[Federal Register Volume 82, Number 240 (Friday, December 15, 2017)]
[Proposed Rules]
[Pages 59528-59533]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2017-26857]


 ========================================================================
 Proposed Rules
                                                 Federal Register
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 This section of the FEDERAL REGISTER contains notices to the public of 
 the proposed issuance of rules and regulations. The purpose of these 
 notices is to give interested persons an opportunity to participate in 
 the rule making prior to the adoption of the final rules.
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  Federal Register / Vol. 82, No. 240 / Friday, December 15, 2017 / 
Proposed Rules  

[[Page 59528]]



FEDERAL RESERVE SYSTEM

12 CFR Part 252

[Regulation YY; Docket No. OP-1587]


Stress Testing Policy Statement

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

ACTION: Proposed rule; policy statement with request for public 
comment.

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SUMMARY: The Board is inviting comment on a proposed policy statement 
on the approach to supervisory stress testing conducted under the 
Board's Regulation YY pursuant to the Dodd-Frank Wall Street Reform and 
Consumer Protection Act (Dodd-Frank Act) and the Board's capital plan 
rule.

DATES: Comments must be received by January 22, 2018.

ADDRESSES: You may submit comments, identified by Docket No. OP-1587 by 
any of the following methods:
     Agency website: http://www.federalreserve.gov. Follow the 
instructions for submitting comments at http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.aspx.
     Federal eRulemaking Portal: http://www.regulations.gov. 
Follow the instructions for submitting comments.
     Email: [email protected]. Include the 
docket number and RIN number in the subject line of the message.
     Fax: (202) 452-2819 or (202) 452-3102.
     Mail: Ann Misback, Secretary, Board of Governors of the 
Federal Reserve System, 20th Street and Constitution Avenue NW, 
Washington, DC 20551.
    All public comments will be made available on the Board's website 
at http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.aspx as 
submitted, unless modified for technical reasons. Accordingly, your 
comments will not be edited to remove any identifying or contact 
information. Public comments may also be viewed electronically or in 
paper form in Room 3515, 1801 K St. NW (between 18th and 19th Streets 
NW), Washington, DC 20006 between 9:00 a.m. and 5:00 p.m. on weekdays. 
For security reasons, the Board requires that visitors make an 
appointment to inspect comments. You may do so by calling (202) 452-
3684. Upon arrival, visitors will be required to present valid 
government-issued photo identification and to submit to security 
screening in order to inspect and photocopy comments.

FOR FURTHER INFORMATION CONTACT: Lisa Ryu, Associate Director, (202) 
263-4833, Kathleen Johnson, Assistant Director, (202) 452-3644, Joseph 
Cox, Supervisory Financial Analyst, (202) 452-3216, Hillel Kipnis, 
Senior Financial Analyst, (202) 452-2924, Aurite Werman, Financial 
Analyst, (202) 263-4802, Division of Supervision and Regulation; 
Benjamin W. McDonough, Assistant General Counsel, (202) 452-2036, or 
Julie Anthony, Counsel, (202) 475-6682, 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: 

I. Overview

    The proposed policy statement (Policy Statement) outlines the key 
principles and policies governing the Board's approach to the 
development, implementation, and validation of models used in the 
supervisory stress test. The supervisory stress test models are used to 
produce estimates of post-stress capital ratios for covered 
companies,\1\ pursuant to the Dodd-Frank Wall Street Reform and 
Consumer Protection Act (Dodd-Frank Act) and the Board's stress test 
rules.\2\ This annual exercise is referred to as the Dodd-Frank Act 
Stress Test (DFAST). The supervisory models are also used in the 
Comprehensive Capital Analysis and Review (CCAR), pursuant to the 
Board's capital plan rule.\3\ The Board is proposing the Policy 
Statement to increase transparency around the development, 
implementation, and validation of these models by the Federal Reserve. 
Accordingly, the Policy Statement would not apply to models used by 
covered companies in the company-run stress tests mandated by the Dodd-
Frank Act and the Board's stress test rules.\4\
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    \1\ Covered companies are defined as bank holding companies 
(BHCs) and U.S. intermediate holding companies of foreign banking 
organizations (IHCs) with total consolidated assets of $50 billion 
or more, and any nonbank financial company that the Financial 
Stability Oversight Committee has determined shall be supervised by 
the Board. See 12 U.S.C. 5365.
    \2\ Public Law 111-203, 124 Stat. 1376 (2010); 12 CFR part 252, 
subpart E.
    \3\ 12 CFR 225.8.
    \4\ See 12 U.S.C. 5365(i); 12 CFR part 252, subparts B and F.
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II. Background

