Policy Statement on the Scenario Design Framework for Stress Testing, 71435-71448 [2013-27009]

Download as PDF 71435 Rules and Regulations Federal Register Vol. 78, No. 230 Friday, November 29, 2013 This section of the FEDERAL REGISTER contains regulatory documents having general applicability and legal effect, most of which are keyed to and codified in the Code of Federal Regulations, which is published under 50 titles pursuant to 44 U.S.C. 1510. The Code of Federal Regulations is sold by the Superintendent of Documents. Prices of new books are listed in the first FEDERAL REGISTER issue of each week. 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: Final rule; policy statement. AGENCY: The Board is adopting a final policy statement on the approach to scenario design for stress testing that will 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: This rule will be effective on January 1, 2014. FOR FURTHER INFORMATION CONTACT: Tim Clark, Senior Associate Director, (202) 452–5264, Lisa Ryu, Deputy Associate Director, (202) 263–4833, David Palmer, Senior Supervisory Financial Analyst, (202) 452–2904, or Joseph Cox, Financial Analyst, (202) 452–3216, Division of Banking Supervision and Regulation; Benjamin W. McDonough, Senior Counsel, (202) 452–2036, or Jeremy Kress, Attorney, (202) 872–7589, Legal Division; or Andreas Lehnert, Deputy Director, (202) 452–3325, or Rochelle Edge, Assistant Director, (202) 452–2339, Office of Financial Stability Policy and Research. SUPPLEMENTARY INFORMATION: sroberts on DSK5SPTVN1PROD with RULES SUMMARY: Table of Contents I. Background II. Proposed Policy Statement III. Summary of Comments A. Design of Stress Test Scenarios B. Additional Variables C. Severely Adverse Scenario Development VerDate Mar<15>2010 20:31 Nov 27, 2013 Jkt 232001 D. Adverse Scenario Development E. Market Shock and Additional Scenarios or Components of Scenarios F. Transparency and Timing G. Public Disclosure IV. 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 financial company measure the sufficiency of capital available to support the financial company’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 financial company’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. PO 00000 Frm 00001 Fmt 4700 Sfmt 4700 In particular, building on its experience during the financial 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 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 financial companies for measuring capital needs and for managing and allocating capital resources. 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. This procedure allows the Board to assess whether the bank holding companies have robust, forward-looking 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— 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). E:\FR\FM\29NOR1.SGM 29NOR1 71436 Federal Register / Vol. 78, No. 230 / Friday, November 29, 2013 / Rules and Regulations 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 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 financial companies 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 has required large banking organizations with significant trading activities to include trading and counterparty components (the ‘‘market shock,’’ 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). 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 sroberts on DSK5SPTVN1PROD with RULES 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 VerDate Mar<15>2010 20:31 Nov 27, 2013 Jkt 232001 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 financial company’s business model, which would also greatly affect projected revenue, losses, and capital. II. Proposed Policy Statement In order to enhance the transparency of the scenario design process, on November 23, 2012, the Board published for public comment a proposed policy statement (proposed policy statement) that would be used to develop scenarios for annual supervisory and company-run stress tests under the stress testing rules issued under the Dodd-Frank Act and the capital plan rule.12 The proposed policy statement outlined the characteristics of the supervisory stress test scenarios and explained the considerations and procedures that underlie the formulation of these scenarios. The considerations and procedures described in the proposed 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 proposed policy statement provided a broad description of the baseline, adverse, and severely adverse scenarios and described the types of variables that the Board would expect to include in the macroeconomic scenarios and in the market shock component of the stress test scenarios applicable to companies with significant trading activity. The proposed policy statement also described the Board’s approach to developing the macroeconomic scenarios and market shocks, as well as the relationship between the macroeconomic scenario and the market shock components. The Board noted that it may determine that material modifications to the proposed policy statement are appropriate if the supervisory stress test framework expands materially to include additional components or other 12 77 PO 00000 FR 70124. Frm 00002 Fmt 4700 Sfmt 4700 scenarios that are currently not captured.13 III. Summary of Comments The Board received seven comments on the proposed policy statement. Commenters included financial companies, trade organizations, and public interest groups. In general, commenters supported the proposed policy statement and commended the Board for enhancing the transparency of the scenario design framework. Commenters provided a number of suggestions for improving the proposed framework, including by incorporating additional risks into the supervisory scenarios, providing additional scenarios and variables that would capture salient risks to financial companies, making the scenarios more predictable, and further enhancing the transparency of the scenario design process and stress testing in general. In response to these comments, the Board has modified certain aspects of the proposed policy statement, including expanding the information included in the narrative to be published with the macroeconomic scenarios; adding an historical-based approach to the adverse scenario; and providing additional information about the process for designing the path of international variables. The Board generally has retained the overall principles underlying the policy statement and its overall organization. A. Design of Stress Test Scenarios Commenters suggested a variety of ways for the Board to alter or improve the design of stress test scenarios, including by making the process more predictable, using a variety of stress testing approaches to more fully capture salient risks, tailoring the scenario for nonbank financial companies, and coordinating with the other federal banking regulators. Some commenters advocated for making the scenarios more predictable by anchoring them more firmly in historical episodes or using a probabilistic approach with a specified tail percentile for severity. One commenter asserted that the predictability of the design framework was diminished by the proposed policy statement noting that scenarios would vary in relation to changes in the outlook for economic and financial conditions and changes to specific risks or vulnerabilities. 