[Federal Register Volume 82, Number 240 (Friday, December 15, 2017)]
[Proposed Rules]
[Pages 59533-59547]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2017-26858]


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FEDERAL RESERVE SYSTEM

12 CFR Part 252

[Regulation YY; Docket No. OP-1588]


Policy Statement on the Scenario Design Framework for Stress 
Testing

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 requesting public comment on amendments to its 
policy statement on the scenario design framework for stress testing. 
The proposed amendments to the policy statement would clarify when the 
Board may adopt a change in the unemployment rate in the severely 
adverse scenario of less than 4 percentage points; institute a counter-
cyclical guide for the change in the house price index in the severely 
adverse scenario; and provide notice that the Board plans to 
incorporate wholesale funding costs for banking organizations in the 
scenarios. The Board would continue to use the policy

[[Page 59534]]

statement to develop the macroeconomic scenarios and additional 
scenario components that are used in the supervisory and company-run 
stress tests conducted under the Board's stress test rules 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-1588 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: regs.comments@federalreserve.gov. 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, Joseph Cox, Supervisory Financial Analyst, (202) 452-3216, or 
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; or William Bassett, Associate Director, (202) 736-5644, 
Luca Guerrieri, Deputy Associate Director, (202) 452-2550, or Bora 
Durdu, Chief, (202) 452-3755, Division of Financial Stability.

SUPPLEMENTARY INFORMATION:

I. Background

A. Supervisory Scenarios

    Pursuant to the Board's stress test rules, the Board conducts 
supervisory stress tests of bank holding companies and U.S. 
intermediate holding companies subsidiaries of foreign banking 
organizations with total consolidated assets of $50 billion or more 
(covered companies) and requires covered companies to conduct semi-
annual company-run stress tests.\1\ In addition, savings and loan 
holding companies, state member banks with greater than $10 billion in 
total consolidated assets, and bank holding companies with assets of 
more than $10 billion but less than $50 billion are required to conduct 
annual company-run stress tests.\2\
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    \1\ 12 CFR part 252, subparts E and F. In addition, the 
supervisory stress test rules would apply to any nonbank financial 
company supervised by the Board that becomes subject to these 
requirements pursuant to a rule or order of the Board. Currently, no 
nonbank financial companies supervised by the Board are subject to 
the capital planning or stress test requirements.
    \2\ 12 CFR part 252, subpart B.
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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 
an annual 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 (12 CFR 225.8), and the Federal Reserve also uses these scenarios 
to evaluate each firm's capital plan in the supervisory post-stress 
capital assessment.\3\
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    \3\ Bank holding companies with $50 billion or more in total 
consolidated assets and U.S. intermediate holding companies of 
foreign banking organizations additionally conduct mid-cycle 
company-run stress tests under scenarios that they develop. See 12 
CFR 252.55.
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    On November 29, 2013, the Board adopted a final policy statement on 
its scenario design framework for stress testing (policy statement).\4\ 
The policy statement outlined the characteristics of the supervisory 
stress test scenarios and explained the considerations and procedures 
that underlie the formulation of these scenarios. The considerations 
and procedures described in the 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, and the Board's capital plan 
rule. The policy statement describes in greater detail than the stress 
test rules the baseline, adverse, and severely adverse scenarios. The 
policy statement also describes the Board's approach for developing 
these three macroeconomic scenarios and additional components of the 
stress test scenarios, which apply to a subset of covered companies.
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    \4\ 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, in developing 
the severely adverse scenario, 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.
    The Board's scenario design framework includes a counter-cyclical 
design element in the change in the unemployment rate in the severely 
adverse scenario. 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. 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 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 policy statement provides that the Board intends 
to set the unemployment rate at the higher end of the 3 to 5 percentage 
point range if the Board believes that cyclical systemic risks are high 
(as they would be after a sustained long expansion), and to the lower 
end of the range if cyclical systemic risks are low (as they would be 
in the earlier stages of a recovery).
    The policy statement provides that economic variables included in 
the scenarios may change over time, or that

[[Page 59535]]

the Board may augment the recession approach to account for salient 
risks.\5\ The Board has not historically captured stress to funding 
markets in the supervisory stress test exercise. However, it is 
exploring the inclusion of such a stress in the scenarios, given the 
potential impact that funding shocks could have on firms subject to the 
supervisory stress test.
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    \5\ For example, if scenario variables do not capture material 
risks to capital, or if historical relationships between 
macroeconomic variables change such that one variable is no longer 
an appropriate proxy for another, the Board may add variables to a 
supervisory scenario. The Board may also include additional scenario 
components or additional scenarios that are designed to capture the 
effects of different adverse events on revenue, losses, and capital.
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B. Review of Stress Test Exercises

    The Federal Reserve routinely reviews its experience with each 
year's stress testing and capital planning programs as implemented 
through DFAST and CCAR. These reviews have included formal engagements 
with public interest groups, meetings with academics in the fields of 
economics and finance, and internal assessments.
    In the course of its review of the stress test exercises, the 
Federal Reserve has received feedback on the Board's framework for 
designing stress scenarios. Some participants advocated developing a 
structured process for strengthening scenario design over time. Other 
participants were concerned that the Federal Reserve would be pressured 
to reduce the severity of the scenario over time. As part of its 
internal assessment of the stress test exercises, the Federal Reserve 
also considered ways to further enhance the countercyclical elements, 
transparency, and risk coverage of the scenario design framework.
    After considering feedback received in these reviews and possible 
improvements to the methodology for specifying the macroeconomic 
scenarios used in the supervisory stress test and the annual company-
run stress tests, the Board is proposing to modify the policy statement 
to enhance the countercyclicality and transparency of the Board's 
scenario design framework and improve the risk coverage of the 
scenarios.

