252.54(b)(1).
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To conduct the supervisory stress tests, the Board develops three
scenarios--a baseline, adverse, and severely adverse scenario--and
projects a firm's balance sheet, risk-weighted assets, net income, and
resulting post-stress capital levels and regulatory capital ratios
under each scenario. Similarly, a firm subject to company-run stress
tests under the Board's rules uses the same adverse and severely
adverse scenarios that apply in the supervisory stress test to conduct
a company-run stress test. The scenarios also serve as an input into a
covered company's capital plan under the Board's capital plan rule,\3\
and the Federal Reserve uses these scenarios to evaluate each firm's
capital plan in the supervisory post-stress capital assessment.
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\3\ 12 CFR 225.8.
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On November 29, 2013, the Board adopted a final policy statement on
the scenario design framework for stress testing (policy statement).\4\
The policy statement outlined the characteristics of the stress test
scenarios and explained the considerations and procedures that underlie
the formulation of these scenarios. The policy statement describes the
baseline, adverse, and severely adverse scenarios, the Board's approach
for developing these three macroeconomic scenarios, and the approach
for developing any additional components of the stress test scenarios.
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\4\ 78 FR 71435 (Nov. 29, 2013); see 12 CFR part 252, appendix
A.
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As described in the policy statement, the severely adverse scenario
is designed to reflect conditions that have characterized post-war U.S.
recessions (the recession approach). Historically, recessions typically
feature increases in the unemployment rate and contractions in
aggregate incomes and economic activity. In light of the typical co-
movement of measures of economic activity during economic downturns,
such as the unemployment rate and gross domestic product, the Board
first specifies a path for the unemployment rate and then develops
paths for other measures of activity broadly consistent with the course
of the unemployment rate in developing the severely adverse scenario.
The policy statement also

[[Page 6652]]

provides that economic variables included in the scenarios may change
over time, or that the Board may augment the recession approach with
salient risks.

II. Description of Policy Statement on the Scenario Design Framework
for Stress Testing

On December 15, 2017, the Board invited comment on a proposal to
revise several aspects of the policy statement. First, the proposal
would have modified the current guide in the policy statement for the
peak unemployment rate in the severely adverse scenario to include a
description of the circumstances in which an increase in the
unemployment rate at the lower end of the 3 to 5 percentage point range
suggested by the guide would be warranted. Second, the proposal would
have added to the policy statement an explicit guide for house prices
in the severely adverse scenario based on the ratio of house prices to
per capita disposable personal income (HPI-DPI ratio). Third, the
proposal would have provided notice that the Board may include
variables or additional components in the adverse and severely adverse
scenarios to capture the costs of wholesale funds to banking
organizations. Finally, the proposal would have amended the policy
statement to update references and remove obsolete text.

III. Summary of Comments and Revisions to the Policy Statement on the
Scenario Design Framework for Stress Testing

The Board received twelve comment letters in response to the
proposal. Commenters included public interest groups, academics,
individual banking organizations, and trade and industry groups.
Commenters generally expressed support for the proposal, and provided
alternative views on certain aspects of the proposed rule, including
the inclusion of a stress to wholesale funding in the scenarios.