13 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). E:\FR\FM\29NOR1.SGM 29NOR1 sroberts on DSK5SPTVN1PROD with RULES Federal Register / Vol. 78, No. 230 / Friday, November 29, 2013 / Rules and Regulations The Board believes it is important that scenario development remain flexible in order to ensure that the stress tests have the ability to capture emerging risks or elevated systemic risk. Some commenters noted that it was important for supervisors to retain sufficient discretion in order to prevent the scenario from becoming stale or irrelevant. For these reasons, the final policy statement outlines the general range of scenarios that may be implemented, as well as their overall severity, but the Board retains the flexibility to incorporate developing risks and vary the scenario in response to the Board’s views regarding the level of systemic and other risks. One commenter advocated the use of a variety of approaches to scenario development, including using sensitivity analysis and recommended changing the correlations and dependencies between risk factors given that the relationships between risk factors observed in normal times may not apply during stressful conditions. The final policy statement allows for a variety of approaches to scenario development and for flexibility in changing correlations and dependencies between risk factors. For example, the final policy statement allows for the adverse scenario to follow either a recession approach, a probabilistic approach, or an approach based on historical experiences, with the possibility of including additional risks that the Board believes should be understood and monitored. Further, the final policy statement allows the Board to augment the severely adverse scenario to reflect salient risks that would not be captured under the recession approach that is used to develop the severely adverse scenario. Augmenting the severely adverse scenario to include salient risks and the possibility of including additional risks in the adverse scenario allows for correlations and dependencies between risk factors to be further altered to capture specific stressful outcomes that are identified by economists, bank supervisors, and financial market experts as representing particularly relevant risks. One commenter urged the Board to account in its scenario design framework for unique risks faced by nonbank financial companies supervised by the Board. The commenter asserted that the scenarios for nonbank financial companies should de-emphasize shocks arising from traditional banking activities, as such risks would be less salient for nonbank financial companies. The Board expects to take into account differences among VerDate Mar<15>2010 20:31 Nov 27, 2013 Jkt 232001 bank holding companies and nonbank covered companies supervised by the Board when applying the stress testing requirements.14 As the nonbank financial companies implement the stress testing requirements, the Board may tailor the application for those companies, including by updating its framework for developing supervisory scenarios. The Board will continue to consult with other supervisory authorities, including the Federal Insurance Office, as appropriate. Finally, some commenters stressed the importance of coordination between the Board, the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC) in developing a common scenario in order to prevent the stress testing process from becoming overly complex and burdensome. In addition, commenters suggested that different scenarios from each agency would make the public disclosure of company-run stress test results more difficult to interpret. As noted previously in the stress test rules and in the proposed policy statement, the Board plans to develop scenarios each year in close consultation with the primary federal financial regulatory agencies. The Board, FDIC, and OCC followed this approach both in 2012 and 2013. This coordinated approach allows a common set of scenarios to be used for the annual company-run stress tests across various banking entities within the same organizational structure. The Board plans to continue to develop the annual set of scenarios in consultation with the OCC and the FDIC to reduce the burden that could arise from having the agencies establish inconsistent scenarios. B. Additional Variables Several commenters supported adding additional variables to the supervisory scenarios. A few commenters noted that it would be helpful for the Board to provide companies with a broader suite of variables. In particular, one company noted that in order to run its stress tests under the supervisory scenarios, it had to forecast hundreds of additional variables. One commenter noted that requiring companies to project the paths 14 To date, the Financial Stability Oversight Council has designated three nonbank financial companies for supervision by the Board: General Electric Capital Corporation, American International Group, Inc., and Prudential Financial Inc. These companies will be subject to the Board’s stress testing rules beginning with the stress cycle that commences in the calendar year after the year in which the company first becomes subject to the Board’s minimum regulatory capital requirements, unless the Board accelerates or extends the compliance date. PO 00000 Frm 00003 Fmt 4700 Sfmt 4700 71437 of additional variables could create inconsistency between the scenarios that companies use in their stress tests, reducing the industry-wide comparability of the exercise. Several commenters requested specific variables, including additional country-specific international variables. Commenters requested that the Board include variables on more countries and more scenario variables for each country, including information on unemployment rates, equity market indexes, and home values. One commenter provided tables of suggested variables that many companies use for their own internal processes. Finally, one commenter urged the Board to provide all the factors used in its own models in the supervisory stress test to improve macroprudential supervision and increase the consistency of scenario assumptions and the comparability of results across companies. In defining the supervisory scenarios, the Board expects to provide the variables the Board considers to be the most important descriptors of the scenarios’ economic and financial conditions. However, in response to comments, the Board will provide a narrative with the supervisory scenarios each year to aid companies in projecting other variables based on the variables provided in the scenarios. The narrative will include descriptions of the paths of many additional variables companies may need to project for their companyrun stress tests. The Board may add additional variables to the scenarios in the future if the Board determines that the variables provide additional information about the conditions in the scenarios that cannot be inferred from the other variables in the supervisory scenarios. For example, this year the Board plans to provide two additional interest rate variables, the yield on 5year Treasury bonds and the prime rate, that were specifically requested by one commenter. However, large and complex financial companies should be able to identify their key risks and relate them to the external environment by translating the supervisory scenario into additional variables. Several commenters suggested that the variables from the market shock component