    Supervisory stress testing is a tool that allows the Board to 
assess whether the largest and most complex financial firms are 
sufficiently capitalized to absorb losses in stressful economic 
conditions while continuing to meet obligations to creditors and other 
counterparties and to lend to households and businesses. The 2007-2009 
financial crisis showed that many large bank holding companies (BHCs) 
did not hold capital commensurate with their risk profiles and were 
insufficiently capitalized to withstand unanticipated losses in severe 
economic stress and remain a going concern. Post-crisis reforms to 
regulation and supervision have improved the quality and quantity of 
capital in the financial system. These improvements have strengthened 
financial institutions and have reduced the likelihood and severity of 
future financial crises, which can cause severe and lasting damage to 
the economy.
    The Board's approach to supervisory stress testing has evolved 
since the Supervisory Capital Assessment Program (SCAP) in 2009, which 
was the first evaluation of BHCs' capital levels on a forward-looking 
basis under stress. The lessons from SCAP encouraged the creation, 
pursuant to the Dodd-Frank Act, of DFAST,\5\ a forward-looking 
quantitative evaluation of the impact of stressful economic and 
financial market conditions on covered companies' capital. CCAR is a 
related supervisory program that was developed pursuant to the Board's 
capital plan rule and focuses on forward-looking capital planning and 
the use of stress testing to assess firms' capital adequacy. The 
quantitative assessment in CCAR uses the same

[[Page 59529]]

supervisory stress test as does DFAST, and includes firms' planned 
capital distributions, including any dividend payments or common stock 
repurchases.\6\ By assessing the capital adequacy of a covered company 
under severe projected economic and financial stress, the supervisory 
stress test complements minimum regulatory capital ratios, which 
reflect the covered company's current condition.
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    \5\ 77 FR 62377 (October 12, 2012) (stress test rules). See 12 
CFR part 252, subparts E and F.
    \6\ 12 CFR 225.8. CCAR also includes a qualitative assessment of 
capital planning practices at the largest and most complex firms, 
which is not the subject of this proposed Policy Statement.
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    The proposed Policy Statement describes the principles, policies, 
and procedures that guide the development, implementation, and 
validation of the Federal Reserve's supervisory stress test models, and 
would complement the Board's policy statement on scenario design.\7\
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    \7\ See 12 CFR part 252, appendix A, ``Policy Statement on the 
Scenario Design Framework for Stress Testing.''
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    The Federal Reserve maintains the same standards for model 
development and implementation of supervisory models as the Federal 
Reserve has established for covered companies. In addition to 
maintaining those standards, the Federal Reserve adheres to specific 
principles for model development and implementation. These principles, 
which apply broadly across the full set of supervisory models, have 
guided the formulation of the Federal Reserve's supervisory modeling 
approach and continue to guide changes to supervisory models.
    Models used in the supervisory stress test are also subject to 
ongoing review and validation by an independent unit within the Federal 
Reserve. In addition to addressing principles and policies of model 
development, implementation, and use, the Policy Statement describes 
principles of model validation, which is central to the credibility of 
supervisory models and to the credibility of the stress test exercise. 
The proposed Policy Statement is organized as follows. Section 1 
describes the principles that guide the design of the supervisory 
stress test and the Federal Reserve's approach to supervisory modeling. 
Section 2 describes the governing policies and implementation of the 
supervisory stress test. Section 3 establishes the principles and 
policies for the validation of models used in the supervisory stress 
test. The Board may determine that modifications to the Policy 
Statement would be appropriate if the principles and policies that 
guide decisions in the supervisory stress test are revised materially. 
The Board is inviting public comment on all aspects of the proposed 
Policy Statement.

III. Administrative Law Matters

A. Use of Plain Language

    Section 722 of the Gramm-Leach-Bliley Act (Pub. L. 106-102, 113 
Stat. 1338, 1471, 12 U.S.C. 4809) requires the Federal banking agencies 
to use plain language in all proposed and final rules published after 
January 1, 2000. The Board has sought to present the proposed rule in a 
simple and straightforward manner, and invites comment on the use of 
plain language.

B. Paperwork Reduction Act Analysis

    In accordance with the requirements of the Paperwork Reduction Act 
of 1995 (44 U.S.C. 3506), the Board has reviewed the proposed policy 
statement to assess any information collections. There are no 
collections of information as defined by the Paperwork Reduction Act in 
the proposal.