A. Unemployment Rate in the Severely Adverse Scenario

The Board's approach to the scenario design process is designed to
limit procyclicality in the supervisory stress test through scenario
design. The policy statement provides that the Board anticipates the
unemployment rate in the severely adverse scenario would increase by
between 3 and 5 percentage points from its initial level. 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 path of the
unemployment rate in most cases will be specified so as to raise the
unemployment rate to at least 10 percent. The policy statement also
notes that the typical increase in the unemployment rate in the
severely adverse scenario will be about 4 percentage points.
The proposal would have revised the policy statement to include
more specific guidance for the change in the unemployment rate when the
stress test is conducted during a period in which the unemployment rate
is already elevated. In particular, the proposal would have clarified
that the Board may adopt an increase in the unemployment rate of less
than 4 percentage points when the unemployment rate at the start of the
scenarios is elevated but the labor market is judged to be
strengthening and higher-than-usual credit losses stemming from
previously elevated unemployment rates were either already realized--or
were in the process of being realized--and thus removed from banks'
balance sheets.\5\ The proposed change would have maintained an
unemployment rate path in the macroeconomic scenarios broadly similar
to the approach used to formulate previous scenarios, except during
times in the credit cycle when a smaller change would have been
appropriate.
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\5\ Evidence of a strengthening labor market could include a
declining unemployment rate, steadily expanding nonfarm payroll
employment, or improving labor force participation. Evidence that
credit losses were being realized could include elevated charge-offs
on loans and leases, loan-loss provisions in excess of gross charge-
offs, or other-than-temporary-impairment losses being realized in
securities portfolios that include securities that are subject to
credit risk.
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Commenters were generally supportive of the proposed changes to the
methods to set the path of the unemployment rate in the severely
adverse scenario.\6\ The Board is adopting the revisions to the policy
statement regarding the unemployment rate guide as proposed.
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\6\ A commenter requested clarity on an alternative guide for
the unemployment rate path considered, described in Question number
1 in the proposed amendments to the policy statement. In the
question, the Board described an alternative guide that would
require the path of the unemployment rate to reach the lesser of a
level 4 percentage points above its level at the beginning of the
scenario, or 11 percent. The alternative guide the Board considered
was the path of unemployment rate reaching the greater of a level 4
percentage points above its level at the beginning of the scenario,
or 11 percent. This guide would have further limited procyclicality
in the stress test through scenario design relative to the current
unemployment rate guide.
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B. House Prices in the Severely Adverse Scenario

The proposal would have revised the policy statement to include
guidance for the path of the nominal house price index in the severely
adverse scenario. The nominal house price index is a key variable in
the macroeconomic scenarios. Providing explicit guidance for the path
of this variable over the planning horizon would limit the
procyclicality of the scenarios when initial conditions already reflect
stress. This adjustment also would have improved the transparency of
the Board's scenario design framework.
The proposal would have established a quantitative guide for house
prices, informed by the ratio of the nominal house price index to
nominal per capita disposable income (HPI-DPI ratio). The guide
incorporates minimum declines in the ratio to ensure that the scenario
features stress even when house prices are already depressed, as they
were in 2012. Under most circumstances, the Board would have expected
the decline in the HPI-DPI ratio in the severely adverse scenario to be
25 percent from its starting value or enough to bring the ratio down to
its Great Recession trough, whichever is greater. The Great Recession
trough reflects the lowest point in the HPI-DPI ratio since 1976, but
is comparable to troughs in the ratio reached in other housing
recessions.
Commenters were divided in their views on this aspect of the
proposal. One commenter supported the proposal, and asserted that
publishing the quantitative guide promotes transparency and
reliability. Another commenter asserted that the proposed changes could
result in a guide that specifies house prices that are unlikely to be
realized and that may be procyclical, as the guide could impose severe
declines following a recession characterized by declining house prices.
Another commenter expressed the view that it would be preferable to
set the level and change in house prices using different ratios, such
as the ratio of house prices to median income or the ratio of house
prices to nominal rents, and asserted that the use of per capita income
in the ratio that determines the path of house prices does not reflect
the affordability of a home for the average family.
The Board's proposed approach to formulating house price paths
would allow for levels of severity that may fall outside of U.S.
postwar historical experience. As the 2007-2009 financial crisis
demonstrated, house prices are difficult to predict. Formulating a
house price guide that could lead to a more

[[Page 6653]]