of the adverse and severely adverse scenarios should be provided to all companies subject to stress tests. One industry commenter requested that the market shock to be released to all companies at the same time as the macroeconomic scenario so the companies can use variables from the market shock in their company-run stress tests. E:\FR\FM\29NOR1.SGM 29NOR1 71438 Federal Register / Vol. 78, No. 230 / Friday, November 29, 2013 / Rules and Regulations In order to enhance the transparency of the supervisory and company-run stress tests, the Board expects to publish the market shock component annually.15 However, only companies with significant trading activity, as determined by the Board and specified in the Capital Assessments and Stress Testing report (FR Y–14) (trading companies) are subject to the market shock component.16 Companies that are not subject to the market shock should not incorporate the market shock component into their stress tests or complete the Securities AFS Market Shock tab on the FR Y–14A Summary Schedule. Moreover, unlike the scenarios, the market shock is not a time series but rather is assumed to be an instantaneous event. Companies should not assume that the risk factor moves in the market shock are appropriate for inclusion in their stress tests as a complement to the macroeconomic scenarios. sroberts on DSK5SPTVN1PROD with RULES C. Severely Adverse Scenario Development Several commenters provided feedback on the proposed approach for developing the severely adverse scenario. Some commenters suggested alternative frameworks that would limit the variability in the severity of the scenario. An industry participant suggested that the Board should avoid volatility in scenario severity based on the economic conditions at the starting point of the exercise, as variation in the scenario severity would cause stress losses and capital requirements to vary considerably. Another commenter supported the historical approach to designing the severely adverse scenario, asserting that it would constrain the scenario to a plausible range and make the scenario more predictable. One commenter expressed a preference for the probabilistic approach and advocated for a consistent probabilistic severity (i.e., the same tail percentile) with idiosyncratic differences in risk factor movements to reflect existing and emerging concerns. The commenter acknowledged the drawbacks that the Board identified with the probabilistic approach but 15 On March 7, 2013 the Board published the market shock components of the supervisory adverse and severely adverse scenarios that were used for the stress test cycle commencing on November 15, 2012. The severely adverse market shock is available online at: http:// www.federalreserve.gov/bankinforeg/accessible2013-ccar-severely-adverse-market-shocks.htm. 16 Consistent with the instructions to the FR Y– 14A, bank holding companies with greater than $500 billion in total consolidated assets that are subject to the amended market risk rule are considered to have significant trading activity. VerDate Mar<15>2010 20:31 Nov 27, 2013 Jkt 232001 suggested that these problems could be overcome with rigor in calibration and supervisory discretion in picking variables and paths of variables. Finally, the commenter suggested that the supervisory judgment required to use the probabilistic approach will ensure a proactive and prudential supervisory scenario design process. As noted in the proposed policy statement, the Board intends to offset natural procyclical tendencies in its scenario design framework by using an approach that ensures the scenarios reach a minimum severity level. The Board believes that setting a floor for the severity of the scenario is appropriate in light of cyclical systemic risks that build up at financial intermediaries during robust expansions that may be obscured by the strength of the overall environment. The Board also believes that varying the scenario severity in response to systemic risks is aligned with the goals of scenario design and stress testing. As such, the Board believes varying the severity of the severely adverse scenario based on current macroeconomic conditions—in the same manner as described in the proposed policy statement—better meets the goals of scenario design and stress testing than alternative methods of specifying the severity of the supervisory scenarios. D. Adverse Scenario Development One commenter suggested that the process for designing the adverse scenario should be constrained, perhaps by historical experience, so that the scenario does not change drastically from year to year. The commenter noted that an exception could be granted for cases where the Board has identified material emerging risks not captured in adverse historical precedents. The commenter suggested that the Board select from a menu of historical macroeconomic events or derive the paths of adverse scenario variables from a combination of the historical events, which would allow the adverse scenario variables to fluctuate within a more predictable range. The Board does not believe that predictability of the scenarios from year to year should be the overriding factor determining the specification of the adverse scenario. Other factors are also important in determining the specification of the adverse scenario, including, but not limited to, improved understanding of relevant risks to the banking industry (that may not captured in the severely adverse scenario), nonlinearities in the effect of macroeconomic conditions on the companies’ financial condition, and PO 00000 Frm 00004 Fmt 4700 Sfmt 4700 risks identified by the companies in their living wills or in the companydeveloped scenarios for the CCAR or mid-cycle company-run stress tests. The Board believes that adverse scenarios based on historical experiences represent important stresses to financial companies and has added this approach to the list of possible approaches used to formulate the adverse scenario. However, the Board believes that there are notable benefits from formulating the adverse scenario following other approaches. Varying the approach the Board uses for the adverse scenario each year—by incorporating specific risks or by using the probabilistic approach, for instance— permits flexibility so that the results of the scenario provide the most value to supervisors, in light of current economic conditions. Consequently, the adverse scenario design framework in the final policy statement contains a range of options and is not limited only to historical episodes. E. Market Shock and Additional Scenarios or Components of Scenarios The Board did not receive comments on its proposed framework for designing the market shock scenario component. However, several commenters advocated for the inclusion of additional scenarios and components of scenarios in the stress tests. One commenter urged the Board to include operational risk because, in the commenter’s view, operational risk failures can allow for the accretion of credit and market risk. Another commenter focused on the need for a supervisory scenario that included liquidity risk, even in a capital stress test. The commenter noted that shortterm funding risk was a major contributor to the financial crisis due to the interrelationship between capital and liquidity. The commenter advocated for supervisory scenarios that take into account the potential