II. Review of the Supervisory Scenarios

A. Unemployment and House Prices in the Severely Adverse Scenario

    The Board investigated possible improvements to the methodology for 
specifying the macroeconomic scenarios used in supervisory and company-
run stress tests. A main area of inquiry was the severity of 
macroeconomic scenarios used in previous stress test exercises. As 
noted, the scenario design framework was formulated to increase the 
severity of the severely adverse scenario during economic expansions in 
order to limit the procyclicality of the financial system by increasing 
the resilience of the banking system to building risks. The review 
evaluated the path of key variables in the severely adverse scenarios 
since 2011, and determined that amendments to the scenario design 
framework could further limit procyclicality.\6\
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    \6\ For completeness, the tables present data from the 2017 
severely adverse scenario, however, this data was not available at 
the time of the review conducted by the Board. The data from 2017 
was generally consistent with the analysis of the earlier scenarios.
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    The severity of a scenario can be gauged by considering both the 
maximum (or minimum) levels obtained by key variables and changes of 
the variables from their starting points. Table 1 shows the peak and 
change in the unemployment rate in the supervisory severely adverse 
scenarios since 2011.\7\ The peak unemployment rate in the severely 
adverse scenario has been falling since CCAR 2012 as the economy 
improved. Beginning in 2016, the countercyclical element of the Board's 
scenario design framework acted to increase scenario severity, so while 
the peak level of the unemployment rate remained about the same, the 
change in the unemployment rate increased. The countercyclical design 
of the scenarios is also reflected in the change in real GDP, which, in 
2017, declined by the largest amount since 2012.
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    \7\ The change in real gross domestic product (real GDP) is also 
presented as an additional gauge of severity because the path of 
real GDP is formulated based on the path of the unemployment.

                                        Table 1--Unemployment Rate and Real GDP in the Severely Adverse Scenario
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                                                                               Stress test exercise                                Great        Severe
                                                  -----------------------------------------------------------------------------  recession    recessions
                                                    2011 \a\   2012 \a\     2013       2014       2015       2016       2017        \b\          \c\
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                                             Panel A: Developments as published in the supervisory scenarios
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Unemployment Rate:
    Peak Level (pct.)............................       11.1       12.6       12.1       11.3       10.1       10.0       10.0         10.0          9.3
    Change Start-to-peak (pp.)...................        1.5        3.6        4.0        4.0        4.0        5.0        5.3          4.5          3.6
Real GDP:
    Change Start-to-trough (pct.)................       -4.1       -6.9       -4.8       -4.7       -4.7       -6.2       -6.6         -4.7         -3.4
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Note:
\a\ In 2011 and 2012 the scenario was referred to as the ``supervisory stress scenario.''
\b\ Great Recession is defined as that which occurred in Q4:2007-Q2:2009.
\c\ Recessions classified as severe: 1957:Q3-1958:Q2, 1973:Q4-1975:Q1, 1981:Q3-1982:Q4, and 2007:Q4-2009:Q2.

    The Board also evaluated its approach to developing the path of 
house prices, which is a key scenario variable, to assess whether it 
could improve the transparency of the measure and to identify a guide 
that would formalize the Board's countercyclical objectives. To date, 
the Board has developed the path of house prices using a judgmental 
approach, and has not established a quantitative guide for the 
trajectory of house prices.
    As demonstrated in Panel A of table 2, the existing approach to 
house prices has resulted in increasing severity over time. The 
declines in the nominal house price index (nominal HPI) from the start 
to the trough have increased from 21 percent (in 2012 and 2013) to 
about 25-26 percent (in 2014 through 2017). The increased severity in 
the decline in nominal HPI in supervisory scenarios beginning in 2014 
offset the rise in observed house prices over that period, and hence 
limited procyclicality.
    Assessing the procyclicality of house price paths over time is 
complicated by the fact that house prices--in contrast to the 
unemployment rate--naturally trend upward over time. The ratio of 
nominal house prices to nominal, per capita, disposable personal income 
(HPI-DPI ratio, henceforth), does not exhibit an upward trend and, as 
such, provides an alternative way to assess the

[[Page 59536]]

procyclicality of the scenarios' house price paths. The severity of a 
scenario depends on both the change and the trough level of the HPI-DPI 
ratio. Panel A of table 2 indicates that the change in the HPI-DPI 
ratio increased in absolute terms in the years 2014 to 2017 compared to 
the years 2012 and 2013. However, the trough of the HPI-DPI ratio 
achieved in the severely adverse scenarios has generally moved up since 
2012. Scenarios with higher HPI-DPI troughs may be less severe even if 
they feature the same decline in the ratio.

                                                 Table 2--House Prices in the Severely Adverse Scenario
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                                                                               Stress test exercise                                Great       Housing
                                                  -----------------------------------------------------------------------------  recession    recessions
                                                    2011 \a\   2012 \a\     2013       2014       2015       2016       2017        \b\          \c\
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                                             Panel A: Developments as published in the supervisory scenarios
Nominal HPI:
    Change Start-to-trough (pct.)................        -11        -21        -21        -26        -26        -25        -25          -30          2.5
    Trough Level \c\.............................        124        106        111        116        126        135        134          130  ...........
HPI-DPI Ratio:
    Change Start-to-trough (pct.)................        -11        -19        -18        -27        -25        -25        -24          -41          -25
    Trough Level \c\.............................         89         76         78         75         79         82         81           87           95
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                                                  Panel B: Developments as implied by the HPI-DPI Guide
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Nominal HPI:
    Change Start-to-trough (pct.)................        -25        -27        -27        -24        -25        -25        -26          -30          2.5
    Trough Level \c\.............................        104         98        102        119        127        134        134          130  ...........
HPI-DPI Ratio:
    Change Start-to-trough (pct.)................        -25        -25        -25        -25        -25        -25        -25          -41          -25
    Trough Level \d\.............................         75         70         72         76         80         82         79           87           95
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Note:
\a\ In 2011 and 2012 the scenario was referred to as the ``supervisory stress scenario.''
\b\ Great Recession is defined as that which occurred in Q4:2007-Q2:2009.
\c\ Housing recessions are defined as the following date ranges: 1980-1985, 1989-1996, and 2006-2011. 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.
\d\ Both the nominal HPI and HPI-DPI ratios are indexed to 100 in 2000:Q1.