severe decline in house prices than the U.S. has experienced in recent
history is an important element of the scenario design process, as the
universe of plausible economic stress scenarios is not limited to those
that have already occurred.
The proposed guide to specifying the path of house prices would
limit procyclicality in the stress test through scenario design, as the
scenarios will get less severe as house price growth outstrips income
growth or more severe when house price growth lags behind income
growth. If, for example, house prices were particularly elevated
relative to disposable personal incomes, as is often the case in times
of economic expansion, the proposed guide would specify a larger
decline in house prices in the scenario, relative to the initial level
of house prices, than would a specified fixed decline.
In developing the proposed guide for the path of house prices in
the macroeconomic scenario, the Board considered alternative
quantitative approaches, including using a long-term trend in the real
house price index to compute fair-market value and setting the house
price guide based on behavior of real house prices relative to trend.
Outcomes under this alternative guide are similar to the path of house
prices that would result from adhering to the HPI-DPI guide. The Board
also considered basing the quantitative guide for house prices in the
severely adverse scenario on the ratio of nominal house prices to
nominal rents to assess fair-market value. Historical price-to-rent
ratios trend upward over time. The drawback of either of these
alternative approaches is the uncertainty and difficulty surrounding
estimation of statistical trends.\7\ The HPI-DPI ratio is preferable in
that respect, as it does not appear to exhibit a trend.
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\7\ See Rochelle M. Edge and Ralf R. Meisenzahl (2011), ``The
Unreliability of Credit-to-GDP Ratio Gaps in Real Time: Implications
for Countercyclical Capital Buffers,'' International Journal of
Central Banking, vol. 7, no. 4, pp. 261-298.
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For the reasons stated above and after considering the comments,
the Board is adopting the proposed guide for the path of house prices
in the severely adverse scenario, consistent with the greater of a
decline in the HPI-DPI ratio of 25 percent of its starting value or a
decline sufficient to bring the ratio to its Great Recession trough.
The introduction of the quantitative guide with both a minimum change
in the ratio and a level of severity that the ratio would be required
to reach is consistent with the rule for the path of the unemployment
rate and will further the Board's goal of limiting procyclicality in
the stress test through scenario design. The guide offers a more
systematic approach to specifying house price paths than the current
approach, while broadly preserving the decline in nominal HPI featured
in recent stress testing cycles.

C. Incorporating Short-Term Wholesale Funding Costs in the Adverse and
Severely Adverse Scenarios

The proposal would have provided notice that the Board may in the
future include variables, or an additional component in the scenarios,
to capture the cost of wholesale funds to banking organizations.
Including stress to funding costs in the scenarios would account for
the impact of increased costs of certain runnable liabilities on net
income and capital of banking organizations reliant on short-term
wholesale funding in times of economic stress.
Several commenters supported the inclusion of changes in wholesale
funding costs in stress scenarios. Commenters expressed the view that
not incorporating short-term wholesale funding in past scenarios
reflects a significant gap in scenario design. Another commenter who
supported inclusion of wholesale funding costs in stress test scenarios
suggested that the Board use the liquidity classifications used for the
Liquidity Coverage Ratio and the Net Stable Funding Ratio to capture
changes in funding costs or availability. One commenter requested that
the Board include a run of a certain percentage of firms' funding as
part of the stress test, asserting that dependence on runnable funding
is a key source of risk that should be examined.
Other commenters sought additional detail about the proposed
funding stress, expressing concern that the proposed amendments did not
contain sufficient information. A commenter stated that, without
additional information, it is unclear whether the funding shock would
be duplicative of other regimes that address funding-related risks.
One commenter opposed the inclusion of a wholesale funding stress
in the Board's scenarios, and another commenter expressed that
implementing the funding stress through a single supervisory model
would distort the accuracy and predictability of stress testing
exercises. A commenter recommended that the Board proceed with caution
when designing any measure of short-term wholesale funding costs for
inclusion in supervisory stress testing, and noted that the Board
should not rely on the methodology used to calculate the presence of
short-term wholesale funding in its Method 2 global systemically
important bank (GSIB) surcharge approach.
In response to comments, the Board has determined that it will
delay the inclusion of scenario variables or an additional component in
the scenarios to capture the cost of wholesale funding costs for
banking organizations in the adverse and severely adverse scenarios.
Instead, the Board will further explore incorporating a stress to
wholesale funding costs in the supervisory stress test. The reliance by
banking organizations on certain types of runnable liabilities is a key
risk dimension that is not currently addressed in the supervisory
stress test, and accordingly, the Board will continue to research
appropriate methods for capturing the impact on capital adequacy of
changes in wholesale funding conditions under stress.

D. Scenario Design Framework and Process for Scenario Publication

In the proposal, the Board asked questions relating to whether
there are other risks that the Board should consider capturing in the
scenarios and whether there are other modifications not included in the
proposal that could further enhance the scenario development process.
In response to these questions, the Board received comments relating to
the inclusion of salient risks in the scenarios, the severity of the
scenarios, the release date of the scenarios, and the transparency of
scenario variables.
1. Inclusion of Salient Risks in Scenarios
Several commenters strongly supported the inclusion of salient
market risks in the scenarios in general to make the supervisory stress
test sufficiently dynamic. One commenter recommended that the Board
incorporate events that are not in the historical record in scenarios,
and that the Board allow the list of variables included in the
scenarios to change. Similarly, a commenter expressed support for the
incorporation in the stress test of shocks unlike those already
experienced, since firms should be prepared to withstand events beyond
those already endured. The commenter recommended that the Board
consider extraordinary shocks, such as a war with North Korea, the
collapse of the Bitcoin market, or major losses caused by trader
misconduct, in its scenarios.
The current policy statement states that it may be appropriate to
augment scenarios with salient risks, as