for asset shocks that reduce capital to also cause a company to lose access to certain funding markets. Finally, one commenter suggested that the Board incorporate all possible risks in a single scenario or combine separate stress testing exercises appropriately to create a comprehensive and coherent stress test. While operational risk and funding risk are material risks to some financial companies, no single stress test can incorporate all risks that affect a financial company. Companies should supplement stress tests conducted pursuant to the Dodd-Frank Act and capital plan rule with other stress tests and other risk measurement tools. For E:\FR\FM\29NOR1.SGM 29NOR1 Federal Register / Vol. 78, No. 230 / Friday, November 29, 2013 / Rules and Regulations example, as part of its supervisory process, the Board evaluates liquidity risk, including through stress testing, and the Board has proposed a rule that would require large bank holding companies and nonbank financial companies supervised by the Board to conduct liquidity stress tests.17 Companies should conduct additional stress testing, as needed, to ensure that all risks and vulnerabilities, including funding and operational risk, are addressed—as described in the stress testing guidance issued by the agencies in May 2012.18 If the Board requires companies to apply additional scenarios or components of scenarios on a regular basis—including for operational risk or the relationship between liquidity and capital risk—then the Board may update the final policy statement to include the process for designing those scenarios or components of scenarios. sroberts on DSK5SPTVN1PROD with RULES F. Transparency and Timing The Board received several comments on enhancing the transparency of the scenario design process, improving communication about the scenarios, and on the timing of when the scenarios are provided to the companies. Several commenters requested additional information about how the Board develops the scenarios or specific aspects of the scenarios. For instance, some commenters requested additional clarification on the process and assumptions for developing the international variables in the macroeconomic scenarios. In response to these comments, the final policy statement contains additional information on how the Board develops the scenarios. Section 4.2.3 of the final policy statement includes a description of the process and assumptions for developing the paths of international variables in the supervisory scenarios. Some commenters requested that the Board include additional narrative information in its scenario release. One commenter requested the Board provide more description around the adverse and severely adverse scenarios, especially in cases where the scenarios do not derive from observable historical events, to aid companies in developing a deeper understanding of the economic situation that the data describes and the relationships between and among variables. The commenter suggested that 17 See Notice of Proposed Rulemaking on Enhanced Prudential Standards and Early Remediation Requirements for Covered Companies, (January 5, 2012) (77 FR 594). 18 See Supervisory Guidance on Stress Testing for Banking Organizations With More Than $10 Billion in Total Consolidated Assets, (May 17, 2012) (codified at 77 FR 29458). VerDate Mar<15>2010 20:31 Nov 27, 2013 Jkt 232001 without a fuller narrative it is difficult for companies to project additional variables in a manner that is consistent with the scenario, leading to inconsistent assumptions and variables across companies. More narrative information on the international variables was specifically requested, including information on whether the international scenarios are intended to reflect global conditions or whether they are designed to reflect idiosyncratic stresses at the country level. Each year, to accompany the release of its supervisory scenarios, the Board has published a brief narrative summary of the macroeconomic scenarios. This narrative describes the supervisory scenarios and explains how they have changed relative to the previous year. In response to comments, the Board will also provide in the narrative a description of the economic situation underlying the scenario, including for the international environment in the scenarios. In addition, to assist companies in projecting the paths of additional variables in a manner consistent with the scenario, the narrative accompanying the supervisory scenarios will also provide descriptions of the general path of some additional variables. These descriptions will be general—that is, they will describe developments for broad classes of variables rather than for specific variables—and will specify the intensity and direction of variable changes but not numeric magnitudes. These descriptions should provide guidance that will be useful to companies in specifying the paths of the additional variables for their company-run stress tests. In practice, it will not be possible for the narrative to include descriptions on all of the additional variables that companies may need to for their company-run stress tests. One commenter requested that the Board communicate, in advance of the scenario release, any additional risks or vulnerabilities that would cause the scenario to vary due to changes in the outlook for economic and financial conditions. The Board expects that if a scenario varies in response to additional risks or vulnerabilities identified by the Board, then those risks and vulnerabilities would be communicated through the narrative that accompanies the supervisory scenarios. Several commenters addressed the timeline for supervisory scenario development. A few commenters requested that the Board provide the supervisory scenarios to the companies earlier in order to provide adequate time for companies to evaluate the scenarios, PO 00000 Frm 00005 Fmt 4700 Sfmt 4700 71439 develop additional required variables, and initiate the stress testing and capital planning processes. One commenter noted that providing the supervisory scenarios two weeks before November 15 would extend the time to companies have to conduct stress tests by 25 to 30 percent. Another commenter felt the current timetable is extremely aggressive and precludes companies from performing more comprehensive due diligence. One commenter acknowledged the concern that a scenario may become dated if it is released too early, but the commenter asserted that this concern is mitigated because only five quarters of the planning horizon will elapse before there is another annual stress test and capital planning exercise. The Board recognizes the importance of providing covered companies adequate time to implement the company-run stress tests. The Board intends to release the scenarios as soon as it is possible to incorporate the relevant data on economic and financial conditions as of the end of the third quarter, but no later than November 15 of each year. One commenter requested that the market shock and the macroeconomic scenarios be released concurrently. The commenter asserted that delays in processing the effect of the scenarios on capital markets positions affects all other processes downstream in the stress tests, including calculation of the company’s capital position. Because the market shock component is an instantaneous shock layered onto the stress test conducted under the