Policy Statement on the Scenario Design Framework for Stress Testing, 70124-70135 [2012-28207]

Download as PDF 70124 Federal Register / Vol. 77, No. 226 / Friday, November 23, 2012 / Proposed Rules Regulation and Regulatory Review.’’ Executive Order 13563 directs Federal agencies to develop and submit a preliminary plan ‘‘under which the agency will periodically review its existing significant regulations to determine whether any such regulations should be modified, streamlined, expanded, or repealed so as to make the agency’s regulatory program more effective or less burdensome in achieving the regulatory objectives.’’ Executive Order 13563 did not, however, apply to independent regulatory agencies. Subsequently, on July 11, 2011, the President issued E.O. 13579, which recommends that independent regulatory agencies also develop retrospective plans similar to those required of other agencies under E.O. 13563. In the spirit of cooperation, in November 2011, in response to E.O. 13579, the NRC made available an initial Plan on the NRC’s Public Web site. The NRC has now updated its initial Plan and has created a draft Plan. The draft Plan is available at the following locations: (1) On the NRC’s Open Government Web page at http:// www.nrc.gov/public-involve/open.html (under the tabs entitled ‘‘Selected NRC Resources’’ and ‘‘Rulemaking’’); (2) on the NRC’s plans, budget, and performance Web page at http:// www.nrc.gov/about-nrc/plansperformance.html); and (3) on http:// www.regulations.gov. The NRC is accepting public comment on this draft Plan. emcdonald on DSK7TPTVN1PROD with PROPOSALS III. Plan for Retrospective Review The NRC’s draft Plan describes the NRC’s processes and activities relating to retrospective review of existing regulations, including discussions of the: (1) Efforts to incorporate risk assessments into regulatory decisionmaking; (2) efforts to address the cumulative effects of regulation; (3) the NRC’s methodology for prioritizing its rulemaking activities; (4) rulemaking initiatives arising out of the NRC’s ongoing review of its regulations related to the recent events at the Fukushima Dai-ichi Nuclear Power Plant in Japan; and (5) the NRC’s previous and ongoing efforts to update its regulations in a systematic, ongoing basis. For the Nuclear Regulatory Commission. Dated at Rockville, Maryland, this 16th day of November 2012. Annette L. Vietti-Cook, Secretary of the Commission. [FR Doc. 2012–28436 Filed 11–21–12; 8:45 am] BILLING CODE 7590–01–P VerDate Mar<15>2010 12:48 Nov 21, 2012 Jkt 229001 FEDERAL RESERVE SYSTEM 12 CFR Part 252 [Regulation YY; Docket No. OP–1452] RIN 7100–AD–86 Policy Statement on the Scenario Design Framework for Stress Testing Board of Governors of the Federal Reserve System (Board). ACTION: Proposed policy statement with request for public comment. AGENCY: The Board is requesting public comment on a policy statement on the approach to scenario design for stress testing that would be used in connection with the supervisory and company-run stress tests conducted under the Board’s Regulations pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act (DoddFrank Act or Act) and the Board’s capital plan rule. DATES: Comments must be received by February 15, 2013. FOR FURTHER INFORMATION CONTACT: Tim Clark, Senior Associate Director, (202) 452–5264, Lisa Ryu, Assistant Director, (202) 263–4833, or David Palmer, Senior Supervisory Financial Analyst, (202) 452–2904, Division of Banking Supervision and Regulation; Benjamin W. McDonough, Senior Counsel, (202) 452–2036, or Christine Graham, Senior Attorney, (202) 452–3099, Legal Division; or Andreas Lehnert, Deputy Director, (202) 452–3325, or Rochelle Edge, Adviser, (202) 452–2339, Office of Financial Stability Policy and Research. SUPPLEMENTARY INFORMATION: SUMMARY: Table of Contents I. Background II. Administrative Law Matters A. Use of Plain Language B. Paperwork Reduction Act Analysis C. Regulatory Flexibility Act Analysis I. Background Stress testing is a tool that helps both bank supervisors and a banking organization measure the sufficiency of capital available to support the banking organization’s operations throughout periods of stress.1 The Board and the other federal banking agencies previously have highlighted the use of stress testing as a means to better understand the range of a banking organization’s potential risk exposures.2 1 A full assessment of a company’s capital adequacy must take into account a range of risk factors, including those that are specific to a particular industry or company. 2 See, e.g., Supervisory Guidance on Stress Testing for Banking Organizations With More Than PO 00000 Frm 00002 Fmt 4702 Sfmt 4702 In particular, as part of its effort to stabilize the U.S. financial system during the 2007–2009 financial crisis, the Board and the Federal Reserve banks, along with other federal financial regulatory agencies, conducted stress tests of large, complex bank holding companies through the Supervisory Capital Assessment Program (SCAP). The SCAP was a forward-looking exercise designed to estimate revenue, losses, and capital needs under an adverse economic and financial market scenario. By looking at the broad capital needs of the financial system and the specific needs of individual companies, these stress tests provided valuable information to market participants, reduced uncertainty about the financial condition of the participating bank holding companies under a scenario that was more adverse than that which was anticipated to occur at the time, and had an overall stabilizing effect. Building on the SCAP and other supervisory work coming out of the crisis, the Board initiated the annual Comprehensive Capital Analysis and Review (CCAR) in late 2010 to assess the capital adequacy and the internal capital planning processes of the same large, complex bank holding companies $10 Billion in Total Consolidated Assets, 77 FR 29458 (May 17, 2012), available at http://www. federalreserve.gov/bankinforeg/srletters/sr1207a1. pdf; Supervision and Regulation Letter SR 10–6, Interagency Policy Statement on Funding and Liquidity Risk Management (March 17, 2010), available at http://www.federalreserve.gov/ boarddocs/srletters/2010/sr1006a1.pdf; Supervision and Regulation Letter SR 10–1, Interagency Advisory on Interest Rate Risk (January 11, 2010), available at http://www.federalreserve.gov/ boarddocs/srletters/2010/SR1001.pdf; Supervision and Regulation Letter SR 09–4, Applying Supervisory Guidance and Regulations on the Payment of Dividends, Stock Redemptions, and Stock Repurchases at Bank Holding Companies (revised March 27, 2009), available at http://www. federalreserve.gov/boarddocs/srletters/2009/ SR0904.htm; Supervision and Regulation Letter SR 07–1, Interagency Guidance on Concentrations in Commercial Real Estate (Jan. 4, 2007), available at http://www.federalreserve.gov/boarddocs/srletters/ 2007/SR0701.htm; Supervision and Regulation Letter SR 12–7, Supervisory Guidance on Stress Testing for Banking Organizations with More Than $10 Billion in Total Consolidated Assets (May 14, 2012), available at http://www.federalreserve.gov/ bankinforeg/srletters/sr1207.htm; Supervision and Regulation Letter SR 99–18, Assessing Capital Adequacy in Relation to Risk at Large Banking Organizations and Others with Complex Risk Profiles (July 1, 1999), available at http://www. federalreserve.gov/boarddocs/srletters/1999/ SR9918.htm; Supervisory Guidance: Supervisory Review Process of Capital Adequacy (Pillar 2) Related to the Implementation of the Basel II Advanced Capital Framework, 73 FR 44620 (July 31, 2008); The Supervisory Capital Assessment Program: SCAP Overview of Results (May 7, 2009), available at http://www.federalreserve.gov/ newsevents/press/bcreg/bcreg20090507a1.pdf; and Comprehensive Capital Analysis and Review: Objectives and Overview (Mar. 18, 2011), available at http://www.federalreserve.gov/newsevents/press/ bcreg/bcreg20110318a1.pdf. E:\FR\FM\23NOP1.SGM 23NOP1 emcdonald on DSK7TPTVN1PROD with PROPOSALS Federal Register / Vol. 77, No. 226 / Friday, November 23, 2012 / Proposed Rules that participated in SCAP and to incorporate stress testing as part of the Board’s regular supervisory program for assessing capital adequacy and capital planning practices at these large bank holding companies. The CCAR represents a substantial strengthening of previous approaches to assessing capital adequacy and promotes thorough and robust processes at large banking organizations for measuring capital needs and for managing and allocating capital resources. The CCAR focuses on the risk measurement and management practices supporting organizations’ capital adequacy assessments, including their ability to deliver credible inputs to their loss estimation techniques, as well as the governance processes around capital planning practices. On November 22, 2011, the Board issued an amendment (capital plan rule) to its Regulation Y to require all U.S. bank holding companies with total consolidated assets of $50 billion or more to submit annual capital plans to the Board to allow the Board to assess whether they have robust, forwardlooking capital planning processes and have sufficient capital to continue operations throughout times of economic and financial stress.3 In the wake of the financial crisis, Congress enacted the Dodd-Frank Act, which requires the Board to implement enhanced prudential supervisory standards, including requirements for stress tests, for covered companies to mitigate the threat to financial stability posed by these institutions.4 Section 165(i)(1) of the Dodd-Frank Act requires the Board to conduct an annual stress test of each bank holding company with total consolidated assets of $50 billion or more and each nonbank financial company that the Council has designated for supervision by the Board (covered company) to evaluate whether the covered company has sufficient capital, on a total consolidated basis, to absorb losses as a result of adverse economic conditions (supervisory stress tests).5 The Act requires that the supervisory stress test provide for at least three different sets of conditions— baseline, adverse, and severely adverse conditions—under which the Board would conduct its evaluation. The Act also requires the Board to publish a summary of the supervisory stress test results. In addition, section 165(i)(2) of the Dodd-Frank Act requires the Board to 3 See Capital Plans, 76 FR 74631 (Dec. 1, 2011) (codified at 12 CFR 225.8). 4 See section 165(i) of the Dodd-Frank Act; 12 U.S.C. 5365(i). 5 See 12 U.S.C. 5365(i)(1). VerDate Mar<15>2010 12:48 Nov 21, 2012 Jkt 229001 issue regulations that require covered companies to conduct stress tests semiannually and require financial companies with total consolidated assets of more than $10 billion that are not covered companies and for which the Board is the primary federal financial regulatory agency to conduct stress tests on an annual basis (collectively, company-run stress tests).6 The Board issued final rules implementing the stress test requirements of the Act on October 12, 2012 (stress test rules).7 The Board’s stress test rules provide that the Board will notify covered companies, by no later than November 15 of each year of a set of conditions (each set, a scenario), it will use to conduct its annual supervisory stress tests.8 The rules further establish that the Board will provide, also by no later than November 15, covered companies and other banking organizations subject to the final rule the scenarios they must use to conduct their annual companyrun stress tests.9 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.10 For example, the Board expects to require large banking organizations with significant trading activities to include global market shock components (described in the following sections) in their adverse and severely adverse scenarios. The Board will provide any additional components or scenarios by no later than December 1 of each year.11 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). Stress tests required under the stress test rules and under the Board’s capital plan rule require the Board and financial institutions to calculate proforma capital levels—rather than ‘‘current’’ or actual levels—over a specified planning horizon under baseline and stressed scenarios. This approach integrates key lessons of the 2007–2009 financial crisis into the Board’s supervisory framework. In the financial crisis, investor and counterparty confidence in the capitalization of financial institutions 6 12 U.S.C. 5365(i)(2). FR 62398 (October 12, 2012); 12 CFR part 252, subparts F–H. 8 See id.; 12 CFR 252.134(b). 9 See id.; 12 CFR 252.144(b), 154(b). The annual company-run stress tests use data as of September 30 of each calendar year. 10 12 CFR 252.144(b), 154(b). 