[[Page 6654]]

approaches that only look to past recessions or rely only on historical
relationships between variables may not always capture current risks to
the economic environment.
Since the inception of the supervisory stress test, the Board has
included various salient risks in its published scenarios. For example,
recent scenarios have included oil price shocks, a severe recession in
the euro area, a hard landing in China, stresses in other emerging
economies, and stresses in domestic housing and corporate sectors. The
salient risks included in the scenarios were not necessarily based on
historical record, and were instead relevant to the risk exposures of
firms participating in the supervisory stress test and based on
economic developments unfolding while the scenarios were being
designed. Where appropriate, the Board intends to continue augmenting
the scenarios with risks it considers to be salient.
2. Scenario Severity
Commenters expressed views on appropriate levels of scenario
severity. Several commenters asserted that maintaining the Board's
current scenario design framework, specifically as related to the
change in the unemployment rate, would lead to implausible scenarios
that are more severe than historical post-war recessions. One commenter
asserted that coupling the global market shock and largest counterparty
default component with the macroeconomic scenario design framework
leads to economic stress scenarios that are particularly implausible.
Another commenter expressed support for changing scenarios more
aggressively and unexpectedly than the Board's current scenario design
framework would specify.
By design, the severity of the scenarios increases as economic
conditions improve. This feature of the Board's scenario design
framework limits the extent to which scenario design adds sources of
procyclicality in the supervisory stress test. A comparison of the
severity of recent CCAR scenarios to benchmarks in past recessions or
financial crises, both domestic and international, suggests that the
scenarios used in the 2017 and 2018 CCAR assessments are plausibly
severe.\8\
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\8\ See Bora Durdu, Rochelle Edge, and Daniel Schwindt (2017),
``Measuring the Severity of Stress-Test Scenarios,'' FEDS Notes
(Washington: Board of Governors of the Federal Reserve System, May
5), https://www.federalreserve.gov/econres/notes/feds-notes/measuring-the-severity-of-stress-test-scenarios-20170505.htm.
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Additionally, the Board has reviewed the impact of amending the
policy statement to clarify its approach to setting the unemployment
rate and to establish a quantitative guide for the path of house
prices. This impact analysis was included in the proposal to amend the
policy statement. The Board concluded that the proposed changes would
not have materially enhanced the severity of scenarios had they been in
effect in prior stress test cycles. Had the proposed quantitative guide
for the path of house prices been in effect in prior stress test
cycles, the implied severity of house prices would have been similar to
that of the path of house prices included in the scenarios from those
stress test cycles published by Board. The amendments to the
unemployment rate guide that the Board is adopting in the final policy
statement would not increase the severity of the scenarios, as they
allow for the possibility of a smaller increase in the unemployment
rate than would have been specified in prior cycles if credit losses
had already been recognized when the unemployment rate at the start of
the scenarios was elevated and the labor market was judged to be
strengthening.
3. Release Date of Scenarios
Commenters requested that the Board set a fixed date in early
January of each calendar year for the release of the scenarios and
additional components used in the stress test. Another commenter
expressed strong support for scenario disclosure after the effective
date of the supervisory stress test, when firms' positions are fixed.
The effective date of the supervisory stress test is December 31,
and the Board publishes final scenarios after December 31 but no later
than February 15, as required under the Board's stress test rules.\9\
Given the need to appropriately incorporate data from major data
releases and other information released prior to scenario publication
into the final scenarios, it is infeasible for the Board to publish the
scenarios in early January.
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\9\ 12 CFR 252.54(b)(1).
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4. Transparency of Scenario Variables
A commenter asserted that some core input variables the Board
publishes in its scenarios are insufficiently transparent to the
public, and recommended that the Board release historical revisions and
latest actuals for core variables more frequently.
With the release of the CCAR 2018 scenarios, the Board modified the
public document that describes sources of scenario variables. The note
regarding scenario variables provided more details on data sources, and
described how each variable series can be retrieved from the source and
replicated. For example, the Board enhanced the transparency of its
description of its U.S. mortgage rate series, which now explains that
the quarterly average of the weekly series for the interest rate of a
conventional, conforming, 30-year fixed-rate mortgage is obtained from
the Primary Mortgage Market Survey of the Federal Home Loan Mortgage
Corporation.
5. Publication of Scenarios for Notice and Comment
Commenters expressed opposing views regarding the publication of
the Board's scenarios for notice and comment. One commenter asserted
that a fully transparent scenario would allow the Board to best achieve
public benefits of disclosure. Another commenter requested that the
Board maintain its current practice of disclosing scenarios only after
banks' portfolios are fixed, as disclosure of the scenarios prior to
the effective date of the stress test could incent firms to modify
their businesses to change the results of the stress test without
changing the risks that firms face. This commenter expressed the view
that the stress test would yield useful information and encourage firms
to maintain a prudent framework for capital planning as long as the
Board does not disclose scenarios for comment before the effective date
of the stress test.
The Board is considering these comments and weighing the costs and
benefits of publishing the scenarios for comment.