macroeconomic scenario, it should not affect most other aspects of a company’s stress test. However, in recognition of companies’ constraints in conducting the company-run stress tests, the Board will seek to release the market shock before the deadline of December 1 of each year. The Board has sought to improve the transparency around its stress testing practices, for example by releasing the stress scenarios with an accompanying narrative in advance of the stress test, publicly disclosing a detailed description of the framework and methodology employed in its supervisory stress test, and publishing for comment this policy statement on its framework for scenario design. In the future, the Board will continue to look for opportunities to provide additional transparency around its stress testing processes, while balancing the need to not reduce the incentives for companies to develop better internal stress test models that factor in their idiosyncratic risks and to consider the results of such E:\FR\FM\29NOR1.SGM 29NOR1 71440 Federal Register / Vol. 78, No. 230 / Friday, November 29, 2013 / Rules and Regulations rule easier to understand. The Board received no comment on these matters and believes that the final policy statement is written plainly and clearly. models in their capital planning process. G. Public Disclosure One commenter requested a broader disclosure of the methods and data that are used in stress tests to enhance the public’s understanding of the process and results. The commenter recommended disclosure of the specification, statistical fit, and out-ofsample forecasting properties of the risk models used in stress testing. As noted previously, the Board has sought to improve the transparency of its supervisory stress testing methodologies and practices, and has required companies subject to Dodd-Frank Act stress tests to publicly disclose some information about their company-run stress tests. The Board expects to revisit the scope of stress testing disclosure from time to time. Another commenter suggested that public disclosure of the results of stress tests conducted by nonbank financial companies may not provide the marketplace with useful information concerning a company’s overall risk profile or response to stressed conditions. The Board notes that section 165(i) of the Dodd-Frank Act requires the publication of a summary of the results of supervisory and company-run stress tests of each company, including nonbank financial companies. Moreover, the Board believes that public disclosure is a key component of stress testing that helps to provide valuable information to market participants, enhance transparency, and promote market discipline. As noted above, the final policy statement will be effective on January 1, 2014. The scenarios for the stress test cycle that commenced on October 1, 2013, which the Board recently published, were designed in a manner generally consistent with the final policy statement. The final policy statement will be effective for supervisory scenarios that govern the resubmission of any stress tests for the cycle that commenced on October 1, 2013, as the Board may require. IV. Administrative Law Matters sroberts on DSK5SPTVN1PROD with RULES 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 invited comment on whether the proposed policy statement was written plainly and clearly, or whether there were ways the Board could make the VerDate Mar<15>2010 20:31 Nov 27, 2013 Jkt 232001 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 policy statement to assess any information collections. There are no collections of information as defined by the Paperwork Reduction Act in this policy statement. C. Regulatory Flexibility Act Analysis In accordance with the Regulatory Flexibility Act, 5 U.S.C. 601 et seq. (‘‘RFA’’), the Board is publishing a final regulatory flexibility analysis for this policy statement. Based on its analysis and for the reasons stated below, the Board believes that the policy statement will not have a significant economic impact on a substantial number of small entities. Nevertheless, the Board is publishing a regulatory flexibility analysis. The Board is adopting a policy statement on the approach to scenario design for stress testing that will be used in connection with the supervisory and company-run stress tests conducted under the Board’s Regulation YY (12 CFR part 252, subparts F, G, and H) pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act or Act) and the Board’s capital plan rule (12 CFR 225.8). To enhance the transparency of the scenario design process, the policy statement outlines the characteristics of the supervisory stress test scenarios and explains the considerations and procedures that underlie the formulation of these scenarios. 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 $35 million or less to $500 million or less.19 As discussed in the Supplementary Information, the policy statement generally would affect the scenario design framework used in regulations that apply to bank holding companies with $10 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 policy statement therefore substantially exceed the $500 million total asset threshold at which a 19 13 PO 00000 CFR 121.201. Frm 00006 Fmt 4700 company is considered a ‘‘small entity’’ under SBA regulations. The 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.20 It is therefore unlikely that a financial firm that is at or below the $500 million asset threshold would be designated by the Council under section 113 of the Dodd-Frank Act because material financial distress at such companies, or the nature, scope, size, scale, concentration, interconnectedness, or mix of it activities, is not likely to pose a threat to the financial stability of the United States. Because the final policy statement is not likely to apply to any company with assets of $500 million or less, it is not expected to affect any small entity for purposes of the RFA. The Board does not believe that the policy statement duplicates, overlaps, or conflicts with any other Federal rules. The policy statement is unlikely to impose any new recordkeeping, reporting, or other compliance requirements or otherwise affect a small banking entity. In light of the foregoing, the Board does not believe that the policy statement will have a significant economic impact on a substantial number of small entities. List of Subjects in 12 CFR Part 252 Administrative practice and procedure, Banks, Banking, Federal Reserve System, Holding companies, Nonbank financial companies supervised by the Board, Reporting and recordkeeping requirements, Securities, Stress testing. Authority and Issuance For the reasons stated in the the Board of Governors of the Federal Reserve System amends 12 CFR chapter II as follows: SUPPLEMENTARY INFORMATION, PART 252—ENHANCED PRUDENTIAL STANDARDS (REGULATION YY) 1. The authority citation for part 252 continues to read as follows: ■ Authority: 12 U.S.C. 321–338a, 1467a(g), 1818, 1831p–1, 1844(b), 1844(c), 5361, 5365, 5366. 20 See Sfmt 4700 E:\FR\FM\29NOR1.SGM 76 FR 4555 (January 26, 2011). 