11 Id. 7 77 PO 00000 Frm 00003 Fmt 4702 Sfmt 4702 70125 eroded rapidly in the face of changes in the current and expected economic and financial conditions, and this loss in market confidence imperiled institutions’ 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 exceeded the regulatory minimums. This is because the institution’s capital ratios were perceived as lagging indicators of its financial condition, particularly when conditions were changing. The stress tests required under the stress test rules and capital plan rule are a valuable supervisory tool that provides a forward-looking assessment of large financial institutions’ 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 firms’ trading and counterparty positions—and not on other types of risk, such as liquidity risk or operational risk unrelated to the macroeconomic environment. Pressures stemming from these sources are considered in separate supervisory exercises. No single supervisory tool, including the stress tests, can provide an assessment of an institution’s ability to withstand every potential source of risk. Selecting appropriate scenarios is an especially significant consideration for stress tests required under the capital plan rule, which ties the review of a bank holding 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 a company’s 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; it will depend on factors that are specific to a given company, such as underwriting standards and the banking organization’s business model, which would also greatly affect projected revenue, losses, and capital. To enhance the transparency of the scenario design process, the Board is requesting public comment on a proposed policy statement (Policy Statement) that would be used to develop scenarios for annual supervisory and company-run stress tests under the stress testing rules E:\FR\FM\23NOP1.SGM 23NOP1 emcdonald on DSK7TPTVN1PROD with PROPOSALS 70126 Federal Register / Vol. 77, No. 226 / Friday, November 23, 2012 / Proposed Rules issued under the Act and the capital plan rule. The Board plans to develop the annual set of scenarios, as outlined below, in consultation with the Office of the Comptroller of the Currency (OCC) and Federal Deposit Insurance Corporation (FDIC) to reduce the burden that could arise from having the agencies establish inconsistent scenarios. The proposed Policy Statement outlines the characteristics of the stress test scenarios and explains the considerations and procedures that underlie the formulation of these scenarios. The considerations and procedures described in this policy statement would apply to the Board’s stress testing framework, including to the stress tests required under 12 CFR part 252, subparts F, G, and H, as well as the Board’s capital plan rule (12 CFR 225.8). The Board may determine that material modifications to the Policy Statement would be appropriate if the supervisory stress test framework expands materially to include additional components or other scenarios that are currently not captured.12 Although the Board does not envision that the approach used to develop scenarios would change from year to year, the characteristics of the scenarios provided to companies would 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 would be used to assess the strength and resilience of the companies’ capital in various economic and financial environments. The proposed Policy Statement is organized as follows. Section 1 provides background on the proposed Policy Statement. Section 2 is an outline of the proposed Policy Statement and describes its scope. 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 macro scenarios and the market shock component of the stress test scenarios applicable to firms with significant trading activity.13 The proposed approach for the macro scenarios differs considerably from that for the market shocks, and, therefore, they are described separately. Section 4 describes the Board’s proposed approach for developing the macro scenarios, and section 5 describes the proposed approach for the market shock components. Section 6 describes the relationship between the macro scenario and the market shock components. Section 7 provides a timeline for the formulation and publication of the macroeconomic assumptions and market shocks. Consistent with the stress testing rules and the Act, the Board will issue a minimum of three different scenarios, including baseline, adverse, and severely adverse scenarios, for use under the stress test rules. Specific circumstances or vulnerabilities, over which the Board determines, in any given year, 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. While the Board generally expects to use the same scenarios for all companies subject to the stress testing rules, 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 trading companies. 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. Early in each stress testing cycle, the Board plans to publish the macro scenarios along with a brief narrative summary that explains how these scenarios have changed relative to the previous year. In cases where scenarios are modified to reflect particular risks 12 Before requiring a company to include additional components or other scenarios in its company-run stress tests, the Board would follow the notice procedures set forth in the stress test rules. See 12 CFR 252.144(b), 154(b). 13 Currently, the firms subject to the market shock component include the six bank holding companies that are subject to the market risk rule and have total consolidated assets greater than $500 billion, as reported on their FR Y–9C. However, the set of companies subject to the market shock could change over time as the size, scope, and complexity of the banking organization’s trading activities evolve. VerDate Mar<15>2010 12:48 Nov 21, 2012 Jkt 229001 PO 00000 Frm 00004 Fmt 4702 Sfmt 4702 and vulnerabilities, the narrative would also explain the underlying motivation for these changes. The Board also plans to release a broad description of the market shock component. The Board seeks comment on all aspects of the proposed Policy Statement. The Board notes that it will not revise the baseline, adverse, and severely adverse scenarios or market shock component that were recently issued under the Board’s stress test rules and the capital plan rule for CCAR 2013 in light of any comments on the proposed policy statement but will consider the comments in developing future macro scenarios. Question 1. In what ways could the Board improve its approach to scenario design? What additional economic or financial variables should the Board consider in developing scenarios? Question 2. In addition to the trading shock, what additional components should the Board include in its stress testing framework? What additional scenarios should the Board consider using in connection with the stress testing framework? Question 3. The policy statement proposes a number of different methods for developing the adverse scenarios. What additional ways might the Board consider specifying the adverse scenario? Question 4. Does the approach for specifying the severely adverse scenarios—specifically, that of featuring a severe recession along with any salient risks to the economic and financial outlook—capture the relevant macroeconomic risks that firms face? Should there be additional features added to the scenario, either in specific circumstances or more generally? II. Administrative Law Matters A. Use of Plain Language Section 722 of the Gramm-LeachBliley Act (Pub. L. 106–102, 113 Stat. 1338, 1471, 12 U.S.C. 4809) requires the Federal banking agencies to use plain language in all proposed and final rules published after January 1, 2000. The Board has sought to present the proposed rule in a simple and straightforward manner, and invites comment on the use of plain language. B. Paperwork Reduction Act Analysis In accordance with the requirements of the Paperwork Reduction Act of 1995 (44 U.S.C. 3506), the Board has reviewed the proposed policy statement to assess any information collections. There are no collections of information as defined by the Paperwork Reduction Act in the proposal. E:\FR\FM\23NOP1.SGM 23NOP1 emcdonald on DSK7TPTVN1PROD with PROPOSALS Federal Register / Vol. 77, No. 226 / Friday, November 23, 2012 / Proposed Rules 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.14 The RFA requires an agency either to provide an initial regulatory flexibility analysis with a proposed rule for which a general notice of proposed rulemaking is required or to certify that the proposed rule will not have a significant economic impact on a substantial number of small entities. Based on its analysis and for the reasons stated below, the Board believes that the proposed policy statement will not have a significant economic impact on a substantial number of small entities. 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.15 The Board believes that the Finance and Insurance sector constitutes a reasonable universe of firms for these purposes because such firms generally engage in actives that are financial in nature. Consequently, bank holding companies or nonbank financial companies with assets sizes of $175 million or less are small entities for purposes of the RFA. As discussed in the SUPPLEMENTARY INFORMATION, the proposed policy statement generally would affect the scenario design framework used in regulations that apply to bank holding companies with $50 billion or more in total consolidated assets and nonbank financial companies that the Council has determined under section 113 of the Dodd-Frank Act must be supervised by the Board and for which such determination is in effect. Companies that are affected by the proposed policy statement therefore substantially exceed the $175 million asset threshold at which a banking entity is considered a ‘‘small entity’’’ under SBA regulations.16 The proposed policy 14 See 5 U.S.C. 603, 604 and 605. CFR 121.201. 16 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. 15 13 VerDate Mar<15>2010 12:48 Nov 21, 2012 Jkt 229001 statement would affect a nonbank financial company designated by the Council under section 113 of the DoddFrank 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.17 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. 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 the Board of Governors of the Federal Reserve System proposes to add the Policy Statement as set forth at the end of the SUPPLEMENTARY INFORMATION as part 252 to 12 CFR chapter II as follows: SUPPLEMENTARY INFORMATION, 17 See PO 00000 76 FR 4555 (January 26, 2011). Frm 00005 Fmt 4702 Sfmt 4702 70127 PART 252—ENHANCED PRUDENTIAL STANDARDS (Regulation YY) 1. The authority citation for part 252 would continue to read as follows: Authority: 12 U.S.C. 321–338a, 1467a(g), 1818, 1831p–1, 1844(b), 1844(c), 5361, 5365, 5366. 2. Appendix A to part 252 would be added to read as follows: Appendix A—Policy Statement on the Scenario Design Framework for Stress Testing 1. Background The Board has imposed stress testing requirements through its regulations implementing section 165(i) of the DoddFrank Act (stress test rules) and through its capital plan rule (12 CFR 225.8). Under the stress test rules issued under section 165(i)(1) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act or 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 and each nonbank financial company that the Financial Stability Oversight Council has designated for supervision by the Board (together, covered companies).18 In addition, under the stress test rules issued under section 165(i)(2) of the Act, covered companies must conduct stress tests semiannually and other financial 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).19 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 companyrun stress tests.20 18 12 U.S.C. 5365(i)(1); 77 FR 62378 (October 12, 2012), to be codified at 12 CFR part 252, subpart F. 19 12 U.S.C. 5365(i)(2); 77 FR 62378, 62396 (October 12, 2012), to be codified at 12 CFR part 252, subparts G and H. 20 The stress test rules define scenarios as ‘‘those sets of conditions that affect the U.S. economy or the financial condition of a [company] that the Board annually determines are appropriate for use in stress tests, including, but not limited to, baseline, adverse, and severely adverse scenarios.’’ The stress test rules define baseline scenario as a ‘‘set of conditions that affect the U.S. economy or the financial condition of a company and that reflect the consensus views of the economic and financial outlook.’’ The stress test rules define adverse scenario a ‘‘set of conditions that affect the U.S. economy or the financial condition of a company that are more adverse than those associated with the baseline scenario and may include trading or other additional components.’’ The stress test rules define severely adverse scenario as a ‘‘set of conditions that affect the U.S. economy or the financial condition of a company and that overall are more severe than those associated with the adverse scenario and may include trading or other additional components.’’ See 12 CFR 252.132(a), (d), (m), and (n); 12 CFR 252.142(a), (d), (o), and (p); 12 CFR 252.152(a), (e), (o), and (p). E:\FR\FM\23NOP1.SGM 23NOP1 emcdonald on DSK7TPTVN1PROD with PROPOSALS 70128 Federal Register / Vol. 77, No. 226 / Friday, November 23, 2012 / Proposed Rules The stress test rules provide that the Board will notify covered companies by no later than November 15 of each year scenarios it will use to conduct its annual supervisory stress tests and provide, also by no later than November 15, covered companies and other banking organizations subject to the final rules the set of scenarios they must use to conduct their annual company-run stress tests.21 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.22 For example, the Board expects to require large banking organizations with significant trading activities to include a global market shock component (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 December 1 of each year.23 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). In addition, section 225.8 of the Board’s Regulation Y (capital plan rule) requires all U.S. bank holding companies with total consolidated assets of $50 billion or more to submit annual capital plans, including stress test results, to the Board to allow the Board to assess whether they have robust, forwardlooking capital planning processes and have sufficient capital to continue operations throughout times of economic and financial stress.24 Stress tests required under the stress test rules and under the capital plan rule require the Board and banking organizations 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 on 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 institutions eroded rapidly in the face of changes in the current and expected economic and financial conditions, and this loss in market confidence imperiled institutions’ 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. The stress tests required under the stress test rules and capital plan rule are a valuable supervisory tool that provides a forwardlooking assessment of large financial institutions’ capital adequacy under 21 12 CFR 252.144(b), 12 CFR 252.154(b). The annual company-run stress tests use data as of September 30 of each calendar year. 22 12 CFR 252.144(b), 154(b). 