C. Regulatory Flexibility Act Analysis

    In accordance with section 3(a) of the Regulatory Flexibility Act 
(RFA), the Board is publishing an initial regulatory flexibility 
analysis of the proposed policy statement. The RFA, 5 U.S.C. 601 et 
seq., requires each federal agency to prepare an initial regulatory 
flexibility analysis in connection with the promulgation of a proposed 
rule, or certify that the proposed rule will not have a significant 
economic impact on a substantial number of small entities.\8\ The RFA 
requires an agency either to provide an initial regulatory flexibility 
analysis with a proposed rule for which a general notice of proposed 
rulemaking is required or to certify that the proposed rule will not 
have a significant economic impact on a substantial number of small 
entities. Based on its analysis and for the reasons stated below, the 
Board believes that the proposed policy statement will not have a 
significant economic impact on a substantial number of small entities.
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    \8\ See 5 U.S.C. 603, 604, and 605.
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    Under regulations issued by the Small Business Administration 
(SBA), a ``small entity'' includes those firms within the ``Finance and 
Insurance'' sector with asset sizes that vary from $7 million or less 
in assets to $175 million or less in assets.\9\ The Board believes that 
the Finance and Insurance sector constitutes a reasonable universe of 
firms for these purposes because such firms generally engage in actives 
that are financial in nature. Consequently, bank holding companies or 
nonbank financial companies with assets sizes of $175 million or less 
are small entities for purposes of the RFA.
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    \9\ 13 CFR 121.201.
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    As discussed in the SUPPLEMENTARY INFORMATION, the proposed policy 
statement generally would affect the stress test framework used in 
regulations that apply to bank holding companies with $50 billion or 
more in total consolidated assets and nonbank financial companies that 
the Council has determined under section 113 of the Dodd-Frank Act must 
be supervised by the Board and for which such determination is in 
effect. Companies that are affected by the proposed policy statement 
therefore substantially exceed the $175 million asset threshold at 
which a banking entity is considered a ``small entity'' under SBA 
regulations.\10\ The proposed policy statement would affect a nonbank 
financial company designated by the Council under section 113 of the 
Dodd-Frank Act regardless of such a company's asset size. Although the 
asset size of nonbank financial companies may not be the determinative 
factor of whether such companies may pose systemic risks and would be 
designated by the Council for supervision by the Board, it is an 
important consideration.\11\ It is therefore unlikely that a financial 
firm that is at or below the $175 million asset threshold would be 
designated by the Council under section 113 of the Dodd-Frank Act 
because material financial distress at such firms, or the nature, 
scope, size, scale, concentration, interconnectedness, or mix of it 
activities, are not likely to pose a threat to the financial stability 
of the United States.
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    \10\ The Dodd-Frank Act provides that the Board may, on the 
recommendation of the Council, increase the $50 billion asset 
threshold for the application of certain of the enhanced standards. 
See 12 U.S.C. 5365(a)(2)(B). However, neither the Board nor the 
Council has the authority to lower such threshold.
    \11\ See 76 FR 4555 (January 26, 2011).
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    As noted above, because the proposed policy statement is not likely 
to apply to any company with assets of $175 million or less, if adopted 
in final form, it is not expected to affect any small entity for 
purposes of the RFA. The Board does not believe that the proposed 
policy statement duplicates, overlaps, or conflicts with any other 
Federal rules. In light of the foregoing, the Board does not believe 
that the proposed policy statement, if adopted in final form, would 
have a significant economic impact on a substantial number of small 
entities supervised. Nonetheless, the Board seeks comment on whether 
the proposed policy statement would impose undue burdens on, or have 
unintended consequences

[[Page 59530]]

for, small organizations, and whether there are ways such potential 
burdens or consequences could be minimized in a manner consistent its 
purpose.

List of Subjects in 12 CFR Part 252

    Administrative practice and procedure, Banks, Banking, Federal 
Reserve System, Holding companies, Nonbank financial companies 
supervised by the Board, Reporting and recordkeeping requirements, 
Securities, Stress testing.

Authority and Issuance

    For the reasons stated in the Supplementary Information, the Board 
of Governors of the Federal Reserve System proposes to amend 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. Add appendix B to part 252 to read as follows:

Appendix B to Part 252--Stress Testing Policy Statement

    This Policy Statement describes the principles, policies, and 
procedures that guide the development, implementation, and 
validation of models used in the Federal Reserve's supervisory 
stress test.

1. Principles of Supervisory Stress Testing

    The system of models used in the supervisory stress test is 
designed to result in projections that are (i) from an independent 
supervisory perspective; (ii) forward-looking; (iii) consistent and 
comparable across covered companies; (iv) generated from simple 
approaches, where appropriate; (v) robust and stable; (vi) 
conservative; and (vii) able to capture the impact of economic 
stress. These principles are further explained below.

1.1. Independence

    In the supervisory stress test, the Federal Reserve uses models 
that are developed internally and independently (i.e., separately 
from models used by covered companies). The supervisory models rely 
on detailed portfolio data provided by covered companies, but do not 
rely on models or estimates provided by covered companies to the 
greatest extent possible.
    The Federal Reserve's stress testing framework is unique among 
regulators in its generation of estimates of covered companies' 
stressed losses and revenues that are not determined in consultation 
with firms or influenced by firm-provided estimates. Doing so 
enables the Federal Reserve to provide the public and the covered 
companies with credible, independent assessments of each firm's 
capital adequacy under stress and helps instill public confidence in 
the banking system.
    The independence of the supervisory stress test allows stress 
test projections to adhere to the other key principles described in 
the Policy Statement. The use of independent models allows for 
consistent treatment across firms. Losses and revenues under stress 
are estimated using the same modeling assumptions for all covered 
companies, enabling comparisons across supervisory stress test 
results. Differences in covered companies' results reflect 
differences in firm-specific risks and input data instead of 
differences in modeling assumptions. The use of independent models 
also ensures that stress test results are produced by stress-focused 
models, designed to project the performance of covered companies in 
adverse economic conditions.
    In instances in which it is not possible or appropriate to 
create a supervisory model for use in the stress test, including 
when supervisory data are insufficient to support a modeled estimate 
of losses or revenues, the Federal Reserve may use firm-provided 
estimates or third-party models or data. For example, in order to 
project trading and counterparty losses, sensitivities to risk 
factors and other information generated by covered companies' 
internal models are used. In the cases where firm-provided or third-
party model estimates are used, the Federal Reserve monitors the 
quality and performance of the estimates through targeted 
examination, additional data collection, or benchmarking. The Board 
releases a list of the providers of third-party models or data used 
in the stress test exercise in the annual disclosure of quantitative 
results.
    Question number 1: The modeling framework of the Federal 
Reserve's supervisory stress test seeks to promote consistency and 
comparability in evaluating the impact of severe economic stress 
upon covered companies by generating independent estimates of 
losses, revenues, and capital. Are there additional advantages or 
disadvantages to this independent framework, relative to a framework 
that relies on models or estimates provided by covered companies?