    Based on this analysis, the Board determined that its scenario 
design framework could be strengthened by (1) enhancing the counter-
cyclicality of the scenarios when conditions at the start of the 
exercise already reflected stress; and (2) improving the transparency 
of the scenario design framework by developing an explicit guide for 
formulating the path of house prices in the severely adverse scenario.

B. Risk Coverage in Supervisory Scenarios

    The Board also has examined whether there were important dimensions 
of risk that had not featured in supervisory scenarios to date. The 
review suggested that a key risk dimension that had not been directly 
addressed in the supervisory stress test was banking organizations' 
reliance on certain types of runnable liabilities, which has been an 
important source of financial stress on banking organizations, as well 
a channel by which one firm's distress affects other firms. For 
example, shocks to the costs of short-term wholesale funding played a 
prominent role in the recent financial crisis, and had a notable effect 
on firms' ability to operate as financial intermediaries. Accordingly, 
the Board is exploring incorporating an increase in the cost of short-
term wholesale funding in its scenarios and stress tests.

III. Proposed Amendments to the Policy Statement

    The proposal includes three modifications to the Board's scenario 
design framework. First, the proposal would modify 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 add to the policy statement an explicit 
guide for house prices in the severely adverse scenario based on the 
HPI-DPI ratio that features both a minimum level and a fixed change in 
the HPI-DPI ratio. Third, the proposal would provide notice that the 
Board is exploring the inclusion of an increase in the cost of funds 
for banking organizations as an explicit factor in the scenarios. 
Finally, the policy statement would be amended to update references and 
remove obsolete text.

A. Unemployment Rate in the Severely Adverse Scenario

    The proposal would 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. The Board currently 
calibrates the peak unemployment rate in the severely adverse scenario 
as the greater of a 3 to 5 percentage point increase from the 
unemployment rate at the beginning of the stress test planning horizon, 
or 10 percent. This approach introduces an element of counter-
cyclicality to the scenario design process, as lower levels of the 
unemployment rate at the beginning of the stress planning horizons 
imply a larger increase in unemployment over the severely adverse 
scenario to a level that is at least consistent with past severe 
recessions.
    Consistent with the current policy statement, the Board believes 
that the typical increase in the unemployment rate in the severely 
adverse scenario will be about 4 percentage points, and that a lower 
increase may be appropriate in certain circumstances. In determining 
the increase in the unemployment rate, the Board would consider the 
level of unemployment at the start of the scenarios, the strength of 
the labor market, and the strength of firms' balance sheets. The 
proposed framework would clarify 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 are in the process of being

[[Page 59537]]

realized--and thus removed from banks' balance sheets. 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.
    This proposed change would keep the unemployment rate in the 
macroeconomic scenario broadly similar to that in previous scenarios 
except during times when a smaller change would be appropriate based on 
the credit cycle. By adopting a smaller change in the unemployment rate 
when the economy was recovering and losses had already been broadly 
recognized by the industry, the proposal would complement the current 
counter-cyclical design elements.
    Question number 1: In connection with this proposal, the Federal 
Reserve considered an alternative guide for the unemployment rate, in 
which the path of the unemployment rate would reach the lesser of a 
level 4 percentage points above its level at the beginning of the 
scenario or 11 percent. On average, this alternative would increase the 
severity of severely adverse scenarios but also would be more 
countercyclical than the current guide. What are the advantages or 
disadvantages to this alternative relative to the proposed guide?

B. House Prices in the Severely Adverse Scenario

    The policy statement would also be amended 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 scenario variable, and 
providing explicit guidance for its path over the planning horizon 
would enhance the transparency and countercyclical design of the 
scenario design framework.
    The proposal would establish a quantitative guide for house prices. 
The guide for house prices would be informed by the ratio of the 
nominal house price index to nominal per capita disposable income (HPI-
DPI ratio). Unlike the level of house prices, the HPI-DPI ratio does 
not exhibit a trend over time. Under most circumstances, the decline in 
the HPI-DPI ratio in the severely adverse scenario is expected to be 25 
percent from its starting value or enough to bring the ratio down to 
its Great Recession trough, whichever is greater. A rule with both a 
minimum change in the ratio and a level of severity that the ratio must 
reach is consistent with the rule for the path of the unemployment rate 
and would further the Board's countercyclical goals in scenario design.
    In its analysis, the Board identified the HPI-DPI trough reached 
during the Great Recession as the lowest trough attained in housing 
recessions since 1976, and considered this trough an appropriate basis 
for explicit guidance for the path of house prices. Setting a minimum 
decline in the HPI-DPI ratio would ensure that additional economic 
stress would be incorporated into the macroeconomic scenario, even if 
house prices were depressed at the outset of the scenario. The Board 
would typically set a minimum decline in the HPI-DPI ratio of 25 
percent from its starting value. A decline of 25 percent is consistent 
with the average decline in housing recessions (see table 2 in the 
Policy Statement) and with the path of house prices in the supervisory 
severely adverse scenarios since 2015.
    Procyclicality in house prices would be limited by setting a 
maximum level for the trough of the HPI-DPI ratio in the severely 
adverse scenario. This would increase the severity of the decline in 
house prices as house prices rise relative to disposable personal 
incomes, as is the case in times of economic expansion. When the HPI-
DPI ratio rises above the level at which a 25 percent decline would 
bring the ratio to its Great Recession trough, at the start of the 
stress test, the change in the ratio would be greater than 25 percent 
in order to bring the ratio to its Great Recession trough.\8\ This 
proposal would offer a more systematic approach to specifying house 
price paths than does the current approach, and would limit 
procyclicality while broadly preserving the decline in the nominal HPI 
featured in recent stress testing cycles.
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    \8\ The Great Recession trough depends on the reference date 
used for indexing. For example, with nominal HPI and HPI-DPI ratios 
indexed to 100 in 2000:Q1, a decline in the HPI-DPI index of more 
than 25 percent would be necessary to reach the Great Recession 
trough of 87 when the HPI-DPI ratio at the start of the supervisory 
scenario was 116 or greater.
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    Question number 2: In connection with this proposal, the Federal 
Reserve considered alternative guides for projecting house prices, 
including guides based on the ratio of the nominal house price index to 
an index of nominal rent prices for residential housing. What are the 
advantages or disadvantages to such alternatives relative to the 
proposed guide?