E. Impact Analysis

The amendments to the policy statement will not materially affect
the severity of the scenarios. The inclusion of a stress to wholesale
funding, which would have been expected to increase the stringency of
the stress test, will be delayed, as noted.
The unemployment rate clarification will reduce the stringency of
the scenario if the economy had already experienced stress and was
recovering, and will not impact the stringency of the scenario at other
points during the economic cycle. The house price guide formalizes an
approach that was previously judgmental with little persistent impact
on the severity of the stress to house prices in the severely adverse
scenario. However, the element of the house price guide that would
limit procyclicality in the stress test through the scenario would
increase the severity of the scenario stress to house

[[Page 6655]]

prices when the ratio of house prices to disposable personal income is
particularly elevated at the start of the stress test.

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 received no comments on these matters and
believes the final policy statement is written plainly and clearly.

B. Paperwork Reduction Act

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).\10\ The Board solicited public
comment on this policy statement in a notice of proposed rulemaking
\11\ 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.
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\10\ See 5 U.S.C. 603, 604 and 605.
\11\ 82 FR 59533 (Dec. 15, 2017).
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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 adopts changes to the Board's policy
statement on the scenario design framework for stress testing. The
final policy statement clarifies that the Board may adopt a change in
the unemployment rate in the severely adverse scenario of less than 4
percentage points under certain economic conditions and institutes a
quantitative guide for the change in the house price index in the
severely adverse scenario. 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).\12\ 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.
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\12\ See 13 CFR 121.201.
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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 would not
apply to any ``small entity'' for purposes of the RFA.
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 part 252 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.

0
2. Appendix A to part 252 is revised 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 $100 billion or more, intermediate
holding company of a foreign banking organization, and nonbank
financial company that the Financial Stability Oversight Council has
designated for supervision by the Board (together, covered
companies).\1\ 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

[[Page 6656]]

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).\2\ 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).\3\
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\1\ 12 U.S.C. 5365(i)(1); 12 CFR part 252, subpart E.
\2\ 12 U.S.C. 5365(i)(2); 12 CFR part 252, subparts B and F.
\3\ 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 as 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 part 252.
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(b) The stress test rules provide that the Board will notify
covered companies by no later than February 15 of each year of the
scenarios it will use to conduct its annual supervisory stress tests
and provide, also by no later than February 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. 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. 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 March 1 of each
year.\4\ 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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\4\ Id.
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(c) In addition, Sec. 225.8 of the Board's Regulation Y
(capital plan rule) requires covered companies to submit annual
capital plans, including stress test results, to the Board in order
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.\5\
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\5\ See 12 CFR 225.8.
---------------------------------------------------------------------------

(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 provide 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 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 B, E, and F as well as the Board's capital
plan rule (12 CFR 225.8).\6\
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\6\ 12 CFR 252.14(a), 12 CFR 252.44(a), 12 CFR 252.54(a).
---------------------------------------------------------------------------

(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
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.\7\ 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.
---------------------------------------------------------------------------

\7\ 12 CFR 252.14(b), 12 CFR 252.44(b), 12 CFR 252.54(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

[[Page 6657]]

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 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.\8\ 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:
---------------------------------------------------------------------------