1.2. Forward-Looking

    The Federal Reserve has designed the supervisory stress test to 
be forward-looking. Supervisory models are tools for producing 
projections of potential losses and revenue effects based on each 
covered company's portfolio and circumstances.
    While supervisory models are specified using historical data, 
they should generally avoid relying solely on extrapolation of past 
trends in order to make projections, and instead should be able to 
incorporate events or outcomes that have not occurred. As described 
in Section 2.4, the Federal Reserve implements several supervisory 
modeling policies to limit reliance on past outcomes in its 
projections of losses and revenues. The incorporation of the 
macroeconomic scenario and global market shock component also 
introduces elements outside the realm of historical experience into 
the supervisory stress test.

1.3. Consistency and Comparability

    The Federal Reserve uses the same set of models and assumptions 
to produce loss projections for all covered companies participating 
in the supervisory stress test. A standard set of scenarios, 
assumptions, and models promotes equitable treatment of firms 
participating in the supervisory stress test and comparability of 
results, supporting cross-firm analysis and providing valuable 
information to supervisors and to the public. Adhering to a 
consistent modeling approach across covered companies means that 
differences in projected results are due to differences in input 
data, such as instrument type or portfolio risk characteristics, 
rather than differences in firm-specific assumptions made by the 
Federal Reserve.

1.4. Simplicity

    The Federal Reserve uses simple approaches in supervisory 
modeling, where possible. Given a range of modeling approaches that 
are equally conceptually sound, the Federal Reserve will select the 
least complex modeling approach. In assessing simplicity, the 
Federal Reserve favors those modeling approaches that allow for a 
more straightforward interpretation of the drivers of model results 
and that minimize operational challenges for model implementation.

1.5. Robustness and Stability

    The Federal Reserve maintains supervisory models that aim to be 
robust and stable, such that changes in model projections over time 
reflect underlying risk factors, scenarios, and model enhancements, 
rather than transitory factors. The estimates of post-stress capital 
produced by the supervisory stress test provide information 
regarding a covered company's capital adequacy to market 
participants, covered companies, and the public. Adherence to this 
principle helps to ensure that changes in these model projections 
over time are not driven by temporary variations in model 
performance or inputs. Supervisory models are recalibrated with 
newly available input data each year. These data affect supervisory 
model projections, particularly in times of evolving risks. However, 
these changes generally should not be the principal driver of a 
change in results, year over year.

1.6. Conservatism

    Given a reasonable set of assumptions or approaches, all else 
equal, the Federal Reserve will opt to use those that result in 
larger losses or lower revenue. For example, given a lack of 
information about the true risk of a portfolio, the Federal Reserve 
will compensate for the lack of data by using a high percentile loss 
rate.

1.7. Focus on the Ability To Evaluate the Impact of Severe Economic 
Stress

    In evaluating whether supervisory models are appropriate for use 
in a stress testing exercise, the Federal Reserve places particular 
emphasis on supervisory models' abilities to project outcomes in 
stressed economic environments. In the supervisory stress test, the 
Federal Reserve also seeks to capture risks to capital that arise 
specifically in times of economic stress, and that would not be 
prevalent in more typical economic environments. For example, the 
Federal Reserve includes losses stemming from the default of a 
covered company's largest

[[Page 59531]]

counterparty in projections of post-stress capital for firms with 
substantial trading or processing and custodial operations. The 
default of a company's largest counterparty is more likely to occur 
in times of severe economic stress than in normal economic 
conditions.

2. Supervisory Stress Test Model Policies

    To be consistent with the seven principles outlined in Section 
1, the Federal Reserve has established policies and procedures to 
guide the development, implementation, and use of all models used in 
supervisory stress test projections, described in more detail below. 
Each policy facilitates adherence to at least one of the modeling 
principles that govern the supervisory stress test, and in most 
cases facilitates adherence to several modeling principles.