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

    To date, the Board's adverse and severely adverse scenarios have 
not incorporated stress to funding markets. The proposal states that 
the Board may include variables or an additional components in the 
scenario to capture the cost of funds, particularly 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. The Board would not expect to 
incorporate wholesale funding costs in the scenarios before 2019, and 
would expect to include wholesale funding costs in the adverse scenario 
before the severely adverse scenario. Accordingly, the Board would not 
expect to include a stress to funding costs in the severely adverse 
scenario until 2020 at the earliest.
    Question number 3: What variable or combinations of variables would 
best represent stress to funding costs or availability in the 
supervisory scenarios?
    Question number 4: What, if any, other risks should the Federal 
Reserve consider capturing in the supervisory scenarios?

D. Impact Analysis

    Generally, the proposed amendments would not affect the severity of 
the scenarios in a manner that persists throughout the economic cycle. 
The one exception is the introduction of an increase in the cost of 
certain runnable liabilities. Generally, the inclusion of a stress to 
wholesale funding would be expected to increase the stringency of the 
stress test. The extent of the increased stringency would depend on the 
implementation of the stress, such as the type of liabilities stressed, 
and the duration and magnitude of the stress considered.
    The proposed unemployment rate clarification would reduce the 
stringency of the scenario if the economy had already experienced 
stress and was recovering, and would not impact the stringency of the 
scenario in other points during the economic cycle. The house price 
guide would formalize an approach that was previously judgmental with 
little persistent impact on the severity of the stress to house prices 
in the severely adverse scenarios. However, the countercyclical element 
of the guide would increase the severity of the stress to house prices 
when the ratio

[[Page 59538]]

of house prices to disposable personal income was particularly elevated 
at the start of the stress test.
    Question number 5: The Federal Reserve is proposing changes to the 
Scenario Design Policy Statement to enhance the countercyclicality, 
risk coverage, and transparency of the scenario development process. 
Are there other modifications not included in this proposal that could 
further enhance the scenario development process?

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 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

    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.\9\ 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 would not have a 
significant economic impact on a substantial number of small entities.
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    \9\ 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.\10\ 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, savings and loan holding companies, state member banks, or 
nonbank financial companies with assets sizes of $175 million or less 
are small entities for purposes of the RFA.
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    \10\ 13 CFR 121.201.
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    As discussed in the SUPPLEMENTARY INFORMATION, the proposed policy 
statement generally would affect the scenario design framework used in 
regulations that apply to covered companies, savings and loan holding 
companies, and state member banks with greater than $10 billion in 
total consolidated assets and bank holding companies with assets of 
more than $10 billion but less than $50 billion. 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.\11\ 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.\12\ 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 its activities, are not likely to pose a 
threat to the financial stability of the United States.
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    \11\ 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.
    \12\ See 76 FR 4555 (January 26, 2011).
---------------------------------------------------------------------------

    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 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. 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 $50 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

[[Page 59539]]

companies with total consolidated assets of more than $10 billion 
and for which the Board is the primary regulatory agency must 
conduct stress tests on an annual basis (together, company-run 
stress tests).\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\
---------------------------------------------------------------------------

    \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, baseline scenario, 
adverse scenario, and severely adverse scenario. See 12 CFR 
252.12(b), (f), (p), and (q); 12 CFR 252.42(b), (e), (n), and (o); 
12 CFR 252.52(b), (e), (o), and (p).
---------------------------------------------------------------------------

    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.\4\ 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.\5\ 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).
---------------------------------------------------------------------------

    \4\ Id.
    \5\ Id.
---------------------------------------------------------------------------

    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 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.\6\
---------------------------------------------------------------------------

    \6\ 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).\7\
---------------------------------------------------------------------------

    \7\ 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.\8\ 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.
---------------------------------------------------------------------------

    \8\ 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 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

[[Page 59540]]

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.\9\ 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:
---------------------------------------------------------------------------

    \9\ 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 three-month 
Treasury bill, the yield on the 5-year Treasury bond, the yield on 
the 10-year Treasury bond, the yield on a 10-year BBB corporate 
security, the prime rate, and the interest rate associated with a 
conforming, conventional, fixed-rate, 30-year mortgage.
    b. The international variables provided for in the 2014 
supervisory scenarios included, for the euro area, the United 
Kingdom, developing Asia, and Japan:
    i. Percent change in real GDP;
    ii. Percent change in the Consumer Price Index or local 
equivalent; and
    iii. The U.S./foreign currency exchange rate.\10\
---------------------------------------------------------------------------

    \10\ 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 will 
ensure that the paths of such additional variables are consistent 
with the scenarios the Board provided. For example, the companies 
may use, as part of their internal stress test models, local-level 
variables, such as state-level unemployment rates or city-level 
house prices. While the Board does not plan to include local-level 
macro variables in the stress test scenarios it provides, it expects 
the companies to evaluate the paths of local-level macro variables 
as needed for their internal models, and ensure internal consistency 
between these variables and their aggregate, macro-economic 
counterparts. The Board will provide the macroeconomic scenario 
component of the stress test scenarios for a period that spans a 
minimum of 13 quarters. The scenario horizon reflects the 
supervisory stress test approach that the Board plans to use. Under 
the stress test rules, the Board will assess the effect of different 
scenarios on the consolidated capital of each company over a 
forward-looking planning horizon of at least nine quarters.

