[Federal Register Volume 84, Number 40 (Thursday, February 28, 2019)]
[Notices]
[Pages 6784-6787]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2019-03505]
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FEDERAL RESERVE SYSTEM
[Docket No. OP-1651]
Enhanced Disclosure of the Models Used in the Federal Reserve's
Supervisory Stress Test
AGENCY: Board of Governors of the Federal Reserve System (Board).
ACTION: Final notification.
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SUMMARY: The Board is finalizing an enhanced disclosure of the models
used in the Federal Reserve's supervisory stress test conducted under
the Board's Regulation YY pursuant to the Dodd-Frank Wall Street Reform
and Consumer Protection Act and the Board's capital plan rule.
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DATES: April 1, 2019.
FOR FURTHER INFORMATION CONTACT: Lisa Ryu, Associate Director, (202)
263-4833, Kathleen Johnson, Assistant Director, (202) 452-3644, Robert
Sarama, Assistant Director (202) 973-7436, 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, Board of Governors of
the Federal Reserve System, 20th Street and Constitution Avenue NW,
Washington, DC 20551. Users of Telecommunication Device for Deaf (TDD)
only, call (202) 263-4869.
SUPPLEMENTARY INFORMATION:
Background
Each year the Federal Reserve publicly discloses the results of the
supervisory stress test.\1\ The disclosures include revenues, expenses,
losses, pre-tax net income, and capital ratios that would result under
two sets of adverse economic and financial conditions. As part of the
disclosures, the Federal Reserve also describes the broad framework and
methodology used in the supervisory stress test, including information
about the models used to estimate components of pre-tax net income and
post-stress capital ratios in the stress test. The annual disclosures
of both the stress test results and supervisory model framework and
methodology represent a significant increase in the public transparency
of large bank supervision in the U.S. since the 2007-2009 financial
crisis.\2\ Indeed, prior to the first supervisory stress test in 2009,
many analysts and institutions cautioned against these disclosures,
arguing that releasing bank-specific loss estimates to the public would
be destabilizing. However, experience to date has shown the opposite to
be true--disclosing these details to the public has garnered public and
market confidence in the process.
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\1\ See, for example, Dodd-Frank Act Stress Test 2018:
Supervisory Stress Test Methodology and Results, June 2018, and
Comprehensive Capital Analysis and Review 2018: Assessment Framework
and Results, June 2018.
\2\ In addition to those public disclosures, the Federal Reserve
has published detailed information about its scenario design
framework and annual letters detailing material model changes. The
Federal Reserve also hosts an annual symposium in which supervisors
and financial industry practitioners share best practices in
modeling, model risk management, and governance.
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The Federal Reserve routinely reviews its stress testing and
capital planning programs, and during those reviews, the Federal
Reserve has received feedback regarding the transparency of the
supervisory stress test models.\3\ Some of those providing feedback
requested more detail on modeling methodologies with a focus on year-
over-year changes in the supervisory models.\4\ Others, however,
cautioned against disclosing too much information about the supervisory
models because doing so could permit firms to reverse-engineer the
stress test.
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\3\ During a review that began in 2015, the Federal Reserve
received feedback from senior management at firms subject to the
Board's capital plan rule, debt and equity market analysts,
representatives from public interest groups, and academics in the
fields of economics and finance. That review also included an
internal assessment.
\4\ Some of the comments in favor of additional disclosure
included requests that the Federal Reserve provide additional
information to firms only, without making the additional disclosures
public. Doing so would be contrary to the Federal Reserve's
established practice of not disclosing information related to the
stress test to firms if that information is not also publicly
disclosed.
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The Federal Reserve recognizes that disclosing additional
information about supervisory models and methodologies has significant
public benefits, and is committed to finding ways to further increase
the transparency of the supervisory stress test. More detailed
disclosures could further enhance the credibility of the stress test by
providing the public with information on the fundamental soundness of
the models and their alignment with best modeling practices. These
disclosures would also facilitate comments on the models from the
public, including academic experts. These comments could lead to
improvements, particularly in the data most useful to understanding the
risks of particular loan types. More detailed disclosures could also
help the public understand and interpret the results of the stress
test, furthering the goal of maintaining market and public confidence
in the U.S. financial system. Finally, more detailed disclosures of how
the Federal Reserve's models assign losses to particular positions
could help those financial institutions that are subject to the stress
test understand the capital implications of changes to their business
activities, such as acquiring or selling a portfolio of assets.