2.1. Soundness in Model Design

    During development, the Federal Reserve (i) subjects supervisory 
models to extensive review of model theory and logic and general 
conceptual soundness; (ii) examines and evaluates justifications for 
modeling assumptions; and (iii) tests models to establish the 
accuracy and stability of the estimates and forecasts that they 
produce.
    After development, the Federal Reserve continues to subject 
supervisory models to scrutiny during implementation to ensure that 
the models remain appropriate for use in the stress test exercise. 
The Federal Reserve monitors changes in the economic environment, 
the structure of covered companies and their portfolios, and the 
structure of the stress testing exercise, if applicable, to verify 
that a model in use continues to serve the purposes for which it was 
designed. Generally, the same principles, rigor, and standards for 
evaluating the suitability of supervisory models that apply in model 
development and design will apply in ongoing monitoring of 
supervisory models.

2.2. Disclosure of Information Related to the Supervisory Stress Test

    In general, the Board does not disclose firm-specific results or 
other information related to the supervisory stress test to covered 
companies if that information is not also publicly disclosed. This 
policy promotes consistent and equitable treatment of covered 
companies by ensuring that institutions do not have access to 
information about the supervisory stress test that is not accessible 
to all covered companies, corresponding to Principle 1.3.
    The Board publicly discloses information related to the 
supervisory stress test on a regular basis, instead of privately 
communicating this information to covered companies. The Board has 
increased the breadth of its public disclosure since the inception 
of the supervisory stress test to include more information about 
model changes and key risk drivers, in addition to more detail on 
different components of projected net revenues and losses. 
Increasing public disclosure helps the public understand and 
interpret the results of the supervisory stress test, particularly 
with respect to the condition and capital adequacy of participating 
firms. Providing additional information about the supervisory stress 
test also allows the public to make an evaluation of the quality of 
the Board's capital adequacy assessment.

2.3. Phasing in of Highly Material Model Changes

    The Federal Reserve may revise its supervisory stress test 
models to include advances in modeling techniques, enhancements in 
response to model validation findings, incorporation of richer and 
more detailed data, public comment, and identification of models 
with improved performance, particularly under adverse economic 
conditions. Revisions to supervisory stress models may at times have 
a material impact on modeled outcomes.
    In order to mitigate sudden and unexpected changes to the 
supervisory stress test results, the Federal Reserve follows a 
general policy of phasing highly material model changes into the 
supervisory stress test over two years. The Federal Reserve assesses 
whether a model change would have a highly significant impact on the 
projections of losses, components of revenue, or post-stress capital 
ratios for covered companies. In these instances, in the first year 
when the model change is first implemented, estimates produced by 
the enhanced model are averaged with estimates produced by the model 
used in the previous stress test exercise. In the second and 
subsequent years, the supervisory stress test exercise will reflect 
only estimates produced by the enhanced model. This policy 
contributes to the stability of the results of the supervisory 
stress test, corresponding to Principle 1.5. By implementing highly 
material model changes over the course of two stress test cycles, 
the Federal Reserve seeks to ensure that changes in model 
projections primarily reflect changes in underlying risk factors and 
scenarios, year over year.
    Question number 2: The Federal Reserve assesses individual model 
changes each year to determine whether these model changes will have 
a highly significant impact on the projections of losses, revenues, 
or post-stress capital ratios for covered companies, and whether 
these changes warrant a phase-in over two stress test exercises. 
What thresholds should the Federal Reserve use to determine whether 
model changes will have a highly significant impact on projections?

2.4. Limiting Reliance on Past Outcomes

    Models should not place undue emphasis on historical outcomes in 
predicting future outcomes. The Federal Reserve aims to produce 
supervisory stress test results that reflect likely outcomes under 
the supervisory scenarios. The supervisory scenarios may potentially 
incorporate events that have not occurred historically. It is not 
consistent with the purpose of a stress testing exercise to assume 
that the future will always be like the past.
    In order to model potential outcomes outside the realm of 
historical experience, the Federal Reserve generally does not 
include variables that would capture unobserved historical patterns 
in supervisory models. The use of industry-level models, restricted 
use of firm-specific fixed effects (described below), and minimized 
use of dummy variables indicating a loan vintage or a specific year 
ensure that the outcomes of the supervisory models are forward-
looking, consistent and comparable across firms, and robust and 
stable.
    Firm-specific fixed effects are variables that identify a 
specific firm and capture unobserved differences in the revenues, 
expenses or losses among firms. Firm-specific fixed effects are 
generally not incorporated in supervisory models in order to avoid 
the assumption that unobserved firm-specific historical patterns 
will continue in the future. Exceptions to this policy are made 
where appropriate. For example, if granular portfolio-level data on 
key drivers of a covered company's performance are limited or 
unavailable, and firm-specific fixed effects are more predictive of 
a covered company's future performance than are industry-level 
variables, then supervisory models may be specified with firm-
specific fixed effects.
    Models used in the supervisory stress test are developed 
according to an industry-level approach, calibrated using data from 
many institutions. In adhering to an industry-level approach, the 
Federal Reserve models the response of specific portfolios and 
instruments to variations in macroeconomic and financial scenario 
variables. In this way, the Federal Reserve ensures that differences 
across covered companies are driven by differences in firm-specific 
input data, as opposed to differences in model parameters or 
specifications. The industry approach to modeling is also forward-
looking, consistent with Principle 1.2, as the Federal Reserve does 
not assume that historical patterns will necessarily continue into 
the future for individual firms. By modeling a portfolio or 
instrument's response to changes in economic or financial conditions 
at the industry level, the Federal Reserve ensures that projected 
future losses are a function of that portfolio or instrument's own 
characteristics, rather than the historical experience of the 
covered company. This policy helps to ensure that two firms with the 
same portfolio receive the same results for that portfolio in the 
supervisory stress test.
    The Federal Reserve minimizes the use of loan vintage or year-
specific fixed effects when estimating models and producing 
supervisory projections. In general, these types of variables are 
employed only when there are significant structural market shifts or 
other unusual factors for which supervisory models cannot otherwise 
account. Similar to the firm-specific fixed effects policy, and 
consistent with Principle 1.2, this vintage indicator policy is in 
place so that projections of future performance under stress do not 
incorporate assumptions that patterns in unmeasured factors from 
brief historical time periods persist. For example, the loans 
originated in a particular year should not be assumed to continue to 
default at a higher rate in the future because they did so in the 
past.
    Question number 3: The Federal Reserve seeks to model potential 
outcomes outside the realm of historical experience, and in 
connection with doing so, has implemented policies to limit its own 
reliance on historical outcomes in model design and calibration. 
What other policies or methodologies would allow the Federal Reserve 
to incorporate