3.2 Market Shock Component

    a. The market shock component of the adverse and severely 
adverse scenarios will only apply to companies with significant 
trading activity and their subsidiaries.\11\ 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, 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).
---------------------------------------------------------------------------

    \11\ 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 trading companies use internally 
to produce profit and loss estimates, under stressful market 
scenarios, for all asset classes that are considered trading assets, 
including equities, credit, interest rates, foreign exchange rates, 
and commodities. Examples of risk factors include, but are not 
limited to:
    i. Equity indices of all developed markets, and of developing 
and emerging market nations to which companies with significant 
trading activity may have exposure, along with term structures of 
implied volatilities;
    ii. Cross-currency FX rates of all major and many minor 
currencies, along term structures of implied volatilities;
    iii. Term structures of government rates (e.g., U.S. 
Treasuries), interbank rates (e.g., swap rates) and other key rates 
(e.g., commercial paper) for all developed markets and for 
developing and emerging market nations to which companies may have 
exposure;
    iv. Term structures of implied volatilities that are key inputs 
to the pricing of interest rate derivatives;
    v. Term structures of futures prices for energy products 
including crude oil (differentiated by country of origin), natural 
gas, and power;
    vi. Term structures of futures prices for metals and 
agricultural commodities;
    vii. ``Value-drivers'' (credit spreads or instrument prices 
themselves) for credit-sensitive product segments including: 
Corporate bonds, credit default swaps, and collateralized debt 
obligations by risk; non-agency residential mortgage-backed 
securities and commercial mortgage-backed securities by risk and 
vintage; sovereign debt; and, municipal bonds; and
    viii. Shocks to the values of private equity positions.

4. Approach for Formulating the Macroeconomic Assumptions for Scenarios

    a. This section describes the Board's approach for formulating 
macroeconomic

[[Page 59541]]

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.\12\ 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.\13\
---------------------------------------------------------------------------

    \12\ More recently, a monthly measure of GDP has been added to 
the list of indicators.
    \13\ 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 of this appendix 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.
---------------------------------------------------------------------------

    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 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

[[Page 59542]]

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.\14\ 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.
---------------------------------------------------------------------------

    \14\ 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 of this appendix, over the 
last half-century, the U.S. economy has experienced four severe 
post-war recessions. In all four of these recessions the 
unemployment rate increased 3 to 5 percentage points and in the 
three most recent of these recessions the unemployment rate reached 
a level between 9 percent and 11 percent.
    c. Under this method, if the initial unemployment rate were 
low--as it would be after a sustained long expansion--the 
unemployment rate in the scenario would increase to a level as high 
as what has been seen in past severe recessions. However, if the 
initial unemployment rate were already high--as would be the case in 
the early stages of a recovery--the unemployment rate would exhibit 
a change as large as what has been seen in past severe recessions.
    d. The Board believes that the typical increase in the 
unemployment rate in the severely adverse scenario will be about 4 
percentage points. However, the Board will calibrate the increase in 
unemployment based on its views of the status of cyclical systemic 
risk. The Board intends to set the unemployment rate at the higher 
end of the range if the Board believed that cyclical systemic risks 
were high (as it would be after a sustained long expansion), and to 
the lower end of the range if cyclical systemic risks were low (as 
it would be in the earlier stages of a recovery). This may result in 
a scenario that is slightly more intense than normal if the Board 
believed that cyclical systemic risks were increasing in a period of 
robust expansion.\15\ 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.\16\ 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.
---------------------------------------------------------------------------

    \15\ 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.
    \16\ 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 will result in scenarios being more severe in robust 
expansions (when the unemployment rate is low) and less severe in 
the early stages of a recovery (when the unemployment rate is high) 
and so would not result in pro-cyclicality. Depending on the initial 
level of the unemployment rate, this approach could lead to only a 
very modest increase in the unemployment rate--or even a decline. As 
a result, this approach--while not procyclical--could result in 
scenarios not featuring stressful macroeconomic outcomes.

4.2.3 Setting the Other Variables in the Severely Adverse Scenario

    a. Generally, all other variables in the severely adverse 
scenario will be specified to be consistent with the increase in the 
unemployment rate. The approach for specifying the paths of these 
variables in the scenario will be a combination of (1) how economic 
models suggest that these variables should evolve given the path of 
the unemployment rate, (2) how these variables have typically 
evolved in past U.S. recessions, and (3) and evaluation of these and 
other factors.
    b. Economic models--such as medium-scale macroeconomic models--
should be able to generate plausible paths consistent with the 
unemployment rate for a number of scenario variables, such as real 
GDP growth, CPI inflation and short-term interest rates, which have 
relatively stable (direct or indirect) relationships with the 
unemployment rate (e.g., Okun's Law, the Phillips Curve, and 
interest rate feedback rules). For some other variables, specifying 
their paths will require a case-by-case consideration.
    c. Declining house prices, which are an important source of 
stress to a company's balance sheet, are not a steadfast feature of 
recessions, and the historical relationship of house prices with the 
unemployment rate 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