23 Id. 24 See Capital plans, 76 FR 74631 (Dec. 1, 2011) (codified at 12 CFR 225.8). VerDate Mar<15>2010 12:48 Nov 21, 2012 Jkt 229001 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 firms’ trading and counterparty positions—and not on other types of risk, such as liquidity risk or operational risk unrelated to the macroeconomic environment. Pressures stemming from these sources are considered in separate supervisory exercises. No single supervisory tool, including the stress tests, can provide an assessment of an institution’s ability to withstand every potential source of risk. Selecting appropriate scenarios is an especially significant consideration, for stress tests required under the capital plan rule, which ties the review of a bank holding 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; 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 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 F, G, and H, as well as the Board’s capital plan rule (12 CFR 225.8).25 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. 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 macro scenarios and the market shock component of the stress test scenarios applicable to firms with significant trading activity. Section 4 describes the 25 The Board may determine that modifications to the approach are appropriate, for instance, to address a broader range of risks, such as, operational risk. PO 00000 Frm 00006 Fmt 4702 Sfmt 4702 Board’s approach for developing the macro scenarios, and section 5 describes the approach for the market shocks. Section 6 describes the relationship between the macro 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 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.26 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. 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. Early in each stress testing cycle, the Board plans to publish the macro scenarios along with a brief narrative summary that explains how these scenarios have changed relative to the previous year. In cases where scenarios are changed to reflect particular risks and vulnerabilities, the narrative will also explain the underlying motivation for these changes. The Board also plans to release a broad description of the market shock components. 3.1 Macro Scenarios The macro scenarios will consist of the future paths of a set of economic and financial variables.27 The economic and financial variables included in the scenarios will likely comprise those included in the 2012 Comprehensive Capital Analysis and Review (CCAR).28 The domestic U.S. 26 12 CFR 252.134(b), 12 CFR 252.144(b), 12 CFR 252.154(b). 27 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. 28 See Appendix III of the 2012 CCAR Instructions and Guidance (www.federalreserve.gov/newsevents/ press/bcreg/bcreg20111122d1.pdf). E:\FR\FM\23NOP1.SGM 23NOP1 emcdonald on DSK7TPTVN1PROD with PROPOSALS Federal Register / Vol. 77, No. 226 / Friday, November 23, 2012 / Proposed Rules variables provided for in the 2012 CCAR included: • Five 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, nominal disposable personal income growth, and the Consumer Price Index (CPI) inflation rate; • 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 • Four measures of interest rates: the rate on the three-month Treasury bill, the yield on the 10-year Treasury bond, the yield on a 10-year BBB corporate security, and the interest rate associated with a conforming, conventional, fixed-rate, 30-year mortgage. The international variables provided for in the 2012 CCAR included, for the euro area, the United Kingdom, developing Asia, and Japan: • Percent change in real GDP; • Percent change in the Consumer Price Index or local equivalent; and • The U.S./foreign currency exchange rate.29 The economic variables included in the scenarios influence key items affecting banking organizations’ 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 banks’ net income and, thus, capital positions. 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 banks’ 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. 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.30 The Board expects the 29 The Board may increase the range of countries or regions included in future scenarios, as appropriate. 30 The Board expects banking organizations will ensure that the paths of such additional variables VerDate Mar<15>2010 12:48 Nov 21, 2012 Jkt 229001 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, such as state-level unemployment rates or citylevel 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 locallevel macro variables as needed for their internal models, and ensure internal consistency between these within-country variables and their aggregate, macroeconomic counterparts. The Board will provide the macro 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 The market shock component of the stress test scenarios will only apply to companies with significant trading activity and their subsidiaries.31 The component consists of large moves in market prices and rates that would be expected to generate losses. Market shocks differ from macro 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 quarterend, and the Board will provide the as-of date for market shocks no later than December 1 of each year. Finally, as described in section 4, market shocks include a much larger set of risk factors than the set of economic and financial variables included in macro 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). 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 are consistent with the scenarios the Board provided. 31 Currently, companies with significant trading activity include the six bank holding companies that are subject to the market risk rule and have total consolidated assets greater than $500 billion, as reported on their FR Y–9C. 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 banking organization’s trading activities evolve. PO 00000 Frm 00007 Fmt 4702 Sfmt 4702 70129 trading assets, including equities, credit, interest rates, foreign exchange rates, and commodities. For example, risk factor shocks for interest rates would capture changes in the level, correlation, and volatility, by country and maturity. Risk factors will be specified separately by currency or geographic region, and include key subcategories relevant to each asset class. For example, the risk factor shocks applied to credit spreads will differ by risk category and the risk factor shocks for spot oil prices will vary by grade and type of crude oil. Examples of risk factors include, but are not limited to: • 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; • Cross-currency FX rates of all major and many minor currencies, along term structures of implied volatilities; • 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 banks may have exposure; • Term structures of implied volatilities that are key inputs to the pricing of interest rate derivatives; • Term structures of futures prices for energy products including crude oil (differentiated by country of origin), natural gas, and power; • Term structures of futures prices for metals and agricultural commodities; • ‘‘Value-drivers’’ (credit spreads or instrument prices themselves) for creditsensitive product segments including: Corporate bonds, credit default swaps, and collateralized debt obligations by risk; nonagency residential mortgage-backed securities and commercial mortgage-backed securities by risk and vintage; sovereign debt; and, municipal bonds; and • Shocks to the values of private equity positions. 4. Approach for Formulating the Macroeconomic Assumptions for Scenarios This section describes the Board’s approach for formulating macroeconomic assumptions for each scenario. The methodologies for formulating this part of each scenario differ by scenario, so these methodologies for the baseline, severely adverse, and the adverse scenarios are described separately in each of the following subsections. 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. E:\FR\FM\23NOP1.SGM 23NOP1 70130 Federal Register / Vol. 77, No. 226 / Friday, November 23, 2012 / Proposed Rules 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). emcdonald on DSK7TPTVN1PROD with PROPOSALS 4.1 Approach for Formulating Macroeconomic Assumptions in the Baseline Scenario 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. The baseline scenario will be developed around a macroeconomic projection that captures the prevailing views of privatesector 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. 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 banking organization and that overall are more severe than those associated with the adverse scenario. The banking organization 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 banking VerDate Mar<15>2010 12:48 Nov 21, 2012 Jkt 229001 organization under the severely adverse scenario. After specifying the unemployment rate, the Board will specify the paths of other macroeconomic variables based on the paths of unemployment, income, and activity. However, many of these other variables have taken wildly divergent paths in previous recessions (e.g., house prices), 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., the relative fragility of the housing finance system). 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 probabilistic approach relies on estimates of uncertainty around the baseline scenario and such estimates are in practice modeldependent. 4.2.1 General Approach: The Recession Approach 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. 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.32 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.33 4.2.2 Setting the Unemployment Rate Under the Severely Adverse Scenario 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.34 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. This methodology is intended to generate scenarios that feature stressful outcomes but 32 More recently, a monthly measure of GDP has been added to the list of indicators. 33 Even though all recessions feature increases in the unemployment rate and contractions in incomes and economic activity, the size of this change has varied over post-war U.S. recessions. Table 1 documents the variability in the depth of post-war U.S. recessions. Some recessions—labeled mild in Table 1—have been relatively modest with GDP edging down just slightly and the unemployment rate moving up about a percentage point. Other recessions—labeled severe in Table 1—have been much harsher with GDP dropping 33⁄4 percent and the unemployment rate moving up a total of about 4 percentage points. 34 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. PO 00000 Frm 00008 Fmt 4702 Sfmt 4702 E:\FR\FM\23NOP1.SGM 23NOP1 emcdonald on DSK7TPTVN1PROD with PROPOSALS Federal Register / Vol. 77, No. 226 / Friday, November 23, 2012 / Proposed Rules do not induce greater procyclicality in the financial system and macroeconomy. When the economy is in the early stages of a recovery, the unemployment rate in a baseline scenario generally trends downward, resulting in a larger difference between the path of the unemployment rate in the severely adverse scenario and the baseline scenario and a severely adverse scenario that is relatively more intense. Conversely, in a sustained strong expansion—when the unemployment rate may be below the level consistent with full employment—the unemployment in a baseline scenario generally trends upward, resulting in a smaller difference between the path of the unemployment rate in the severely adverse scenario and the baseline scenario and a severely adverse scenario that is relatively less intense. Historically, a 3 to 5 percentage point increase in unemployment rate is reflective of stressful conditions. As illustrated in Table 1, over the last half-century, the U.S. economy has experienced four severe post-war recessions. In all four of these recessions the unemployment rate increased 3 to 5 percentage points and in the three most recent of these recessions the unemployment rate reached a level between 9 percent and 11 percent. 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. The Board believes that the typical increase in the unemployment rate in the severely adverse scenario would be about 4 percentage points. However, the Board would 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.35 Conversely, it would 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. However, even at the lower end of the range of unemployment-rate increases, the scenario would still feature an increase in the unemployment rate similar to what has been 35 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. VerDate Mar<15>2010 12:48 Nov 21, 2012 Jkt 229001 seen in about half of the severe recessions of the last 50 years. 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. In setting the increase in the unemployment rate, the Board would 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—would 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. 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 banks are properly capitalized to withstand severe economic and financial conditions, not to serve as an explicit countercyclical offset to the financial system. In developing the approach to the unemployment rate, the Board also considered a method that would increase the unemployment rate to some fairly elevated fixed level over the course of 6 to 8 quarters. This would result in scenarios being more severe in robust expansions (when the unemployment rate is low) and less severe in the early stages of a recovery (when the unemployment rate is high) and so would not result in pro-cyclicality. Depending on the initial level of the unemployment rate, this approach could lead to only a very modest increase in the unemployment rate—or even a decline. As a result, this approach—while not procyclical—could result in scenarios not featuring stressful macroeconomic outcomes. 