[[Page 59532]]

events that have not occurred historically in supervisory stress 
test projections while maintaining the integrity of the supervisory 
stress tests?

2.5. Treatment of Global Market Shock and Largest Counterparty Default 
Components

    Both the global market shock and counterparty default components 
are exogenous components of the supervisory stress scenarios that 
are independent of the macroeconomic and financial market 
environment specified in those scenarios, and do not affect 
projections of risk-weighted assets or balances. The global market 
shock, which specifies movements in numerous market factors,\1\ 
applies only to covered companies with significant trading exposure. 
The largest counterparty default scenario component applies only to 
covered companies with substantial trading or processing and 
custodial operations. Though these stress factors may not be 
directly correlated to macroeconomic or financial assumptions, they 
can materially affect covered companies' risks. Losses from both 
components are therefore considered in addition to the estimates of 
losses under the macroeconomic scenario.
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    \1\ See appendix A to this part, ``Policy Statement on the 
Scenario Design Framework for Stress Testing,'' for a detailed 
description of the global market shock.
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    Counterparty credit risk on derivatives and repo-style 
activities is incorporated in supervisory modeling in part by 
assuming the default of the single counterparty to which the covered 
firm would be most exposed in the global market shock event.\2\ 
Requiring covered companies subject to the largest counterparty 
default component to estimate and report the potential losses and 
effects on capital associated with such an instantaneous default is 
a simple method for capturing an important risk to capital for firms 
with large trading and custodial or processing activities. 
Engagement in substantial trading or custodial operations makes the 
covered companies subject to the largest counterparty default 
scenario component particularly vulnerable to the default of their 
major counterparty or their clients' counterparty, in transactions 
for which the covered companies act as agents. The largest 
counterparty default component is consistent with the purpose of a 
stress testing exercise, as discussed in Principle 1.7. The default 
of a covered company's largest counterparty is a salient risk in a 
macroeconomic and financial crisis, and generally less likely to 
occur in times of economic stability. This approach seeks to ensure 
that covered companies can absorb losses associated with the default 
of any counterparty, in addition to losses associated with adverse 
economic conditions, in an environment of economic uncertainty.
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    \2\ In addition to incorporating counterparty credit risk by 
assuming the default of the covered company's largest counterparty, 
the Federal Reserve incorporates counterparty credit risk in the 
supervisory stress test by estimating mark-to-market losses, credit 
valuation adjustment (CVA) losses, and incremental default risk 
(IDR) losses associated with the global market shock.
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    The full effect of the global market shock and counterparty 
default components is realized in net income in the first quarter of 
the projection horizon in the supervisory stress test. The Board 
expects covered companies with material trading and counterparty 
exposures to be sufficiently capitalized to absorb losses stemming 
from these exposures that could occur during times of general 
macroeconomic stress.

2.6. Incorporation of Business Plan Changes

    The Federal Reserve incorporates material changes in the 
business plans of covered companies, including mergers, 
acquisitions, and divestitures over the projection horizon, in the 
supervisory stress test projections. The incorporation of business 
plan changes in the supervisory stress test is a requirement of the 
capital plan rule,\3\ and captures a risk to the capital of covered 
companies. Allowing for the inclusion of mergers, acquisitions, and 
divestitures is forward-looking, and consistent with Principle 1.2, 
as the Federal Reserve seeks to capture material impacts on a 
covered company's post-stress capital that may arise from a business 
plan change in the course of the projection horizon.
---------------------------------------------------------------------------