[[Page 59543]]

down to its Great Recession trough. As illustrated in Table 2 of 
this appendix, 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.\17\
---------------------------------------------------------------------------

    \17\ The house-price retrenchments that occurred over the 
periods 1980-1985, 1989-1996, 2006-2011 (as detailed in Table 2 of 
this appendix) 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.\18\
---------------------------------------------------------------------------

    \18\ 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.\19\ Generally, the Board believes that the 
companies should consider multiple adverse scenarios for their 
internal capital planning purposes, and likewise, it is appropriate 
that the Board consider more than one adverse scenario to assess a 
company's ability to withstand stress. Accordingly, the Board does 
not identify a single approach for specifying the adverse scenario. 
Rather, the adverse scenario will be formulated according to one of 
the possibilities listed below. The Board may vary the approach it 
uses for the adverse scenario each year so that the results of the 
scenario provide the most value to supervisors, in light of current 
condition of the economy and the financial services industry.
---------------------------------------------------------------------------

    \19\ 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 
understood better or should be monitored, but does not believe 
should be included in the severely adverse scenario, perhaps because 
these risks would render the scenario implausibly severe. For 
instance, the adverse scenario could feature sizable increases in 
oil or natural gas prices or shifts in the yield curve that are 
atypical in a recession. The adverse scenario might also feature 
less acute, but still consequential, adverse outcomes, such as a 
disruptive slowdown in growth from emerging-market economies.
    d. Under the Board's stress test rules, covered companies are 
required to develop their own scenarios for mid-cycle company-run 
stress tests.\20\ 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.
---------------------------------------------------------------------------

    \20\ 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 
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

[[Page 59544]]

to the 1990-1991 recession); or high inflation shock (e.g., the 
inflation pressures of 1977-1979). The Board believes these are 
important stresses that should be understood; however, there may be 
notable benefits from formulating the adverse scenario following 
other approaches--specifically, those described previously in this 
section--and consequently the Board does not believe that the 
adverse scenario should be limited to historical episodes only.
    h. With the exception of cases in which the probabilistic 
approach is used to generate the adverse scenario, the adverse 
scenario will at a minimum contain a mild to moderate recession. 
This is because most of the value from investigating the 
implications of the risks described above is likely to be obtained 
from considering them in the context of balance sheets of companies 
that are under some stress.

5. Approach for Formulating the Market Shock Component

    a. This section discusses the approach the Board proposes to 
adopt for developing the market shock component of the adverse and 
severely adverse scenarios appropriate for companies with 
significant trading activities. The design and specification of the 
market shock component differs from that of the macroeconomic 
scenarios because profits and losses from trading are measured in 
mark-to-market terms, while revenues and losses from traditional 
banking are generally measured using the accrual method. As noted 
above, another critical difference is the time-evolution of the 
market shock component. The market shock component consists of an 
instantaneous ``shock'' to a large number of risk factors that 
determine the mark-to-market value of trading positions, while the 
macroeconomic scenarios supply a projected path of economic 
variables that affect traditional banking activities over the entire 
planning period.
    b. The development of the market shock component that are 
detailed in this section are as follows: baseline (subsection 5.1), 
severely adverse (subsection 5.2), and adverse (subsection 5.3).

5.1 Approach for Formulating the Market Shock Component Under the 
Baseline Scenario

    By definition, market shocks are large, previously unanticipated 
moves in asset prices and rates. Because asset prices should, 
broadly speaking, reflect consensus opinions about the future 
evolution of the economy, large price movements, as envisioned in 
the market shock, should not occur along the baseline path. As a 
result, the market shock will not be included in the baseline 
scenario.

5.2 Approach for Formulating the Market Shock Component Under the 
Severely Adverse Scenario

    This section addresses possible approaches to designing the 
market shock component in the severely adverse scenario, including 
important considerations for scenario design, possible approaches to 
designing scenarios, and a development strategy for implementing the 
preferred approach.

5.2.1 Design Considerations for Market Shocks

    a. The general market practice for stressing a trading portfolio 
is to specify market shocks either in terms of extreme moves in 
observable, broad market indicators and risk factors or directly as 
large changes to the mark-to-market values of financial instruments. 
These moves can be specified either in relative terms or absolute 
terms. Supplying values of risk factors after a ``shock'' is roughly 
equivalent to the macroeconomic scenarios, which supply values for a 
set of economic and financial variables; however, trading stress 
testing differs from macroeconomic stress testing in several 
critical ways.
    b. In the past, the Board used one of two approaches to specify 
market shocks. During SCAP and CCAR in 2011, the Board used a very 
general approach to market shocks and required companies to stress 
their trading positions using changes in market prices and rates 
experienced during the second half of 2008, without specifying risk 
factor shocks. This broad guidance resulted in inconsistency across 
companies both in terms of the severity and the application of 
shocks. In certain areas companies were permitted to use their own 
experience during the second half of 2008 to define shocks. This 
resulted in significant variation in shock severity across 
companies.
    c. To enhance the consistency and comparability in market shocks 
for the stress tests in 2012 and 2013, the Board provided to each 
trading company more than 35,000 specific risk factor shocks, 
primarily based on market moves in the second half of 2008. While 
the number of risk factors used in companies' pricing and stress-
testing models still typically exceed that provided in the Board's 
scenarios, the greater specificity resulted in more consistency in 
the scenario across companies. The benefit of the comprehensiveness 
of risk factor shocks is at least partly offset by potential 
difficulty in creating shocks that are coherent and internally 
consistent, particularly as the framework for developing market 
shocks deviates from historical events.
    d. Also importantly, the ultimate losses associated with a given 
market shock will depend on a company's trading positions, which can 
make it difficult to rank order, ex ante, the severity of the 
scenarios. In certain instances, market shocks that include large 
market moves may not be particularly stressful for a given company. 
Aligning the market shock with the macroeconomic scenario for 
consistency may result in certain companies actually benefiting from 
risk factor moves of larger magnitude in the market scenario if the 
companies are hedging against salient risks to other parts of their 
business. Thus, the severity of market shocks must be calibrated to 
take into account how a complex set of risks, such as directional 
risks and basis risks, interacts with each other, given the 
companies' trading positions at the time of stress. For instance, a 
large depreciation in a foreign currency would benefit companies 
with net short positions in the currency while hurting those with 
net long positions. In addition, longer maturity positions may move 
differently from shorter maturity positions, adding further 
complexity.
    e. The instantaneous nature of market shocks and the immediate 
recognition of mark-to-market losses add another element to the 
design of market shocks, and to determining the appropriate severity 
of shocks. For instance, in previous stress tests, the Board assumed 
that market moves that occurred over the six-month period in late 
2008 would occur instantaneously. The design of the market shocks 
must factor in appropriate assumptions around the period of time 
during which market events will unfold and any associated market 
responses.