The Federal Reserve also believes there are material risks
associated with fully disclosing the models to the firms subject to the
supervisory stress test. One implication of releasing all details of
the models is that firms could conceivably use them to make
modifications to their businesses that change the results of the stress
test without actually changing the risks they face. In the presence of
such behavior, the stress test could give a misleading picture of the
actual vulnerabilities faced by firms. Further, such behavior could
increase correlations in asset holdings among the largest banks, making
the financial system more vulnerable to adverse financial shocks.\5\
Another implication is that full model disclosure could incent banks to
simply use models similar to the Federal Reserve's, rather than build
their own capacity to identify, measure, and manage risk. That
convergence to the Federal Reserve's model would create a ``model
monoculture'' in which all firms have similar internal stress testing
models, and this could cause firms to miss key idiosyncratic risks that
they face.\6\
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\5\ For example, if firms were to deem a specific asset as more
advantageous to hold based on the particulars of the supervisory
models, and an exogenous shock were to occur to that specific asset
class, the firms' losses would be magnified because they held
correlated assets.
\6\ See Til Schuermann, ``The Fed's Stress Tests Add Risk to the
Financial System,'' Wall Street Journal, March 19, 2013.
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I. Proposed Enhanced Model Disclosure
On December 15, 2017, the Board invited comment on a proposal to
enhance the disclosures of those models.\7\ The proposed enhancements
were designed to balance the costs and benefits of model disclosure in
a way that would further enhance the public's understanding of the
supervisory stress test models without undermining the effectiveness of
the stress test as a supervisory tool. The proposed enhanced
disclosures contained three components: (1) Enhanced descriptions of
supervisory models, including key variables; (2) modeled loss rates on
loans grouped by important risk characteristics and summary statistics
associated with the loans in each group; and (3) portfolios of
hypothetical loans and the estimated loss rates associated with the
loans in each portfolio.\8\
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\7\ 82 FR 59547 (December 15, 2017).
\8\ The second and third components would have been provided for
the models used to project losses on the most material loan
portfolios.
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The proposed enhanced descriptions of the models would have
expanded the existing model descriptions in two ways. First, they would
have provided more detailed information about the structure of the
models by including certain important equations that characterize
aspects of the model. Second, they would have included a table that
contains a list of the key variables that influence the results of a
given model, and the table would show the relevant variables for each
component of the model (e.g., PD, LGD,
[[Page 6786]]
EAD), along with information about the source of the variables.
The proposed enhanced disclosure would have included estimated loss
rates for groups of loans with distinct characteristics, which would
allow the public to directly see how supervisory models treat specific
assets under stress. To shed more light on the degree of heterogeneity
of loans within a given group, the proposed enhanced disclosure would
also have included summary statistics associated with the loans in each
group.
The proposed enhanced disclosure would have included the
publication of portfolios of hypothetical loans, along with supervisory
projected loss rates on the portfolios. The portfolios of hypothetical
loans would have been designed to mimic the characteristics of the
actual loans reported by firms participating in the stress test, but
would not have contained any individual firm's actual loan portfolio or
any actual loans reported by firms. The set of variables included for
each portfolio would have been designed such that the public could
independently estimate loss rates for these portfolios, although the
set would not necessarily have included every variable that might be
included in a loss model for the relevant loan type.
Under the proposal, the Board would have provided enhanced versions
of the supervisory model descriptions that are currently published in
the model description appendix of the Board's annual disclosures of
supervisory stress test results, and the Board would also have provided
modeled loss rates on groups of loans and the loss rates associated
with portfolios of hypothetical loans for the most material loan
portfolios. The Board would have expected to publish its enhanced
disclosure in the first quarter of each calendar year, and the annual
disclosure in any given year would reflect updates to supervisory
models for that stress test cycle, but would be based on data and
scenarios from the prior stress test cycle.
II. Summary of Comments
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
suggestions regarding future model disclosures.
A. Fully Disclosing Models for Notice and Comment
Commenters were divided in their views on the appropriate level of
transparency. Some commenters recommended full disclosure of
supervisory models published by the Board through the public notice and
comment process, suggesting that this would result in more accurate
models. Other commenters expressed the view that the Federal Reserve
should fully disclose material aspects of the models such as underlying
formulas, equations, model backtesting, validation outcomes, and
limitations, to enable the public to evaluate the reliability of the
Federal Reserve's results. However, other commenters opposed full
transparency of supervisory models, indicating that it is important for
the stress test to remain flexible and for it not to be perfectly
predictable by the companies subject to it. One commenter cited a
historical study of the Office of Federal Housing Enterprise Oversight
(OFHEO) stress test, noting that the full disclosure of the OFHEO
stress test model rendered that stress test ineffective.
As discussed above, the proposed enhancements were designed to
balance the costs and benefits of disclosure in a way that would
further facilitate the public's understanding of the supervisory stress
test models without undermining the effectiveness of the stress test as
a supervisory tool. More detailed disclosures can enhance the
credibility of the stress test and lead to its improvement, but full
disclosure of all details related to supervisory models could make the
financial system at large more vulnerable by allowing firms to make
modifications to their businesses that would change their supervisory
stress test results without materially changing their risk profile. The
Board views the proposal as striking an appropriate balance between
enhancing model transparency and maintaining the efficacy of the stress
test, and is therefore adopting the enhancements as proposed, with
modifications as described below. The Board intends to continue to
improve its disclosures and to consider ways to further increase the
transparency of the stress test.