\8\ 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.
---------------------------------------------------------------------------

(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 3-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.\9\
---------------------------------------------------------------------------

\9\ The Board may increase the range of countries or regions
included in future scenarios, as appropriate.
---------------------------------------------------------------------------

(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 to 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.\10\ 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 February 1 of each year. Finally, as described
in section 4 of this Appendix, 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).
---------------------------------------------------------------------------

\10\ Currently, companies with significant trading activity
include any bank holding company or intermediate holding company
that (1) has aggregate trading assets and liabilities of $50 billion
or more, or aggregate trading assets and liabilities equal to 10
percent or more of total consolidated assets, and (2) is not a large
and noncomplex firm.. 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.
---------------------------------------------------------------------------

(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 that 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;

[[Page 6658]]

(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.\11\ Third and finally, the growth rate
of potential output can cause the size of the decline in GDP to vary
between recessions. While changes in the unemployment rate can also
vary over time due to demographic factors, this seems to have more
limited implications over time relative to changes in potential
output growth. The unemployment rate used in the severely adverse
scenario will reflect an unemployment rate that has been observed in
severe post-war U.S. recessions, measuring severity by the absolute
level of and relative increase in the unemployment rate.\12\
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\11\ More recently, a monthly measure of GDP has been added to
the list of indicators.
\12\ Even though all recessions feature increases in the
unemployment rate and contractions in incomes and economic activity,
the size of this change has varied over post-war U.S. recessions.
Table 1 documents the variability in the depth of post-war U.S.
recessions. Some recessions--labeled mild in Table 1--have been
relatively modest with GDP edging down just slightly and the
unemployment rate moving up about a percentage point. Other
recessions--labeled severe in Table 1--have been much harsher with
GDP dropping 3\3/4\ percent and the unemployment rate moving up a
total of about 4 percentage points.
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(c) The Board believes that the severely adverse scenario should
also reflect a housing recession. The house prices path set in the
severely adverse scenario will reflect developments that have been
observed in post-war U.S. housing recessions, measuring severity by
the absolute level of and relative decrease in the house prices.
(d) The Board will specify the paths of most other macroeconomic
variables based on the paths of unemployment, income, house prices,
and activity. Some of these other variables, however, have taken
wildly divergent paths in previous recessions (e.g., foreign GDP),
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., economic or financial-
system vulnerabilities in other countries).
(e) 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

[[Page 6659]]

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.\13\ The initial level will be set based on the
conditions at the time that the scenario is designed. However, if a
3 to 5 percentage point increase in the unemployment rate does not
raise the level of the unemployment rate to at least 10 percent--the
average level to which it has increased in the most recent three
severe recessions--the path of the unemployment rate in most cases
will be specified so as to raise the unemployment rate to at least
10 percent.
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\13\ 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 was
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 was 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 believes that cyclical systemic risks
are high (as it would be after a sustained long expansion), and to
the lower end of the range if cyclical systemic risks are 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.\14\ 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. Indeed, the Board expects that, in
general, it will adopt a change in the unemployment rate of less
than 4 percentage points when the unemployment rate at the start of
the scenarios is elevated but the labor market is judged to be
strengthening and higher-than-usual credit losses stemming from
previously elevated unemployment rates were either already
realized--or are in the process of being realized--and thus removed
from banks' balance sheets.\15\ 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.
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\14\ 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.
\15\ Evidence of a strengthening labor market could include a
declining unemployment rate, steadily expanding nonfarm payroll
employment, or improving labor force participation. Evidence that
credit losses are being realized could include elevated charge-offs
on loans and leases, loan-loss provisions in excess of gross charge-
offs, or losses being realized in securities portfolios that include
securities that are subject to credit risk.
---------------------------------------------------------------------------

(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 would result in scenarios being more severe in robust
expansions (when the unemployment rate is low) and less severe in
the early stages of a recovery (when the unemployment rate is high)
and so would not result in pro-cyclicality. Depending on the initial
level of the unemployment rate, this approach could lead to only a
very modest increase in the unemployment rate--or even a decline. As
a result, this approach--while not procyclical--could result in
scenarios not featuring stressful macroeconomic outcomes.