5.2.2 Approaches to Market Shock Design

    a. As an additional component of the adverse and severely 
adverse scenarios, the Board plans to use a standardized set of 
market shocks that apply to all companies with significant trading 
activity. The market shocks could be based on a single historical 
episode, multiple historical periods, hypothetical (but plausible) 
events, or some combination of historical episodes and hypothetical 
events (hybrid approach). Depending on the type of hypothetical 
events, a scenario based on such events may result in changes in 
risk factors that were not previously observed. In the supervisory 
scenarios for 2012 and 2013, the shocks were largely based on 
relative moves in asset prices and rates during the second half of 
2008, but also included some additional considerations to factor in 
the widening of spreads for European sovereigns and financial 
companies based on actual observation during the latter part of 
2011.
    b. For the market shock component in the severely adverse 
scenario, the Board plans to use the hybrid approach to develop 
shocks. The hybrid approach allows the Board to maintain certain 
core elements of consistency in market shocks each year while 
providing flexibility to add hypothetical elements based on market 
conditions at the time of the stress tests. In addition, this 
approach will help ensure internal consistency in the scenario 
because of its basis in historical episodes; however, combining the 
historical episode and hypothetical events may require small 
adjustments to ensure mutual consistency of the joint moves. In 
general, the hybrid approach provides considerable flexibility in 
developing scenarios that are relevant each year, and by introducing 
variations in the scenario, the approach will also reduce the 
ability of companies with significant trading activity to modify or 
shift their portfolios to minimize expected losses in the severely 
adverse market shock.
    c. The Board has considered a number of alternative approaches 
for the design of market shocks. For example, the Board explored an 
option of providing tailored market shocks for each trading company, 
using information on the companies' portfolio gathered through 
ongoing supervision, or other means. By specifically targeting known 
or potential vulnerabilities in a company's trading position, the 
tailored approach will be useful in assessing each company's capital 
adequacy as it relates to the company's idiosyncratic risk. However, 
the Board does not believe this approach to

[[Page 59545]]

be well-suited for the stress tests required by regulation. 
Consistency and comparability are key features of annual supervisory 
stress tests and annual company-run stress tests required in the 
stress test rules. It would be difficult to use the information on 
the companies' portfolio to design a common set of shocks that are 
universally stressful for all covered companies. As a result, this 
approach will be better suited to more customized, tailored stress 
tests that are part of the company's internal capital planning 
process or to other supervisory efforts outside of the stress tests 
conducted under the capital rule and the stress test rules.

5.2.3 Development of the Market Shock

    a. Consistent with the approach described above, the market 
shock component for the severely adverse scenario will incorporate 
key elements of market developments during the second half of 2008, 
but also incorporate observations from other periods or price and 
rate movements in certain markets that the Board deems to be 
plausible though such movements may not have been observed 
historically. Over time the Board also expects to rely less on 
market events of the second half of 2008 and more on hypothetical 
events or other historical episodes to develop the market shock.
    b. The developments in the credit markets during the second half 
of 2008 were unprecedented, providing a reasonable basis for market 
shocks in the severely adverse scenario. During this period, key 
risk factors in virtually all asset classes experienced extremely 
large shocks; the collective breadth and intensity of the moves have 
no parallels in modern financial history and, on that basis, it 
seems likely that this episode will continue to be the most relevant 
historical scenario, although experience during other historical 
episodes may also guide the severity of the market shock component 
of the severely adverse scenario. Moreover, the risk factor moves 
during this episode are directly consistent with the ``recession'' 
approach that underlies the macroeconomic assumptions. However, 
market shocks based only on historical events could become stale and 
less relevant over time as the company's positions change, 
particularly if more salient features are not added each year.
    c. While the market shocks based on the second half of 2008 are 
of unparalleled magnitude, the shocks may become less relevant over 
time as the companies' trading positions change. In addition, more 
recent events could highlight the companies' vulnerability to 
certain market events. For example, in 2011, Eurozone credit spreads 
in the sovereign and financial sectors surpassed those observed 
during the second half of 2008, necessitating the modification of 
the severely adverse market shock in 2012 and 2013 to reflect a 
salient source of stress to trading positions. As a result, it is 
important to incorporate both historical and hypothetical outcomes 
into market shocks for the severely adverse scenario. For the time 
being, the development of market shocks in the severely adverse 
scenario will begin with the risk factor movements in a particular 
historical period, such as the second half of 2008. The Board will 
then consider hypothetical but plausible outcomes, based on 
financial stability reports, supervisory information, and internal 
and external assessments of market risks and potential flash points. 
The hypothetical outcomes could originate from major geopolitical, 
economic, or financial market events with potentially significant 
impacts on market risk factors. The severity of these hypothetical 
moves will likely be guided by similar historical events, 
assumptions embedded in the companies' internal stress tests or 
market participants, and other available information.
    d. Once broad market scenarios are agreed upon, specific risk 
factor groups will be targeted as the source of the trading stress. 
For example, a scenario involving the failure of a large, 
interconnected globally active financial institution could begin 
with a sharp increase in credit default swap spreads and a 
precipitous decline in asset prices across multiple markets, as 
investors become more risk averse and market liquidity evaporates. 
These broad market movements will be extrapolated to the granular 
level for all risk factors by examining transmission channels and 
the historical relationships between variables, though in some 
cases, the movement in particular risk factors may be amplified 
based on theoretical relationships, market observations, or the 
saliency to company trading books. If there is a disagreement 
between the risk factor movements in the historical event used in 
the scenario and the hypothetical event, the Board will reconcile 
the differences by assessing a priori expectation based on financial 
and economic theory and the importance of the risk factors to the 
trading positions of the covered companies.