    \3\ 12 CFR 225.8(e)(2).
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    The incorporation of business plan changes in supervisory 
projections is consistent with the purpose of a stress testing 
exercise, corresponding to Principle 1.7. In CCAR specifically, the 
Board evaluates whether covered companies have the ability to 
complete their projected capital actions in the supervisory stress 
test while remaining above post-stress minimum capital and leverage 
ratios. Business plan changes such as mergers, acquisitions, or 
divestitures, may have material impacts on these firm-projected 
capital actions and on the projected ability of a covered company to 
make planned capital distributions and maintain capital ratios above 
regulatory minima.
    A consistent methodology for modeling of business plan changes 
is applied across covered companies. The data that are available 
about characteristics of assets being acquired or divested are 
generally limited and less granular than other data collected by the 
Board in the Capital Assessments and Stress Testing (FR Y-14) 
information collection. Projections of the effects of business plan 
changes may rely on less granular information and may result in 
simpler modeling approaches than supervisory projections for legacy 
portfolios or businesses.

2.7. Credit Supply Maintenance

    The supervisory stress test incorporates the assumption that 
aggregate credit supply does not contract during the stress period. 
The aim of supervisory stress testing is to assess whether firms are 
sufficiently capitalized to absorb losses during times of economic 
stress, while meeting obligations and continuing to lend to 
households and businesses. The assumption that a balance sheet of 
constant or increasing magnitude is maintained allows supervisors to 
evaluate the health of the banking sector, assuming firms continue 
to lend during times of stress.
    In order to implement this policy, the Federal Reserve must make 
assumptions about new loan balances. To predict losses on new 
originations over the planning horizon, newly originated loans are 
assumed to have the same risk characteristics as the existing 
portfolio, where applicable, with the exception of loan age and 
delinquency status. These newly originated loans would be part of a 
covered company's normal business, even in a stressed economic 
environment. While an individual firm may assume that it reacts to 
rising losses by sharply restricting its lending, (e.g. by exiting a 
particular business line), the banking industry as a whole cannot do 
so without creating a ``credit crunch'' and substantially increasing 
the severity and duration of an economic downturn. The assumption 
that the magnitude of firm balance sheets will be fixed or growing 
in the supervisory stress test ensures that covered companies cannot 
assume they will ``shrink to health,'' and serves the Federal 
Reserve's goal of helping to ensure that major financial firms 
remain sufficiently capitalized to accommodate credit demand in a 
severe downturn. In addition, by precluding the need to make 
assumptions about how underwriting standards might tighten or loosen 
during times of economic stress, the Federal Reserve adheres to 
Principle 1.3 and promotes consistency across covered companies.
    Question number 4: The Federal Reserve seeks to assess covered 
companies' capital adequacy in times of stress while those firms 
continue to lend. Beyond assuming that the magnitude of firm balance 
sheets is fixed or growing, are there other assumptions that could 
be incorporated into the supervisory stress test that would allow 
the Federal Reserve to make this assessment?

2.8. Firm-Specific Overlays and Additional Firm-Provided Data

    The Federal Reserve does not make firm-specific overlays to 
model results used in the supervisory stress test. This policy 
ensures that the supervisory stress test results are determined 
solely by the industry-level supervisory models and by firm-specific 
input data. The Federal Reserve does not use additional input data 
submitted by one or more covered companies unless it collects 
comparable data from all the covered companies that have material 
exposure in a given area. Input data necessary to produce 
supervisory stress test estimates is collected via the Capital 
Assessments and Stress Testing (FR Y-14) information collection. The 
Federal Reserve may request additional information from covered 
companies, but otherwise will not incorporate additional information 
provided as part of a firm's CCAR submission or obtained through 
other channels into stress test projections.
    This policy curbs the use of data only from firms that have 
incentives to provide it, as in cases in which additional data would 
support the estimation of a lower loss rate or a higher revenue 
rate, and adheres to Principle 1.3 by promoting consistency across 
the stress test results of covered companies.

2.9. Treatment of Missing or Erroneous Data

    Missing data, or data with deficiencies significant enough to 
preclude the use of supervisory models, create uncertainty around 
estimates of losses or components of revenue. If data that are 
direct inputs to

[[Page 59533]]

supervisory models are not provided as required by the Capital 
Assessments and Stress Testing (FR Y-14) information collection or 
are reported erroneously, then a conservative value will be assigned 
to the specific data based on all available data reported by covered 
companies, depending on the extent of the data deficiency. If the 
data deficiency is severe enough that a modeled estimate cannot be 
produced for a portfolio segment or portfolio, then the Federal 
Reserve may assign a conservative rate (e.g., 10th or 90th 
percentile PPNR or loss rate, respectively) to that segment or 
portfolio.
    This policy reflects a conservative assumption given a lack of 
information sufficient to produce a risk-sensitive estimate of 
losses or revenues. This policy promotes policy 1.3 by ensuring 
consistent treatment for all covered companies that report data 
deemed insufficient to produce a modeled estimate. Finally, this 
policy is simple and transparent, consistent with Principle 1.4.