4.2.3 Setting the Other Variables in the Severely Adverse Scenario 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. Economic models—such as medium-scale macroeconomic models—should be able to PO 00000 Frm 00009 Fmt 4702 Sfmt 4702 70131 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. For example, declining house prices, which are an important source of stress to a bank’s balance sheet, are not a steadfast feature of recessions, and the historical relationship of house prices with the unemployment rate or any other variable that deteriorates in recessions is not strong. Simply adopting their typical path in a severe recession would likely underestimate risks stemming from the housing sector. In this case, some modified approach—in which perhaps recessions in which house prices declined were judgmentally weighted more heavily—would be appropriate. 4.2.4 Adding Salient Risks to the Severely Adverse Scenario The severely adverse scenario will be developed to reflect specific risks to the economic and financial outlook that are especially salient but would 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. There are some important instances when it would 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. 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 FDIC and the 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. 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. The Board will factor in particular risks to the domestic and international macroeconomic outlook identified by its E:\FR\FM\23NOP1.SGM 23NOP1 70132 Federal Register / Vol. 77, No. 226 / Friday, November 23, 2012 / Proposed Rules 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 comovements 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.36 emcdonald on DSK7TPTVN1PROD with PROPOSALS 4.3 Approach for Formulating Macroeconomic Assumptions in the Adverse Scenario 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.37 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. 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 bank loss positions and incomes are nonlinear, there could be potential value from this approach. Another method to specify the adverse scenario is to capture risks in the adverse 36 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. 37 For example, in the context of CCAR, the Board currently uses the adverse scenario as one consideration in evaluating a bank holding company’s capital adequacy. VerDate Mar<15>2010 12:48 Nov 21, 2012 Jkt 229001 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. Under the Board’s stress test rules, covered companies are required to develop their own scenarios for mid-cycle company-run stress tests.38 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 firms describe in their living wills as being able to cause their failures. 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. Finally, the Board may consider specifying the adverse scenario using the probabilistic approach described in section 3.2.1 (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. With the exception of cases in which the probabilistic approach is used to generate the adverse scenario, the adverse scenario would 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 covered companies and large banks that are under some stress. 5. Approach for Formulating Scenario Market Price and Rate Shocks This section discusses the approach the Board proposes to adopt for developing the stress scenario component appropriate for companies with significant trading activities. The design and specification of the stress components for trading differ from that of the macro scenarios because profits and losses from the trading are measured in mark-tomarket terms, while revenues and losses from traditional banking are generally measured using the accrual method. As noted above, 38 12 PO 00000 CFR 252.145. Frm 00010 Fmt 4702 Sfmt 4702 another critical difference is the timeevolution of the trading stress tests. The trading stress component consists of an instantaneous ‘‘shock’’ to a large number of risk factors that determine the mark-tomarket value of trading positions, while the macro scenarios supply a projected path of economic variables that affect traditional banking activities over the entire planning period. The development of the scenarios in the final rules 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 Scenario for Trading Variables 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, market shocks 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 market shocks 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 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 macro 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. 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. To enhance the consistency and comparability in market shocks for CCAR in 2012, the Board provided to each trading company more than 35,000 specific risk E:\FR\FM\23NOP1.SGM 23NOP1 Federal Register / Vol. 77, No. 226 / Friday, November 23, 2012 / Proposed Rules emcdonald on DSK7TPTVN1PROD with PROPOSALS 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. 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 macro 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. The instantaneous nature of market shocks and the immediate recognition of mark-tomarket losses add another element to the design of market shocks, and to determining the appropriate severity of shocks. For instance, in both SCAP and CCAR, 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 would unfold and any associated market responses. 5.2.2 Approaches to Trading Stress Component Design For each scenario, 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 2012 CCAR, 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. VerDate Mar<15>2010 12:48 Nov 21, 2012 Jkt 229001 For 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 tweaks 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 scenario. 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, this approach would be useful in assessing each company’s capital adequacy as it relates to the company’s idiosyncratic risk. However, the Board does not believe this approach to be well-suited for the stress tests required by regulation. Consistency and comparability are key features of annual supervisory stress tests and annual company-run stress tests required in the stress test rules. It would be difficult to use the information on the companies’ portfolio to design a common set of shocks that are universally stressful for all covered companies. As a result, this approach would be better suited to more customized, tailored stress tests that are part of the company’s internal capital planning process or to other supervisory efforts outside of the stress tests conducted under the stress test rules. 5.2.3 Development of the Trading Stress Scenario Consistent with the approach describe 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. 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, particularly as the bank holding company’s portfolio changes over time and a different combination of events would better capture material risk in bank holding company’s portfolio in the given year. The developments in the credit markets during the second half of 2008 were PO 00000 Frm 00011 Fmt 4702 Sfmt 4702 70133 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 dominant 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. 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 stress scenario for the CCAR 2012 to reflect a salient source of stress to trading positions. As a result, it is important to incorporate both historical and hypothetical outcomes in 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 the 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. For the time being, the development of market shocks in the severely adverse scenario will begin with the risk factor movements in the particular historical period, such as the second half of 2008. The Board will then develop hypothetical but plausible scenarios, based on financial stability reports, supervisory information, and internal and external assessments of market risks and potential flash points. 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 swaps spreads and a precipitous decline in asset prices across multiple markets, as investors become more risk averse and market liquidity evaporates. E:\FR\FM\23NOP1.SGM 23NOP1 70134 Federal Register / Vol. 77, No. 226 / Friday, November 23, 2012 / Proposed Rules emcdonald on DSK7TPTVN1PROD with PROPOSALS These broad market movements would 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 consistency with the macro scenario, 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 Scenario for Trading Variables Under the Adverse Scenario The market shock component included in the adverse scenario will be designed to be generally less severe than the severely adverse scenario while providing useful information to supervisors. As in the case of the macro scenario, the market shock component in the adverse scenario can be developed in a number of different ways. 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. As discussed above, due to differences in companies’ trading positions, it can be difficult to know ex ante whether the adverse scenario or severely adverse scenario would result in greater losses for a given company. However, the Board anticipates that the adverse scenario would generally result in lower aggregate trading losses than the severely adverse scenario, particularly given the importance of creditrelated losses. 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. 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 2012 CCAR, 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 would 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. 39 12 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 would 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 would 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. 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 more 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. However, this approach would provide valuable information to supervisors, by focusing on different facets of potential vulnerabilities. Finally, the design of the adverse scenario for annual stress tests could be informed by the companies’ own market shock components used for their mid-cycle company-run stress tests.39 6. Consistency Between the Economic and Financial Variable Scenarios and the Market Price and Rate Shock Scenarios 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 macro 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. Generally, the market shock scenario will be directionally consistent with the macro scenario, though the magnitude of moves in broad risk factors, such as interest rates, foreign exchange rates, and prices, may differ. Because the market shock is designed, in part, to mimic the effects of a sudden market dislocation, while the macro 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. However, such differences should not be viewed as inconsistency in scenarios as long as the macro scenario and the market shock component of the scenario are directionally consistent. 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. 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 would also seek to reflect the same risk in one of the market shocks. For example, if the macro scenario were to feature a substantial decline in house price, it would 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. 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 The Board will provide a description of the macro scenarios by no later than November 15 of each year. 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 July and August of each year and to update the scenarios based on incoming macroeconomic data releases and other information through the end of October. Currently, the Board does not plan to publish the details of the market shock component. The Board expects to provide a broad overview of the market shock component. CFR 252.145. VerDate Mar<15>2010 12:48 Nov 21, 2012 Jkt 229001 PO 00000 Frm 00012 Fmt 4702 Sfmt 4702 E:\FR\FM\23NOP1.SGM 23NOP1 Federal Register / Vol. 77, No. 226 / Friday, November 23, 2012 / Proposed Rules 70135 TABLE 1—CLASSIFICATION OF U.S. RECESSIONS Peak 1957Q3 1960Q2 1969Q4 1973Q4 1980Q1 1981Q3 1990Q3 2001Q1 2007Q4 Average Average Average Trough ....................... ....................... ....................... ....................... ....................... ....................... ....................... ....................... ....................... ....................... ....................... ....................... Severity 1958Q2 ........... 1961Q1 ........... 1970Q4 ........... 1975Q1 ........... 1980Q3 ........... 1982Q4 ........... 1991Q1 ........... 2001Q4 ........... 2009Q2 ........... ......................... ......................... ......................... Severe ............ Typical ............ Typical ............ Severe ............ Typical ............ Severe ............ Mild ................. Mild ................. Severe ............ Severe ............ Moderate ........ Mild ................. Duration (quarters) 4 4 5 6 3 6 3 4 7 6 4 3 (Medium) .............................. (Medium) .............................. (Medium) .............................. (Long) .................................. (Short) .................................. (Long) .................................. (Short) .................................. (Medium) .............................. (Long) .................................. .............................................. .............................................. .............................................. Decline in real GDP Change in the unemployment rate during the recession Total change in the unemployment rate (incl. after the recession) 3.2 1.6 2.2 3.4 1.4 3.3 0.9 1.3 4.5 3.7 1.8 1.1 3.2 1.8 2.4 4.1 1.4 3.3 1.9 2.0 5.1 3.9 1.8 1.9 ¥3.1 ¥0.5 ¥0.1 ¥3.1 ¥2.2 ¥2.6 ¥1.3 0.7 [¥4.7] ¥3.8 ¥1.0 ¥0.3 By order of the Board of Governors of the Federal Reserve System, November 15, 2012. Margaret McCloskey Shanks, Deputy Secretary of the Board. [FR Doc. 2012–28207 Filed 11–21–12; 8:45 am] emcdonald on DSK7TPTVN1PROD with PROPOSALS BILLING CODE 6210–01–P VerDate Mar<15>2010 12:48 Nov 21, 2012 Jkt 229001 PO 00000 Frm 00013 Fmt 4702 Sfmt 9990 E:\FR\FM\23NOP1.SGM 23NOP1