B. Content of Disclosures of Models
Commenters were generally supportive of the proposed enhancements
to the model disclosures. Several commenters asserted that the
portfolios of hypothetical loans in particular would help the public
understand the models. Consistent with the proposal, commenters
requested that the Board provide detailed descriptions of modeling
assumptions and equations.
Some commenters expressed the view that the Board should publish a
more detailed model disclosure than the one provided in the proposal.
These commenters requested decompositions that explain the proportion
of changes from scenarios, portfolio composition, model changes, and
additional details about model backtesting and assumptions. One
commenter stated that the Board should provide a comprehensive
explanation of the cost and benefit analysis used to determine the
content of its proposed enhanced model disclosure.
The Board intends to publish enhanced versions of the supervisory
model descriptions that are currently published in the model
description appendix of the Board's annual disclosures of supervisory
stress test results, and to publish the loss rates on groups of loans
and portfolios of hypothetical loans and associated loss rates for the
most material loan portfolios. In prior stress test results
disclosures, the Board has discussed the key drivers of the supervisory
stress test results, such as changes in firms' portfolio composition,
and the Board intends to continue to consider ways to provide
additional information on key drivers of aggregate results as
appropriate.
One commenter outlined proposed variables on which to group loan
loss rates in the enhanced disclosure. The segments the commenter
suggested for corporate loans were generally consistent with those
segments the Board provided in the example of disclosure for the
corporate loan loss model in the proposal.
C. Disclosure of Specific Models
Commenters requested more detail on the models used to project pre-
provision net revenue (PPNR) and operational-risk losses in the
supervisory stress test. Several commenters specifically requested
enhanced disclosure of the components of PPNR (i.e., net interest
income, noninterest income, and noninterest expense), including
additional detail on the structure, characteristics, and variables used
to model each component of PPNR. One commenter requested forecasted
PPNR metrics by scenario for hypothetical firms.
Commenters also requested that enhanced disclosure be provided for
a number of other models, including the models used to project other-
than-temporary losses on securities, other comprehensive income, losses
associated with the global market shock and associated losses, deferred
tax assets, loan loss provisions, the purchase accounting treatment for
material business plan changes, and transfer pricing revenues. One
commenter requested that the Board
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release supervisory models used to project losses for previous stress
tests.
The Board intends to include in its enhanced model disclosure
detailed descriptions of the supervisory models that are currently
addressed in the model description appendix of the Board's annual
disclosure of supervisory stress test results, including the models
used to project PPNR and operational-risk losses. These descriptions
would contain the structural form of key model equations and key input
variables. Further, the Board intends to publish projections of certain
components of PPNR, including net interest income, noninterest income,
and noninterest expense, for each covered company in its annual results
disclosure.
The detailed disclosure of modeled loss rates similar to the
example provided in the proposal requires loan- or security-level data
reported to the Board on a regular basis; therefore, such disclosures
are not feasible for certain types of models or calculations, such as
the calculation of deferred tax assets. The Board intends to publish
enhanced modeled loss rate disclosures for the most material loan
portfolios over the next several years, starting with two of the most
material loan portfolios in 2019. Over time, the Federal Reserve will
extend enhanced modeled loss rate disclosures to non-loan portfolios,
such as securities. The specific portfolios and the level of detail
provided for each portfolio will depend on constraints such as those
related to vendor data contracts, where applicable.
Models used in previous years are described in the Board's annual
disclosure of supervisory stress test results.
D. Timing of Enhanced Model Disclosure
Some commenters requested that enhanced disclosure be provided in
early January of each calendar year. Another commenter asserted that
the benefits of a stress test model disclosure are maximized and costs
are minimized when disclosure takes place after the stress tests are
completed.
Consistent with the proposal, the Board expects to publish details
about the models in the first quarter of each calendar year.
Specifically, the Board expects to publish enhanced model descriptions
for all models and enhanced modeled loss rate disclosures for two of
the most material loan models in the first quarter of 2019. In 2020,
the Board intends to revise enhanced model descriptions, as
appropriate, and to publish enhanced modeled loss rate disclosures for
two additional models.
Publication of the supervisory model disclosure prior to the
release of the supervisory stress test results will help firms and the
public anticipate the extent to which changes in supervisory results
may result from changes in the models. In recent years, the Board has
increased the information it provides to the public about supervisory
models, and has detailed material model changes in an annual letter
published in advance of the stress test. The Board believes that the
benefits of providing that information in advance of the stress test
outweigh the costs of doing so.
By order of the Board of Governors of the Federal Reserve
System, February 22, 2019.
Ann Misback,
Secretary of the Board.
[FR Doc. 2019-03505 Filed 2-27-19; 8:45 am]
BILLING CODE 6210-01-P