5.3 Approach for Formulating the Market Shock Under the Adverse 
Scenario

    a. The market shock component included in the adverse scenario 
will feature risk factor movements that are generally less 
significant than the market shock component of the severely adverse 
scenario. However, the adverse market shock may also feature risk 
factor shocks that are substantively different from those included 
in the severely adverse scenario, in order to provide useful 
information to supervisors. As in the case of the macroeconomic 
scenario, the market shock component in the adverse scenario can be 
developed in a number of different ways.
    b. The adverse scenario could be differentiated from the 
severely adverse scenario by the absolute size of the shock, the 
scenario design process (e.g., historical events versus hypothetical 
events), or some other criteria. The Board expects that as the 
market shock component of the adverse scenario may differ 
qualitatively from the market shock component of the severely 
adverse scenario, the results of adverse scenarios may be useful in 
identifying a particularly vulnerable area in a trading company's 
positions.
    c. There are several possibilities for the adverse scenario and 
the Board may use a different approach each year to better explore 
the vulnerabilities of companies with significant trading activity. 
One approach is to use a scenario based on some combination of 
historical events. This approach is similar to the one used for the 
market shock in 2012, where the market shock component was largely 
based on the second half of 2008, but also included a number of risk 
factor shocks that reflected the significant widening of spreads for 
European sovereigns and financials in late 2011. This approach will 
provide some consistency each year and provide an internally 
consistent scenario with minimal implementation burden. Having a 
relatively consistent adverse scenario may be useful as it 
potentially serves as a benchmark against the results of the 
severely adverse scenario and can be compared to past stress tests.
    d. Another approach is to have an adverse scenario that is 
identical to the severely adverse scenario, except that the shocks 
are smaller in magnitude (e.g., 100 basis points for adverse versus 
200 basis points for severely adverse). This ``scaling approach'' 
generally fits well with an intuitive interpretation of ``adverse'' 
and ``severely adverse.'' Moreover, since the nature of the moves 
will be identical between the two classes of scenarios, there will 
be at least directional consistency in the risk factor inputs 
between scenarios. While under this approach the adverse scenario 
will be superficially identical to the severely adverse, the logic 
underlying the severely adverse scenario may not be applicable. For 
example, if the severely adverse scenario was based on a historical 
scenario, the same could not be said of the adverse scenario. It is 
also remains possible, although unlikely, that a scaled adverse 
scenario actually will result in greater losses, for some companies, 
than the severely adverse scenario with similar moves of greater 
magnitude. For example, if some companies are hedging against tail 
outcomes then the more extreme trading book dollar losses may not 
correspond to the most extreme market moves. The market shock 
component of the adverse scenario in 2013 was largely based on the 
scaling approach where a majority of risk factor shocks were smaller 
in magnitude than the severely adverse scenario, but it also 
featured long-term interest rate shocks that were not part of the 
severely adverse market shock.
    e. Alternatively, the market shock component of an adverse 
scenario could differ substantially from the severely adverse 
scenario with respect to the sizes and nature of the shocks. Under 
this approach, the market shock component could be constructed using 
some combination of historical and hypothetical events, similar to 
the severely adverse scenario. As a result, the market shock 
component of the adverse scenario could be viewed as an alternative 
to the severely adverse scenario and, therefore, it is possible that 
the adverse scenario could have larger losses for some companies 
than the severely adverse scenario.
    f. Finally, the design of the adverse scenario for annual stress 
tests could be informed by the companies' own trading scenarios used 
for their BHC-designed scenarios in CCAR and in their mid-cycle 
company-run stress tests.\21\
---------------------------------------------------------------------------

    \21\ 12 CFR 252.55.

---------------------------------------------------------------------------

[[Page 59546]]

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 to Appendix A of Part 252--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
--------------------------------------------------------------------------------------------------------------------------------------------------------
Source: Bureau of Economic Analysis, National Income and Product Accounts, Comprehensive Revision on July 31, 2013.


                                          Table 2 to Appendix A of Part 252--House Prices in Housing Recessions
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                                          HPI-DPI Trough
                                                                                                          Percent change  Percent change       Level
              Peak                        Trough                 Severity           Duration (quarters)       in NHPI       in HPI-DPI      (2000:Q1 =
                                                                                                                                               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 this table are based on the timing of house-price retrenchments.



[[Page 59547]]

    By order of the Board of Governors of the Federal Reserve 
System, December 7, 2017.
Ann E. Misback,
Secretary of the Board.

[FR Doc. 2017-26858 Filed 12-14-17; 8:45 am]
 BILLING CODE 6210-01-P