Agencies

[Federal Register Volume 77, Number 226 (Friday, November 23, 2012)]
[Proposed Rules]
[Pages 70124-70135]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2012-28207]


=======================================================================
-----------------------------------------------------------------------

FEDERAL RESERVE SYSTEM

12 CFR Part 252

[Regulation YY; Docket No. OP-1452]
RIN 7100-AD-86


Policy Statement on the Scenario Design Framework for Stress 
Testing

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

ACTION: Proposed policy statement with request for public comment.

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

SUMMARY: The Board is requesting public comment on a policy statement 
on the approach to scenario design for stress testing that would be 
used in connection with the supervisory and company-run stress tests 
conducted under the Board's Regulations pursuant to the Dodd-Frank Wall 
Street Reform and Consumer Protection Act (Dodd-Frank Act or Act) and 
the Board's capital plan rule.

DATES: Comments must be received by February 15, 2013.

FOR FURTHER INFORMATION CONTACT: Tim Clark, Senior Associate Director, 
(202) 452-5264, Lisa Ryu, Assistant Director, (202) 263-4833, or David 
Palmer, Senior Supervisory Financial Analyst, (202) 452-2904, Division 
of Banking Supervision and Regulation; Benjamin W. McDonough, Senior 
Counsel, (202) 452-2036, or Christine Graham, Senior Attorney, (202) 
452-3099, Legal Division; or Andreas Lehnert, Deputy Director, (202) 
452-3325, or Rochelle Edge, Adviser, (202) 452-2339, Office of 
Financial Stability Policy and Research.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Background
II. Administrative Law Matters
    A. Use of Plain Language
    B. Paperwork Reduction Act Analysis
    C. Regulatory Flexibility Act Analysis

I. Background

    Stress testing is a tool that helps both bank supervisors and a 
banking organization measure the sufficiency of capital available to 
support the banking organization's operations throughout periods of 
stress.\1\ The Board and the other federal banking agencies previously 
have highlighted the use of stress testing as a means to better 
understand the range of a banking organization's potential risk 
exposures.\2\
---------------------------------------------------------------------------

    \1\ A full assessment of a company's capital adequacy must take 
into account a range of risk factors, including those that are 
specific to a particular industry or company.
    \2\ See, e.g., Supervisory Guidance on Stress Testing for 
Banking Organizations With More Than $10 Billion in Total 
Consolidated Assets, 77 FR 29458 (May 17, 2012), available at http://www.federalreserve.gov/bankinforeg/srletters/sr1207a1.pdf; 
Supervision and Regulation Letter SR 10-6, Interagency Policy 
Statement on Funding and Liquidity Risk Management (March 17, 2010), 
available at http://www.federalreserve.gov/boarddocs/srletters/2010/sr1006a1.pdf; Supervision and Regulation Letter SR 10-1, Interagency 
Advisory on Interest Rate Risk (January 11, 2010), available at 
http://www.federalreserve.gov/boarddocs/srletters/2010/SR1001.pdf; 
Supervision and Regulation Letter SR 09-4, Applying Supervisory 
Guidance and Regulations on the Payment of Dividends, Stock 
Redemptions, and Stock Repurchases at Bank Holding Companies 
(revised March 27, 2009), available at http://www.federalreserve.gov/boarddocs/srletters/2009/SR0904.htm; 
Supervision and Regulation Letter SR 07-1, Interagency Guidance on 
Concentrations in Commercial Real Estate (Jan. 4, 2007), available 
at http://www.federalreserve.gov/boarddocs/srletters/2007/SR0701.htm; Supervision and Regulation Letter SR 12-7, Supervisory 
Guidance on Stress Testing for Banking Organizations with More Than 
$10 Billion in Total Consolidated Assets (May 14, 2012), available 
at http://www.federalreserve.gov/bankinforeg/srletters/sr1207.htm; 
Supervision and Regulation Letter SR 99-18, Assessing Capital 
Adequacy in Relation to Risk at Large Banking Organizations and 
Others with Complex Risk Profiles (July 1, 1999), available at 
http://www.federalreserve.gov/boarddocs/srletters/1999/SR9918.htm; 
Supervisory Guidance: Supervisory Review Process of Capital Adequacy 
(Pillar 2) Related to the Implementation of the Basel II Advanced 
Capital Framework, 73 FR 44620 (July 31, 2008); The Supervisory 
Capital Assessment Program: SCAP Overview of Results (May 7, 2009), 
available at http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20090507a1.pdf; and Comprehensive Capital Analysis and Review: 
Objectives and Overview (Mar. 18, 2011), available at http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20110318a1.pdf.
---------------------------------------------------------------------------

    In particular, as part of its effort to stabilize the U.S. 
financial system during the 2007-2009 financial crisis, the Board and 
the Federal Reserve banks, along with other federal financial 
regulatory agencies, conducted stress tests of large, complex bank 
holding companies through the Supervisory Capital Assessment Program 
(SCAP). The SCAP was a forward-looking exercise designed to estimate 
revenue, losses, and capital needs under an adverse economic and 
financial market scenario. By looking at the broad capital needs of the 
financial system and the specific needs of individual companies, these 
stress tests provided valuable information to market participants, 
reduced uncertainty about the financial condition of the participating 
bank holding companies under a scenario that was more adverse than that 
which was anticipated to occur at the time, and had an overall 
stabilizing effect.
    Building on the SCAP and other supervisory work coming out of the 
crisis, the Board initiated the annual Comprehensive Capital Analysis 
and Review (CCAR) in late 2010 to assess the capital adequacy and the 
internal capital planning processes of the same large, complex bank 
holding companies

[[Page 70125]]

that participated in SCAP and to incorporate stress testing as part of 
the Board's regular supervisory program for assessing capital adequacy 
and capital planning practices at these large bank holding companies. 
The CCAR represents a substantial strengthening of previous approaches 
to assessing capital adequacy and promotes thorough and robust 
processes at large banking organizations for measuring capital needs 
and for managing and allocating capital resources. The CCAR focuses on 
the risk measurement and management practices supporting organizations' 
capital adequacy assessments, including their ability to deliver 
credible inputs to their loss estimation techniques, as well as the 
governance processes around capital planning practices. On November 22, 
2011, the Board issued an amendment (capital plan rule) to its 
Regulation Y to require all U.S. bank holding companies with total 
consolidated assets of $50 billion or more to submit annual capital 
plans 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.\3\
---------------------------------------------------------------------------

    \3\ See Capital Plans, 76 FR 74631 (Dec. 1, 2011) (codified at 
12 CFR 225.8).
---------------------------------------------------------------------------

    In the wake of the financial crisis, Congress enacted the Dodd-
Frank Act, which requires the Board to implement enhanced prudential 
supervisory standards, including requirements for stress tests, for 
covered companies to mitigate the threat to financial stability posed 
by these institutions.\4\ Section 165(i)(1) of the Dodd-Frank Act 
requires the Board to conduct an annual stress test of each bank 
holding company with total consolidated assets of $50 billion or more 
and each nonbank financial company that the Council has designated for 
supervision by the Board (covered company) to evaluate whether the 
covered company has sufficient capital, on a total consolidated basis, 
to absorb losses as a result of adverse economic conditions 
(supervisory stress tests).\5\ The Act requires that the supervisory 
stress test provide for at least three different sets of conditions--
baseline, adverse, and severely adverse conditions--under which the 
Board would conduct its evaluation. The Act also requires the Board to 
publish a summary of the supervisory stress test results.
---------------------------------------------------------------------------

    \4\ See section 165(i) of the Dodd-Frank Act; 12 U.S.C. 5365(i).
    \5\ See 12 U.S.C. 5365(i)(1).
---------------------------------------------------------------------------

    In addition, section 165(i)(2) of the Dodd-Frank Act requires the 
Board to issue regulations that require covered companies to conduct 
stress tests semi-annually and require financial companies with total 
consolidated assets of more than $10 billion that are not covered 
companies and for which the Board is the primary federal financial 
regulatory agency to conduct stress tests on an annual basis 
(collectively, company-run stress tests).\6\ The Board issued final 
rules implementing the stress test requirements of the Act on October 
12, 2012 (stress test rules).\7\
---------------------------------------------------------------------------