29NOR1 Federal Register / Vol. 78, No. 230 / Friday, November 29, 2013 / Rules and Regulations 2. Appendix A to part 252 is added to read as follows: ■ Appendix A to Part 252—Policy Statement on the Scenario Design Framework for Stress Testing 1. Background a. The Board has imposed stress testing requirements through its regulations (stress test rules) implementing section 165(i) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act or Act) and through its capital plan rule (12 CFR 225.8). Under the stress test rules issued under section 165(i)(1) of the Act, the Board conducts an annual stress test (supervisory stress tests), on a consolidated basis, of each bank holding company with total consolidated assets of $50 billion or more and each nonbank financial company that the Financial Stability Oversight Council has designated for supervision by the Board (together, covered companies).21 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).22 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 (macroeconomic scenarios).23 b. The stress test rules provide that the Board will notify covered companies by no later than November 15 of each year of the scenarios it will use to conduct its annual supervisory stress tests and provide, also by no later than November 15, covered companies and other financial companies subject to the final rules the set of scenarios they must use to conduct their annual 21 12 U.S.C. 5365(i)(1); 12 CFR part 252, subpart sroberts on DSK5SPTVN1PROD with RULES F. 22 12 U.S.C. 5365(i)(2); 12 CFR part 252, subparts G and H. 23 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). VerDate Mar<15>2010 20:31 Nov 27, 2013 Jkt 232001 company-run stress tests.24 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.25 For example, the Board expects to require large banking organizations with significant trading activities to include a trading and counterparty component (market shock, described in the following sections) in their adverse and severely adverse scenarios. The Board will provide any additional components or scenario by no later than December 1 of each year.26 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). c. In addition, § 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.27 d. Stress tests required under the stress test rules and under the capital plan rule require the Board and financial companies to calculate pro-forma capital levels—rather than ‘‘current’’ or actual levels—over a specified planning horizon under baseline and stressful scenarios. This approach integrates key lessons of the 2007–2009 financial crisis into the Board’s supervisory framework. During the financial crisis, investor and counterparty confidence in the capitalization of financial companies eroded rapidly in the face of changes in the current and expected economic and financial conditions, and this loss in market confidence imperiled companies’ ability to access funding, continue operations, serve as a credit intermediary, and meet obligations to creditors and counterparties. Importantly, such a loss in confidence occurred even when a financial institution’s capital ratios were in excess of regulatory minimums. This is because the institution’s capital ratios were perceived as lagging indicators of its financial condition, particularly when conditions were changing. e. The stress tests required under the stress test rules and capital plan rule are a valuable supervisory tool that provides a forwardlooking assessment of large financial companies’ capital adequacy under hypothetical economic and financial market conditions. Currently, these stress tests primarily focus on credit risk and market risk—that is, risk of mark-to-market losses associated with companies’ trading and counterparty positions—and not on other types of risk, such as liquidity risk. Pressures stemming from these sources are considered 24 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. 25 12 CFR 252.144(b), 154(b). 26 Id. 27 See Capital plans, 76 FR 74631 (Dec. 1, 2011) (codified at 12 CFR 225.8). PO 00000 Frm 00007 Fmt 4700 Sfmt 4700 71441 in separate supervisory exercises. No single supervisory tool, including the stress tests, can provide an assessment of a company’s ability to withstand every potential source of risk. f. Selecting appropriate scenarios is an especially significant consideration for stress tests required under the capital plan rule, which ties the review of a 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, however; it will depend on factors that are specific to a given company, such as underwriting standards and the company’s business model, which would also greatly affect projected revenue, losses, and capital. 2. Overview and Scope a. This policy statement provides more detail on the characteristics of the stress test scenarios and explains the considerations and procedures that underlie the approach for formulating these scenarios. The considerations and procedures described in this policy statement apply to the Board’s stress testing framework, including to the stress tests required under 12 CFR part 252, subparts F, G, and H, as well as the Board’s capital plan rule (12 CFR 225.8).28 b. Although the Board does not envision that the broad approach used to develop scenarios will change from year to year, the stress test scenarios will reflect changes in the outlook for economic and financial conditions and changes to specific risks or vulnerabilities that the Board, in consultation with the other federal banking agencies, determines should be considered in the annual stress tests. The stress test scenarios should not be regarded as forecasts; rather, they are hypothetical paths of economic variables that will be used to assess the strength and resilience of the companies’ capital in various economic and financial environments. c. The remainder of this policy statement is organized as follows. Section 3 provides a broad description of the baseline, adverse, and severely adverse scenarios and describes the types of variables that the Board expects to include in the macroeconomic scenarios and the market shock component of the stress test scenarios applicable to companies with significant trading activity. Section 4 describes the Board’s approach for developing the macroeconomic scenarios, and section 5 describes the approach for the market shocks. Section 6 describes the relationship between the macroeconomic scenario and the market shock components. Section 7 provides a timeline for the formulation and publication of the 28 The Board may determine that modifications to the approach are appropriate, for instance, to address a broader range of risks, such as, operational risk. E:\FR\FM\29NOR1.SGM 29NOR1 71442 Federal Register / Vol. 78, No. 230 / Friday, November 29, 2013 / Rules and Regulations macroeconomic assumptions and market shocks. sroberts on DSK5SPTVN1PROD with RULES 3. Content of the Stress Test Scenarios a. The Board will publish a minimum of three different scenarios, including baseline, adverse, and severely adverse conditions, for use in stress tests required in the stress test rules.29 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. b. While the Board generally expects to use the same scenarios for all companies subject to the final rule, it may require a subset of companies— depending on a company’s financial condition, size, complexity, risk profile, scope of operations, or activities, or risks to the U.S. economy—to include additional scenario components or additional scenarios that are designed to capture different effects of adverse events on revenue, losses, and capital. One example of such components is the market shock that applies only to companies