2.10. Treatment of Immaterial Portfolio Data

    The Federal Reserve makes a distinction between missing or 
insufficient data reported by covered companies for material and 
immaterial portfolios. To limit regulatory burden, the Federal 
Reserve allows covered companies not to report detailed loan-level 
or portfolio-level data for loan types that are not material as 
defined in the FR Y-14 reporting instructions. In these cases, a 
loss rate representing the median rates among covered companies for 
whom the rate is calculated will be applied to immaterial 
portfolios. This approach is consistent across covered companies, 
simple, and transparent, promoting Principles 1.3 and 1.4.
    Question number 5: Each of the modeling policies described in 
Section 2 are consistent with at least one of the central principles 
of supervisory stress test modeling described herein. Are there 
other policies the Federal Reserve could implement to further 
promote the principles of independence, forward-looking perspective, 
consistency and comparability, simplicity, robustness and stability, 
or conservativism, or that would focus on the ability to evaluate 
the impact of severe economic stress?

3. Principles and Policies of Supervisory Model Validation

    Independent and comprehensive model validation is key to the 
credibility of the supervisory stress test. An independent unit of 
validation staff within the Federal Reserve, with input from an 
advisory council of academic experts not affiliated with the Federal 
Reserve, ensures that stress test models are subject to effective 
challenge, defined as critical analysis by objective, informed 
parties that can identify model limitations and recommend 
appropriate changes.
    The Federal Reserve's supervisory model validation program, 
built upon the principles of independence, technical competence, and 
stature, is able to subject models to effective challenge, expanding 
upon supervisory modeling teams' efforts to manage model risk and 
confirming that supervisory models are appropriate for their 
intended uses. The supervisory model validation program produces 
reviews that are consistent, thorough, and comprehensive. Its 
structure ensures independence from the Federal Reserve's model 
development function, and its prominent role in communicating the 
state of model risk to the Board of Governors assures its stature 
within the Federal Reserve.

3.1. Structural Independence

    The management and staff of the internal model validation 
program are structurally independent from the model development 
teams. Validators do not report to model developers, and vice versa. 
This ensures that model validation is conducted and overseen by 
objective parties. Validation staff's performance criteria include 
an ability to review all aspects of the models rigorously, 
thoroughly, and objectively, and to provide meaningful and clear 
feedback to model developers and users.
    In addition, a council of external academic experts provides 
independent advice on the Federal Reserve's process to assess models 
used in the supervisory stress test. In biannual meetings with 
Federal Reserve officials, members of the council discuss selected 
supervisory models, after being provided with detailed model 
documentation for those models, including some confidential 
supervisory information. The documentation and discussions enable 
the council to assess the effectiveness of the models used in the 
supervisory stress tests and of the overarching model validation 
program.

3.2. Technical Competence of Validation Staff

    The model validation program is designed to provide thorough, 
high-quality reviews that are consistent across supervisory models.
    First, the model validation program employs technically expert 
staff with knowledge across model types. Second, reviews for every 
supervisory model follow the same set of review guidelines, and take 
place on an ongoing basis. The model validation program is 
comprehensive, in the sense that validators assess all models 
currently in use, and expand the scope of validation beyond basic 
model use, and cover both model soundness and performance.
    The model validation program covers three main areas of 
validation: (1) Conceptual soundness; (2) ongoing monitoring; and 
(3) outcomes analysis. Validation staff evaluate all aspects of 
model development, implementation, and use, including but not 
limited to theory, design, methodology, input data, testing, 
performance, documentation standards, implementation controls 
(including access and change controls), and code verification. 
Finally, the model validation program seeks to balance technical 
expertise with fresh scrutiny of supervisory models. In order to 
provide a new perspective on established models and practices, 
validation staff are re-allocated across models at regular 
intervals.

3.3. Stature of Validation Function

    Through clear communication and participation in the model 
decision making process, the validation function has the influence 
and stature within the Federal Reserve to ensure that any issues and 
deficiencies are appropriately addressed in a timely and substantive 
manner.
    The model validation program communicates its findings and 
recommendations regarding model risk to all internal stakeholders. 
Validators provide detailed feedback to model developers and provide 
thematic feedback or observations on the overall system of models to 
the management of the modeling teams. Model validation feedback is 
also communicated to the users of supervisory model output for use 
in their deliberations and decisions about supervisory stress 
testing. In addition, the Federal Reserve Board's Director of 
Supervision and Regulation approves all models used in the 
supervisory stress test in advance of each exercise, based on 
validators' recommendations, development responses, and suggestions 
for risk mitigants. In several cases, models have been modified or 
implemented differently based on validators' feedback. The advisory 
council of academic experts also contributes to the stature of the 
Federal Reserve's validation program, by providing an external point 
of view on modifications to supervisory models and on validation 
program governance.
    Ultimately, the validation program serves to inform the Board of 
Governors about the state of model risk in the overall stress 
testing program, along with ongoing practices to control and 
mitigate model risk.

    By order of the Board of Governors of the Federal Reserve 
System, December 7, 2017.
Ann E. Misback,
Secretary of the Board.
[FR Doc. 2017-26857 Filed 12-14-17; 8:45 am]
BILLING CODE 6210-01-P