    \6\ 12 U.S.C. 5365(i)(2).
    \7\ 77 FR 62398 (October 12, 2012); 12 CFR part 252, subparts F-
H.
---------------------------------------------------------------------------

    The Board's stress test rules provide that the Board will notify 
covered companies, by no later than November 15 of each year of a set 
of conditions (each set, a scenario), it will use to conduct its annual 
supervisory stress tests.\8\ The rules further establish that the Board 
will provide, also by no later than November 15, covered companies and 
other banking organizations subject to the final rule the scenarios 
they must use to conduct their annual company-run stress tests.\9\ 
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.\10\ For example, the Board expects to require 
large banking organizations with significant trading activities to 
include global market shock components (described in the following 
sections) in their adverse and severely adverse scenarios. The Board 
will provide any additional components or scenarios by no later than 
December 1 of each year.\11\ 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).
---------------------------------------------------------------------------

    \8\ See id.; 12 CFR 252.134(b).
    \9\ See id.; 12 CFR 252.144(b), 154(b). The annual company-run 
stress tests use data as of September 30 of each calendar year.
    \10\ 12 CFR 252.144(b), 154(b).
    \11\ Id.
---------------------------------------------------------------------------

    Stress tests required under the stress test rules and under the 
Board's capital plan rule require the Board and financial institutions 
to calculate pro-forma capital levels--rather than ``current'' or 
actual levels--over a specified planning horizon under baseline and 
stressed scenarios. This approach integrates key lessons of the 2007-
2009 financial crisis into the Board's supervisory framework. In the 
financial crisis, investor and counterparty confidence in the 
capitalization of financial institutions eroded rapidly in the face of 
changes in the current and expected economic and financial conditions, 
and this loss in market confidence imperiled institutions' 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 exceeded the regulatory minimums. This is because the 
institution's capital ratios were perceived as lagging indicators of 
its financial condition, particularly when conditions were changing.
    The stress tests required under the stress test rules and capital 
plan rule are a valuable supervisory tool that provides a forward-
looking assessment of large financial institutions' 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 firms' trading and 
counterparty positions--and not on other types of risk, such as 
liquidity risk or operational risk unrelated to the macroeconomic 
environment. Pressures stemming from these sources are considered in 
separate supervisory exercises. No single supervisory tool, including 
the stress tests, can provide an assessment of an institution's ability 
to withstand every potential source of risk.
    Selecting appropriate scenarios is an especially significant 
consideration for stress tests required under the capital plan rule, 
which ties the review of a bank holding 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 a company's 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; it will depend on factors that are 
specific to a given company, such as underwriting standards and the 
banking organization's business model, which would also greatly affect 
projected revenue, losses, and capital.
    To enhance the transparency of the scenario design process, the 
Board is requesting public comment on a proposed policy statement 
(Policy Statement) that would be used to develop scenarios for annual 
supervisory and company-run stress tests under the stress testing rules

[[Page 70126]]

issued under the Act and the capital plan rule. The Board plans to 
develop the annual set of scenarios, as outlined below, in consultation 
with the Office of the Comptroller of the Currency (OCC) and Federal 
Deposit Insurance Corporation (FDIC) to reduce the burden that could 
arise from having the agencies establish inconsistent scenarios.
    The proposed Policy Statement outlines the characteristics of the 
stress test scenarios and explains the considerations and procedures 
that underlie the formulation of these scenarios. The considerations 
and procedures described in this policy statement would apply to the 
Board's stress testing framework, including to the stress tests 
required under 12 CFR part 252, subparts F, G, and H, as well as the 
Board's capital plan rule (12 CFR 225.8). The Board may determine that 
material modifications to the Policy Statement would be appropriate if 
the supervisory stress test framework expands materially to include 
additional components or other scenarios that are currently not 
captured.\12\
---------------------------------------------------------------------------

    \12\ Before requiring a company to include additional components 
or other scenarios in its company-run stress tests, the Board would 
follow the notice procedures set forth in the stress test rules. See 
12 CFR 252.144(b), 154(b).
---------------------------------------------------------------------------

    Although the Board does not envision that the approach used to 
develop scenarios would change from year to year, the characteristics 
of the scenarios provided to companies would 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 would be used to assess the strength and resilience of the 
companies' capital in various economic and financial environments.
    The proposed Policy Statement is organized as follows. Section 1 
provides background on the proposed Policy Statement. Section 2 is an 
outline of the proposed Policy Statement and describes its scope. 
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 macro scenarios and the market 
shock component of the stress test scenarios applicable to firms with 
significant trading activity.\13\ The proposed approach for the macro 
scenarios differs considerably from that for the market shocks, and, 
therefore, they are described separately. Section 4 describes the 
Board's proposed approach for developing the macro scenarios, and 
section 5 describes the proposed approach for the market shock 
components. Section 6 describes the relationship between the macro 
scenario and the market shock components. Section 7 provides a timeline 
for the formulation and publication of the macroeconomic assumptions 
and market shocks.
---------------------------------------------------------------------------

    \13\ Currently, the firms subject to the market shock component 
include the six bank holding companies that are subject to the 
market risk rule and have total consolidated assets greater than 
$500 billion, as reported on their FR Y-9C. However, the set of 
companies subject to the market shock could change over time as the 
size, scope, and complexity of the banking organization's trading 
activities evolve.
---------------------------------------------------------------------------

    Consistent with the stress testing rules and the Act, the Board 
will issue a minimum of three different scenarios, including baseline, 
adverse, and severely adverse scenarios, for use under the stress test 
rules. Specific circumstances or vulnerabilities, over which the Board 
determines, in any given year, 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.
    While the Board generally expects to use the same scenarios for all 
companies subject to the stress testing rules, 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 trading companies. 
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.
    Early in each stress testing cycle, the Board plans to publish the 
macro scenarios along with a brief narrative summary that explains how 
these scenarios have changed relative to the previous year. In cases 
where scenarios are modified to reflect particular risks and 
vulnerabilities, the narrative would also explain the underlying 
motivation for these changes. The Board also plans to release a broad 
description of the market shock component.
    The Board seeks comment on all aspects of the proposed Policy 
Statement. The Board notes that it will not revise the baseline, 
adverse, and severely adverse scenarios or market shock component that 
were recently issued under the Board's stress test rules and the 
capital plan rule for CCAR 2013 in light of any comments on the 
proposed policy statement but will consider the comments in developing 
future macro scenarios.
    Question 1. In what ways could the Board improve its approach to 
scenario design? What additional economic or financial variables should 
the Board consider in developing scenarios?
    Question 2. In addition to the trading shock, what additional 
components should the Board include in its stress testing framework? 
What additional scenarios should the Board consider using in connection 
with the stress testing framework?
    Question 3. The policy statement proposes a number of different 
methods for developing the adverse scenarios. What additional ways 
might the Board consider specifying the adverse scenario?
    Question 4. Does the approach for specifying the severely adverse 
scenarios--specifically, that of featuring a severe recession along 
with any salient risks to the economic and financial outlook--capture 
the relevant macroeconomic risks that firms face? Should there be 
additional features added to the scenario, either in specific 
circumstances or more generally?

II. Administrative Law Matters

A. Use of Plain Language

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

B. Paperwork Reduction Act Analysis

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

[[Page 70127]]

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.\14\ The RFA 
requires an agency either to provide an initial regulatory flexibility 
analysis with a proposed rule for which a general notice of proposed 
rulemaking is required or to certify that the proposed rule will not 
have a significant economic impact on a substantial number of small 
entities. Based on its analysis and for the reasons stated below, the 
Board believes that the proposed policy statement will not have a 
significant economic impact on a substantial number of small entities.
---------------------------------------------------------------------------

    \14\ See 5 U.S.C. 603, 604 and 605.
---------------------------------------------------------------------------

    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.\15\ The Board believes 
that the Finance and Insurance sector constitutes a reasonable universe 
of firms for these purposes because such firms generally engage in 
actives that are financial in nature. Consequently, bank holding 
companies or nonbank financial companies with assets sizes of $175 
million or less are small entities for purposes of the RFA.
---------------------------------------------------------------------------

    \15\ 13 CFR 121.201.
---------------------------------------------------------------------------

    As discussed in the SUPPLEMENTARY INFORMATION, the proposed policy 
statement generally would affect the scenario design framework used in 
regulations that apply to bank holding companies with $50 billion or 
more in total consolidated assets and nonbank financial companies that 
the Council has determined under section 113 of the Dodd-Frank Act must 
be supervised by the Board and for which such determination is in 
effect. Companies that are affected by the proposed policy statement 
therefore substantially exceed the $175 million asset threshold at 
which a banking entity is considered a ``small entity''' under SBA 
regulations.\16\ 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.\17\ 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.
---------------------------------------------------------------------------

    \16\ 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.
    \17\ 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 add the Policy 
Statement as set forth at the end of the SUPPLEMENTARY INFORMATION as 
part 252 to 12 CFR chapter II as follows:

PART 252--ENHANCED PRUDENTIAL STANDARDS (Regulation YY)

    1. The authority citation for part 252 would continue to read as 
follows:

    Authority: 12 U.S.C. 321-338a, 1467a(g), 1818, 1831p-1, 1844(b), 
1844(c), 5361, 5365, 5366.