with significant trading activity. Additional components or scenarios may also include other stress factors that may not necessarily be directly correlated to macroeconomic or financial assumptions but nevertheless can materially affect companies’ risks, such as the unexpected default of a major counterparty. c. Early in each stress testing cycle, the Board plans to publish the macroeconomic scenarios along with a brief narrative summary that provides a description of the economic situation underlying the scenario and explains how the scenarios have changed relative to the previous year. In addition, to assist companies in projecting the paths of additional variables in a manner consistent with the scenario, the narrative will also provide descriptions of the general path of some additional variables. These descriptions will be general—that is, they will describe developments for broad classes of variables rather than for specific variables—and will specify the intensity and direction of variable changes but not numeric magnitudes. These descriptions should provide guidance that will be useful to companies in specifying the paths of the additional variables for their company-run stress tests. Note that in practice it will not be possible for the narrative to include descriptions on all of the additional variables that companies may need to for their company-run stress tests. In cases where scenarios are designed to reflect particular risks and vulnerabilities, the narrative will also explain the underlying motivation for these features of the scenario. The Board also plans to release a broad description of the market shock components. 29 12 CFR 252.134(b), 12 CFR 252.144(b), 12 CFR 252.154(b). VerDate Mar<15>2010 20:31 Nov 27, 2013 Jkt 232001 3.1 Macroeconomic Scenarios a. The macroeconomic scenarios will consist of the future paths of a set of economic and financial variables.30 The economic and financial variables included in the scenarios will likely comprise those included in the ‘‘2014 Supervisory Scenarios for Annual Stress Tests Required under the Dodd-Frank Act Stress Testing Rules and the Capital Plan Rule’’ (2013 supervisory scenarios). The domestic U.S. variables provided for in the 2013 supervisory scenarios included: i. Six measures of economic activity and prices: real and nominal gross domestic product (GDP) growth, the unemployment rate of the civilian non-institutional population aged 16 and over, real and nominal disposable personal income growth, and the Consumer Price Index (CPI) inflation rate; ii. Four measures of developments in equity and property markets: The Core Logic National House Price Index, the National Council for Real Estate Investment Fiduciaries Commercial Real Estate Price Index, the Dow Jones Total Stock Market Index, and the Chicago Board Options Exchange Market Volatility Index; and iii. Six measures of interest rates: the rate on the three-month Treasury bill, the yield on the 5-year Treasury bond, the yield on the 10-year Treasury bond, the yield on a 10-year BBB corporate security, the prime rate, and the interest rate associated with a conforming, conventional, fixed-rate, 30-year mortgage. b. The international variables provided for in the 2014 supervisory scenarios included, for the euro area, the United Kingdom, developing Asia, and Japan: i. Percent change in real GDP; ii. Percent change in the Consumer Price Index or local equivalent; and iii. The U.S./foreign currency exchange rate.31 c. The economic variables included in the scenarios influence key items affecting financial companies’ net income, including pre-provision net revenue and credit losses on loans and securities. Moreover, these variables exhibit fairly typical trends in adverse economic climates that can have unfavorable implications for companies’ net income and, thus, capital positions. d. The economic variables included in the scenario may change over time. For example, the Board may add variables to a scenario if the international footprint of companies that are subject to the stress testing rules changed notably over time such that the variables already included in the scenario no longer sufficiently capture the material risks of these companies. Alternatively, historical relationships between macroeconomic variables could change over time such that one variable (e.g., disposable personal 30 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. 31 The Board may increase the range of countries or regions included in future scenarios, as appropriate. PO 00000 Frm 00008 Fmt 4700 Sfmt 4700 income growth) that previously provided a good proxy for another (e.g., light vehicle sales) in modeling companies’ pre-provision net revenue or credit losses ceases to do so, resulting in the need to create a separate path, or alternative proxy, for the other variable. However, recognizing the amount of work required for companies to incorporate the scenario variables into their stress testing models, the Board expects to eliminate variables from the scenarios only in rare instances. e. The Board expects that the company may not use all of the variables provided in the scenario, if those variables are not appropriate to the company’s line of business, or may add additional variables, as appropriate. The Board expects the companies will ensure that the paths of such additional variables are consistent with the scenarios the Board provided. For example, the companies may use, as part of their internal stress test models, local-level variables, such as state-level unemployment rates or city-level house prices. While the Board does not plan to include local-level macro variables in the stress test scenarios it provides, it expects the companies to evaluate the paths of local-level macro variables as needed for their internal models, and ensure internal consistency between these variables and their aggregate, macroeconomic counterparts. The Board will provide the macroeconomic scenario component of the stress test scenarios for a period that spans a minimum of 13 quarters. The scenario horizon reflects the supervisory stress test approach that the Board plans to use. Under the stress test rules, the Board will assess the effect of different scenarios on the consolidated capital of each company over a forward-looking planning horizon of at least nine quarters. 