4.2.3 Setting the Other Variables in the Severely Adverse Scenario

(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 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) 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.
(c) Declining house prices, which are an important source of
stress to a company's balance sheet, are not a steadfast feature of

[[Page 6660]]

recessions, and the historical relationship of house prices with the
unemployment rate is not strong. Simply adopting their typical path
in a severe recession would likely underestimate risks stemming from
the housing sector. In specifying the path for nominal house prices,
the Board will consider the ratio of the nominal house price index
(HPI) to nominal, per capita, disposable income (DPI). The Board
believes that the typical decline in the HPI-DPI ratio will be at a
minimum 25 percent from its starting value, or enough to bring the
ratio down to its Great Recession trough. As illustrated in Table 2,
housing recessions have on average featured HPI-DPI ratio declines
of about 25 percent and the HPI-DPI ratio fell to its Great
Recession trough.\16\
---------------------------------------------------------------------------

\16\ The house-price retrenchments that occurred over the
periods 1980-1985, 1989-1996, 2006-2011 (as detailed in Table 2) are
referred to in this document as housing recessions. The date-ranges
of housing recessions are based on the timing of house-price
retrenchments. These dates were also associated with sustained
declines in real residential investment, although, the precise
timings of housing recessions would likely be slightly different
were they to be classified based on real residential investment in
addition to house prices. The ratios described in Table 2 are
calculated based on nominal HPI and HPI-DPI ratios indexed to 100 in
2000:Q1.
---------------------------------------------------------------------------

(d) 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
that uses both judgment and economic models informs 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.\17\
---------------------------------------------------------------------------

\17\ 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.\18\ 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 the
current condition of the economy and the financial services
industry.
---------------------------------------------------------------------------

\18\ For example, in the context of CCAR, the Board currently
uses the adverse scenario as one consideration in evaluating a
firm'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
better understood 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.\19\ 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.
---------------------------------------------------------------------------

\19\ 12 CFR 252.55.
---------------------------------------------------------------------------

(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 example, using this approach for the adverse

[[Page 6661]]

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 the 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 6662]]

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 would be
useful in assessing each company's capital adequacy as it relates to
the company's idiosyncratic risk. However, the Board does not
believe this approach to be well-suited for the stress tests
required by regulation. Consistency and comparability are key
features of annual supervisory stress tests and annual company-run
stress tests required in the stress test rules. It would be
difficult to use the information on the companies' portfolios to
design a common set of shocks that are universally stressful for all
covered companies. As a result, this approach would be better suited
to more customized, tailored stress tests that are part of the
company's internal capital planning process or to other supervisory
efforts outside of the stress tests conducted under the 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 will 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 expectations 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 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 possible, although unlikely, that a scaled adverse scenario
actually will result in greater losses, for some companies, than a
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
in which 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.
(f) Finally, the design of the adverse scenario for annual
stress tests could be

[[Page 6663]]

informed by the companies' own trading scenarios used for their BHC-
designed scenarios in CCAR and in their mid-cycle company-run stress
tests.\20\
---------------------------------------------------------------------------

\20\ 12 CFR 252.55.
---------------------------------------------------------------------------

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 February 15. 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 October and November of each year and to
update the scenarios, based on incoming macroeconomic data releases
and other information, through the end of January.
(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 March 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
--------------------------------------------------------------------------------------------------------------------------------------------------------
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.

Table 2--House Prices in Housing Recessions
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HPI-DPI trough
Peak Trough Severity Duration (quarters) %-change in %-change in level (2000:Q1 =
NHPI HPI-DPI 100)
--------------------------------------------------------------------------------------------------------------------------------------------------------
1980Q2............................ 1985Q2............... Moderate............ 20 (long)........... 26.6 -15.9 102.1
1989Q4............................ 1997Q1............... Moderate............ 29 (long)........... 10.5 -17.0 94.9
2005Q4............................ 2012Q1............... Severe.............. 25 (long)........... -29.6 -41.3 86.9
Average........................... ..................... .................... 24.7................ 2.5 -24.7 94.6
--------------------------------------------------------------------------------------------------------------------------------------------------------
Source: CoreLogic, BEA.
Note: The date-ranges of housing recessions listed in Table 2 are based on the timing of house-price retrenchments.

[[Page 6664]]

By order of the Board of Governors of the Federal Reserve System
February 22, 2019.
Ann Misback,
Secretary of the Board.
[FR Doc. 2019-03504 Filed 2-27-19; 8:45 am]
BILLING CODE 6210-01-P