    2. Appendix A to part 252 would be added to read as follows:

Appendix A--Policy Statement on the Scenario Design Framework for 
Stress Testing

1. Background

    The Board has imposed stress testing requirements through its 
regulations implementing section 165(i) of the Dodd-Frank Act 
(stress test rules) and through its capital plan rule (12 CFR 
225.8). Under the stress test rules issued under section 165(i)(1) 
of the Dodd-Frank Wall Street Reform and Consumer Protection Act 
(Dodd-Frank Act or 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 and each nonbank financial company that the Financial Stability 
Oversight Council has designated for supervision by the Board 
(together, covered companies).\18\ In addition, under the stress 
test rules issued under section 165(i)(2) of the Act, covered 
companies must conduct stress tests semi-annually and other 
financial companies with total consolidated assets of 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).\19\ 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.\20\
---------------------------------------------------------------------------

    \18\ 12 U.S.C. 5365(i)(1); 77 FR 62378 (October 12, 2012), to be 
codified at 12 CFR part 252, subpart F.
    \19\ 12 U.S.C. 5365(i)(2); 77 FR 62378, 62396 (October 12, 
2012), to be codified at 12 CFR part 252, subparts G and H.
    \20\ The stress test rules define scenarios as ``those sets of 
conditions that affect the U.S. economy or the financial condition 
of a [company] that the Board annually determines are appropriate 
for use in stress tests, including, but not limited to, baseline, 
adverse, and severely adverse scenarios.'' The stress test rules 
define baseline scenario as a ``set of conditions that affect the 
U.S. economy or the financial condition of a company and that 
reflect the consensus views of the economic and financial outlook.'' 
The stress test rules define adverse scenario a ``set of conditions 
that affect the U.S. economy or the financial condition of a company 
that are more adverse than those associated with the baseline 
scenario and may include trading or other additional components.'' 
The stress test rules define severely adverse scenario as a ``set of 
conditions that affect the U.S. economy or the financial condition 
of a company and that overall are more severe than those associated 
with the adverse scenario and may include trading or other 
additional components.'' See 12 CFR 252.132(a), (d), (m), and (n); 
12 CFR 252.142(a), (d), (o), and (p); 12 CFR 252.152(a), (e), (o), 
and (p).

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

[[Page 70128]]

    The stress test rules provide that the Board will notify covered 
companies by no later than November 15 of each year scenarios it 
will use to conduct its annual supervisory stress tests and provide, 
also by no later than November 15, covered companies and other 
banking organizations subject to the final rules the set of 
scenarios they must use to conduct their annual company-run stress 
tests.\21\ 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.\22\ For example, 
the Board expects to require large banking organizations with 
significant trading activities to include a global market shock 
component (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 December 1 of each year.\23\ 
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).
---------------------------------------------------------------------------

    \21\ 12 CFR 252.144(b), 12 CFR 252.154(b). The annual company-
run stress tests use data as of September 30 of each calendar year.
    \22\ 12 CFR 252.144(b), 154(b).
    \23\ Id.
---------------------------------------------------------------------------

    In addition, section 225.8 of the Board's Regulation Y (capital 
plan rule) requires all U.S. bank holding companies with total 
consolidated assets of $50 billion or more 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.\24\
---------------------------------------------------------------------------

    \24\ See Capital plans, 76 FR 74631 (Dec. 1, 2011) (codified at 
12 CFR 225.8).
---------------------------------------------------------------------------

    Stress tests required under the stress test rules and under the 
capital plan rule require the Board and banking organizations 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 on 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 institutions eroded rapidly in the 
face of changes in the current and expected economic and financial 
conditions, and this loss in market confidence imperiled 
institutions' 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.
    The stress tests required under the stress test rules and 
capital plan rule are a valuable supervisory tool that provides a 
forward-looking assessment of large financial institutions' 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 firms' trading and counterparty positions--and not 
on other types of risk, such as liquidity risk or operational risk 
unrelated to the macroeconomic environment. Pressures stemming from 
these sources are considered in separate supervisory exercises. No 
single supervisory tool, including the stress tests, can provide an 
assessment of an institution's ability to withstand every potential 
source of risk.
    Selecting appropriate scenarios is an especially significant 
consideration, for stress tests required under the capital plan 
rule, which ties the review of a bank holding 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; 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

    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 F, G, and H, as well as the Board's capital 
plan rule (12 CFR 225.8).\25\
---------------------------------------------------------------------------

    \25\ The Board may determine that modifications to the approach 
are appropriate, for instance, to address a broader range of risks, 
such as, operational risk.
---------------------------------------------------------------------------

    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.
    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 macro scenarios and the market 
shock component of the stress test scenarios applicable to firms 
with significant trading activity. Section 4 describes the Board's 
approach for developing the macro scenarios, and section 5 describes 
the approach for the market shocks. Section 6 describes the 
relationship between the macro 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

    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.\26\ 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.
---------------------------------------------------------------------------

    \26\ 12 CFR 252.134(b), 12 CFR 252.144(b), 12 CFR 252.154(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.
    Early in each stress testing cycle, the Board plans to publish 
the macro scenarios along with a brief narrative summary that 
explains how these scenarios have changed relative to the previous 
year. In cases where scenarios are changed to reflect particular 
risks and vulnerabilities, the narrative will also explain the 
underlying motivation for these changes. The Board also plans to 
release a broad description of the market shock components.

3.1 Macro Scenarios

    The macro scenarios will consist of the future paths of a set of 
economic and financial variables.\27\ The economic and financial 
variables included in the scenarios will likely comprise those 
included in the 2012 Comprehensive Capital Analysis and Review 
(CCAR).\28\ The domestic U.S.

[[Page 70129]]

variables provided for in the 2012 CCAR included:
---------------------------------------------------------------------------

    \27\ 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.
    \28\ See Appendix III of the 2012 CCAR Instructions and Guidance 
(www.federalreserve.gov/newsevents/press/bcreg/bcreg20111122d1.pdf).
---------------------------------------------------------------------------

     Five 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, 
nominal disposable personal income growth, and the Consumer Price 
Index (CPI) inflation rate;
     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
     Four measures of interest rates: the rate on the three-
month Treasury bill, the yield on the 10-year Treasury bond, the 
yield on a 10-year BBB corporate security, and the interest rate 
associated with a conforming, conventional, fixed-rate, 30-year 
mortgage.
    The international variables provided for in the 2012 CCAR 
included, for the euro area, the United Kingdom, developing Asia, 
and Japan:
     Percent change in real GDP;
     Percent change in the Consumer Price Index or local 
equivalent; and
     The U.S./foreign currency exchange rate.\29\
---------------------------------------------------------------------------

    \29\ The Board may increase the range of countries or regions 
included in future scenarios, as appropriate.
---------------------------------------------------------------------------

    The economic variables included in the scenarios influence key 
items affecting banking organizations' 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 banks' 
net income and, thus, capital positions.
    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 banks' 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.
    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.\30\ 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, 
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 
within-country variables and their aggregate, macro-economic 
counterparts. The Board will provide the macro 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.
---------------------------------------------------------------------------

    \30\ The Board expects banking organizations will ensure that 
the paths of such additional variables are consistent with the 
scenarios the Board provided.
---------------------------------------------------------------------------

3.2 Market Shock Component

    The market shock component of the stress test scenarios will 
only apply to companies with significant trading activity and their 
subsidiaries.\31\ The component consists of large moves in market 
prices and rates that would be expected to generate losses. Market 
shocks differ from macro 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 December 1 of each 
year. Finally, as described in section 4, market shocks include a 
much larger set of risk factors than the set of economic and 
financial variables included in macro 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).
---------------------------------------------------------------------------

    \31\ Currently, companies with significant trading activity 
include the six bank holding companies that are subject to the 
market risk rule and have total consolidated assets greater than 
$500 billion, as reported on their FR Y-9C. 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 banking organization's trading activities 
evolve.
---------------------------------------------------------------------------

    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. For example, risk factor shocks for interest rates 
would capture changes in the level, correlation, and volatility, by 
country and maturity. Risk factors will be specified separately by 
currency or geographic region, and include key sub-categories 
relevant to each asset class. For example, the risk factor shocks 
applied to credit spreads will differ by risk category and the risk 
factor shocks for spot oil prices will vary by grade and type of 
crude oil.
    Examples of risk factors include, but are not limited to:
     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;
     Cross-currency FX rates of all major and many minor 
currencies, along term structures of implied volatilities;
     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 banks may have 
exposure;
     Term structures of implied volatilities that are key 
inputs to the pricing of interest rate derivatives;
     Term structures of futures prices for energy products 
including crude oil (differentiated by country of origin), natural 
gas, and power;
     Term structures of futures prices for metals and 
agricultural commodities;
     ``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
     Shocks to the values of private equity positions.

4. Approach for Formulating the Macroeconomic Assumptions for Scenarios

    This section describes the Board's approach for formulating 
macroeconomic assumptions for each scenario. The methodologies for 
formulating this part of each scenario differ by scenario, so these 
methodologies for the baseline, severely adverse, and the adverse 
scenarios are described separately in each of the following 
subsections.
    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.

[[Page 70130]]

    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

    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.
    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.
    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 banking organization and that overall are more severe 
than those associated with the adverse scenario. The banking 
organization 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 banking organization under the severely adverse scenario.

4.2.1 General Approach: The Recession Approach

    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.
    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.\32\ 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.\33\
---------------------------------------------------------------------------

    \32\ More recently, a monthly measure of GDP has been added to 
the list of indicators.
    \33\ Even though all recessions feature increases in the 
unemployment rate and contractions in incomes and economic activity, 
the size of this change has varied over post-war U.S. recessions. 
Table 1 documents the variability in the depth of post-war U.S. 
recessions. Some recessions--labeled mild in Table 1--have been 
relatively modest with GDP edging down just slightly and the 
unemployment rate moving up about a percentage point. Other 
recessions--labeled severe in Table 1--have been much harsher with 
GDP dropping 3\3/4\ percent and the unemployment rate moving up a 
total of about 4 percentage points.
---------------------------------------------------------------------------

    After specifying the unemployment rate, the Board will specify 
the paths of other macroeconomic variables based on the paths of 
unemployment, income, and activity. However, many of these other 
variables have taken wildly divergent paths in previous recessions 
(e.g., house prices), 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., the relative fragility of the housing finance system).
    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 
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

    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.\34\ 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.
---------------------------------------------------------------------------

    \34\ 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.
---------------------------------------------------------------------------

    This methodology is intended to generate scenarios that feature 
stressful outcomes but

[[Page 70131]]

do not induce greater procyclicality in the financial system and 
macroeconomy. When the economy is in the early stages of a recovery, 
the unemployment rate in a baseline scenario generally trends 
downward, resulting in a larger difference between the path of the 
unemployment rate in the severely adverse scenario and the baseline 
scenario and a severely adverse scenario that is relatively more 
intense. Conversely, in a sustained strong expansion--when the 
unemployment rate may be below the level consistent with full 
employment--the unemployment in a baseline scenario generally trends 
upward, resulting in a smaller difference between the path of the 
unemployment rate in the severely adverse scenario and the baseline 
scenario and a severely adverse scenario that is relatively less 
intense. Historically, a 3 to 5 percentage point increase in 
unemployment rate is reflective of stressful conditions. As 
illustrated in Table 1, over the last half-century, the U.S. economy 
has experienced four severe post-war recessions. In all four of 
these recessions the unemployment rate increased 3 to 5 percentage 
points and in the three most recent of these recessions the 
unemployment rate reached a level between 9 percent and 11 percent.
    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.
    The Board believes that the typical increase in the unemployment 
rate in the severely adverse scenario would be about 4 percentage 
points. However, the Board would 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.\35\ Conversely, it would 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. However, even at the lower end of the 
range of unemployment-rate increases, the scenario would 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.
---------------------------------------------------------------------------

    \35\ 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.
---------------------------------------------------------------------------

    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.
    In setting the increase in the unemployment rate, the Board 
would 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--would 
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.
    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 banks are 
properly capitalized to withstand severe economic and financial 
conditions, not to serve as an explicit countercyclical offset to 
the financial system.
    In developing the approach to the unemployment rate, the Board 
also considered a method that would increase the unemployment rate 
to some fairly elevated fixed level over the course of 6 to 8 
quarters. This would result in scenarios being more severe in robust 
expansions (when the unemployment rate is low) and less severe in 
the early stages of a recovery (when the unemployment rate is high) 
and so would not result in pro-cyclicality. Depending on the initial 
level of the unemployment rate, this approach could lead to only a 
very modest increase in the unemployment rate--or even a decline. As 
a result, this approach--while not procyclical--could result in 
scenarios not featuring stressful macroeconomic outcomes.

4.2.3 Setting the Other Variables in the Severely Adverse Scenario

    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.
    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. For example, 
declining house prices, which are an important source of stress to a 
bank's balance sheet, are not a steadfast feature of recessions, and 
the historical relationship of house prices with the unemployment 
rate or any other variable that deteriorates in recessions is not 
strong. Simply adopting their typical path in a severe recession 
would likely underestimate risks stemming from the housing sector. 
In this case, some modified approach--in which perhaps recessions in 
which house prices declined were judgmentally weighted more 
heavily--would be appropriate.

4.2.4 Adding Salient Risks to the Severely Adverse Scenario

    The severely adverse scenario will be developed to reflect 
specific risks to the economic and financial outlook that are 
especially salient but would 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.
    There are some important instances when it would 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.
    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 
FDIC and the 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.
    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.
    The Board will factor in particular risks to the domestic and 
international macroeconomic outlook identified by its

[[Page 70132]]

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.\36\
---------------------------------------------------------------------------

    \36\ 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

    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.\37\ 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.
---------------------------------------------------------------------------

    \37\ For example, in the context of CCAR, the Board currently 
uses the adverse scenario as one consideration in evaluating a bank 
holding company's capital adequacy.
---------------------------------------------------------------------------

    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 bank loss positions and incomes are 
nonlinear, there could be potential value from this approach.
    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.
    Under the Board's stress test rules, covered companies are 
required to develop their own scenarios for mid-cycle company-run 
stress tests.\38\ 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 firms describe in 
their living wills as being able to cause their failures.
---------------------------------------------------------------------------

    \38\ 12 CFR 252.145.
---------------------------------------------------------------------------

    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.
    Finally, the Board may consider specifying the adverse scenario 
using the probabilistic approach described in section 3.2.1 (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.
    With the exception of cases in which the probabilistic approach 
is used to generate the adverse scenario, the adverse scenario would 
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 covered companies and large banks 
that are under some stress.

5. Approach for Formulating Scenario Market Price and Rate Shocks

    This section discusses the approach the Board proposes to adopt 
for developing the stress scenario component appropriate for 
companies with significant trading activities. The design and 
specification of the stress components for trading differ from that 
of the macro scenarios because profits and losses from the 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 trading stress tests. The trading stress 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 
macro scenarios supply a projected path of economic variables that 
affect traditional banking activities over the entire planning 
period.
    The development of the scenarios in the final rules 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 Scenario for Trading Variables 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, market shocks 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 market 
shocks 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

    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 macro 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.
    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.
    To enhance the consistency and comparability in market shocks 
for CCAR in 2012, the Board provided to each trading company more 
than 35,000 specific risk

[[Page 70133]]

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.
    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 macro 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.
    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 both SCAP and CCAR, 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 would unfold and any associated market 
responses.

5.2.2 Approaches to Trading Stress Component Design

    For each scenario, 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 2012 CCAR, 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.
    For 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 
tweaks 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 
scenario.
    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, this 
approach would be useful in assessing each company's capital 
adequacy as it relates to the company's idiosyncratic risk. However, 
the Board does not believe this approach to be well-suited for the 
stress tests required by regulation. Consistency and comparability 
are key features of annual supervisory stress tests and annual 
company-run stress tests required in the stress test rules. It would 
be difficult to use the information on the companies' portfolio to 
design a common set of shocks that are universally stressful for all 
covered companies. As a result, this approach would be better suited 
to more customized, tailored stress tests that are part of the 
company's internal capital planning process or to other supervisory 
efforts outside of the stress tests conducted under the stress test 
rules.

5.2.3 Development of the Trading Stress Scenario

    Consistent with the approach describe 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. 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, particularly as the bank holding 
company's portfolio changes over time and a different combination of 
events would better capture material risk in bank holding company's 
portfolio in the given year.
    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 dominant 
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.
    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 stress scenario for the CCAR 2012 to reflect a salient source of 
stress to trading positions. As a result, it is important to 
incorporate both historical and hypothetical outcomes in 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 the 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.
    For the time being, the development of market shocks in the 
severely adverse scenario will begin with the risk factor movements 
in the particular historical period, such as the second half of 
2008. The Board will then develop hypothetical but plausible 
scenarios, based on financial stability reports, supervisory 
information, and internal and external assessments of market risks 
and potential flash points. 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 swaps spreads and a 
precipitous decline in asset prices across multiple markets, as 
investors become more risk averse and market liquidity evaporates.

[[Page 70134]]

These broad market movements would 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 consistency with the macro scenario, 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 Scenario for Trading Variables Under 
the Adverse Scenario

    The market shock component included in the adverse scenario will 
be designed to be generally less severe than the severely adverse 
scenario while providing useful information to supervisors. As in 
the case of the macro scenario, the market shock component in the 
adverse scenario can be developed in a number of different ways.
    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. As discussed above, due to differences in 
companies' trading positions, it can be difficult to know ex ante 
whether the adverse scenario or severely adverse scenario would 
result in greater losses for a given company. However, the Board 
anticipates that the adverse scenario would generally result in 
lower aggregate trading losses than the severely adverse scenario, 
particularly given the importance of credit-related losses. 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.
    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 2012 
CCAR, 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 would 
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.
    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 
would 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 would 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.
    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 more 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. However, this approach would 
provide valuable information to supervisors, by focusing on 
different facets of potential vulnerabilities.
    Finally, the design of the adverse scenario for annual stress 
tests could be informed by the companies' own market shock 
components used for their mid-cycle company-run stress tests.\39\
---------------------------------------------------------------------------

    \39\ 12 CFR 252.145.
---------------------------------------------------------------------------

6. Consistency Between the Economic and Financial Variable Scenarios 
and the Market Price and Rate Shock Scenarios

    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 macro 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.
    Generally, the market shock scenario will be directionally 
consistent with the macro scenario, though the magnitude of moves in 
broad risk factors, such as interest rates, foreign exchange rates, 
and prices, may differ. Because the market shock is designed, in 
part, to mimic the effects of a sudden market dislocation, while the 
macro 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. 
However, such differences should not be viewed as inconsistency in 
scenarios as long as the macro scenario and the market shock 
component of the scenario are directionally consistent. 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.
    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 would also seek to reflect the 
same risk in one of the market shocks. For example, if the macro 
scenario were to feature a substantial decline in house price, it 
would 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.
    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

    The Board will provide a description of the macro scenarios by 
no later than November 15 of each year. 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 July and August of each year and to update 
the scenarios based on incoming macroeconomic data releases and 
other information through the end of October.
    Currently, the Board does not plan to publish the details of the 
market shock component. The Board expects to provide a broad 
overview of the market shock component.

[[Page 70135]]



                                                       Table 1--Classification of U.S. Recessions
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                                         Total change in
                                                                                                                         Change in the         the
                                                                                                           Decline in     unemployment     unemployment
                Peak                         Trough                Severity         Duration (quarters)     real GDP    rate during the    rate (incl.
                                                                                                                           recession        after the
                                                                                                                                            recession)
--------------------------------------------------------------------------------------------------------------------------------------------------------
1957Q3.............................  1958Q2...............  Severe...............  4 (Medium)...........         -3.1               3.2              3.2
1960Q2.............................  1961Q1...............  Typical..............  4 (Medium)...........         -0.5               1.6              1.8
1969Q4.............................  1970Q4...............  Typical..............  5 (Medium)...........         -0.1               2.2              2.4
1973Q4.............................  1975Q1...............  Severe...............  6 (Long).............         -3.1               3.4              4.1
1980Q1.............................  1980Q3...............  Typical..............  3 (Short)............         -2.2               1.4              1.4
1981Q3.............................  1982Q4...............  Severe...............  6 (Long).............         -2.6               3.3              3.3
1990Q3.............................  1991Q1...............  Mild.................  3 (Short)............         -1.3               0.9              1.9
2001Q1.............................  2001Q4...............  Mild.................  4 (Medium)...........          0.7               1.3              2.0
2007Q4.............................  2009Q2...............  Severe...............  7 (Long).............        [-4.7]              4.5              5.1
Average............................  .....................  Severe...............  6....................         -3.8               3.7              3.9
Average............................  .....................  Moderate.............  4....................         -1.0               1.8              1.8
Average............................  .....................  Mild.................  3....................         -0.3               1.1              1.9
--------------------------------------------------------------------------------------------------------------------------------------------------------


    By order of the Board of Governors of the Federal Reserve 
System, November 15, 2012.
Margaret McCloskey Shanks,
Deputy Secretary of the Board.

[FR Doc. 2012-28207 Filed 11-21-12; 8:45 am]
BILLING CODE 6210-01-P