3.2 Market Shock Component a. The market shock component of the adverse and severely adverse scenarios will only apply to companies with significant trading activity and their subsidiaries.32 The component consists of large moves in market prices and rates that would be expected to generate losses. Market shocks differ from macroeconomic scenarios in a number of ways, both in their design and application. For instance, market shocks that might typically be observed over an extended period (e.g., 6 months) are assumed to be an instantaneous event which immediately affects the market value of the companies’ trading assets and liabilities. In addition, under the stress test rules, the as-of date for market shocks will differ from the quarterend, and the Board will provide the as-of date for market shocks no later than December 1 of each year. Finally, as 32 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 financial company’s trading activities evolve. E:\FR\FM\29NOR1.SGM 29NOR1 Federal Register / Vol. 78, No. 230 / Friday, November 29, 2013 / Rules and Regulations sroberts on DSK5SPTVN1PROD with RULES described in section 4, the market shock includes a much larger set of risk factors than the set of economic and financial variables included in macroeconomic scenarios. Broadly, these risk factors include shocks to financial market variables that affect asset prices, such as a credit spread or the yield on a bond, and, in some cases, the value of the position itself (e.g., the market value of private equity positions). b. The Board envisions that the market shocks will include shocks to a broad range of risk factors that are similar in granularity to those risk factors trading companies use internally to produce profit and loss estimates, under stressful market scenarios, for all asset classes that are considered trading assets, including equities, credit, interest rates, foreign exchange rates, and commodities. Examples of risk factors include, but are not limited to: i. Equity indices of all developed markets, and of developing and emerging market nations to which companies with significant trading activity may have exposure, along with term structures of implied volatilities; ii. Cross-currency FX rates of all major and many minor currencies, along term structures of implied volatilities; iii. Term structures of government rates (e.g., U.S. Treasuries), interbank rates (e.g., swap rates) and other key rates (e.g., commercial paper) for all developed markets and for developing and emerging market nations to which companies may have exposure; iv. Term structures of implied volatilities that are key inputs to the pricing of interest rate derivatives; v. Term structures of futures prices for energy products including crude oil (differentiated by country of origin), natural gas, and power; vi. Term structures of futures prices for metals and agricultural commodities; vii. ‘‘Value-drivers’’ (credit spreads or instrument prices themselves) for 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 viii. Shocks to the values of private equity positions. 4. Approach for Formulating the Macroeconomic Assumptions for Scenarios a. This section describes the Board’s approach for formulating macroeconomic assumptions for each scenario. The methodologies for formulating this part of each scenario differ by scenario, so these methodologies for the baseline, severely adverse, and the adverse scenarios are described separately in each of the following subsections. b. In general, the baseline scenario will reflect the most recently available consensus views of the macroeconomic outlook expressed by professional forecasters, government agencies, and other public-sector organizations as of the beginning of the annual stress-test cycle. The severely adverse scenario will consist of a set of economic and VerDate Mar<15>2010 20:31 Nov 27, 2013 Jkt 232001 71443 financial conditions that reflect the conditions of post-war U.S. recessions. The adverse scenario will consist of a set of economic and financial conditions that are more adverse than those associated with the baseline scenario but less severe than those associated with the severely adverse scenario. c. Each of these scenarios is described further in sections below as follows: baseline (subsection 4.1), severely adverse (subsection 4.2), and adverse (subsection 4.3) condition of a financial company and that overall are more severe than those associated with the adverse scenario. The financial company will be required to publicly disclose a summary of the results of its stress test under the severely adverse scenario, and the Board intends to publicly disclose the results of its analysis of the financial company under the adverse scenario and the severely adverse scenario. 4.1 Approach for Formulating Macroeconomic Assumptions in the Baseline Scenario a. The stress test rules define the baseline scenario as a set of conditions that affect the U.S. economy or the financial condition of a banking organization, and that reflect the consensus views of the economic and financial outlook. Projections under a baseline scenario are used to evaluate how companies would perform in more likely economic and financial conditions. The baseline serves also as a point of comparison to the severely adverse and adverse scenarios, giving some sense of how much of the company’s capital decline could be ascribed to the scenario as opposed to the company’s capital adequacy under expected conditions. b. The baseline scenario will be developed around a macroeconomic projection that captures the prevailing views of 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. c. For some scenario variables—such as U.S. real GDP growth, the unemployment rate, and the consumer price index—there will be a large number of different forecasts available to project the paths of these variables in the baseline scenario. For others, a more limited number of forecasts will be available. If available forecasts diverge notably, the baseline scenario will reflect an assessment of the forecast that is deemed to be most plausible. In setting the paths of variables in the baseline scenario, particular care will be taken to ensure that, together, the paths present a coherent and plausible outlook for the U.S. and global economy, given the economic climate in which they are formulated. a. The Board intends to use a recession approach to develop the severely adverse scenario. In the recession approach, the Board will specify the future paths of variables to reflect conditions that characterize post-war U.S. recessions, generating either a typical or specific recreation of a post-war U.S. recession. The Board chose this approach because it has observed that the conditions that typically occur in recessions—such as increasing unemployment, declining asset prices, and contracting loan demand—can put significant stress on companies’ balance sheets. This stress can occur through a variety of channels, including higher loss provisions due to increased delinquencies and defaults; losses on trading positions through sharp moves in market prices; and lower bank income through reduced loan originations. For these reasons, the Board believes that the paths of economic and financial variables in the severely adverse scenario should, at a minimum, resemble the paths of those variables observed during a recession. b. This approach requires consideration of the type of recession to feature. All post-war U.S. recessions have not been identical: some recessions have been associated with very elevated interest rates, some have been associated with sizable asset price declines, and some have been relatively more global. The most common features of recessions, however, are increases in the unemployment rate and contractions in aggregate incomes and economic activity. For this and the following reasons, the Board intends to use the unemployment rate as the primary basis for specifying the severely adverse scenario. First, the unemployment rate is likely the most representative single summary indicator of adverse economic conditions. Second, in comparison to GDP, labor market data have traditionally featured more prominently than GDP in the set of indicators that the National Bureau of Economic Research reviews to inform its recession dates.33 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 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 PO 00000 Frm 00009 Fmt 4700 Sfmt 4700 4.2.1 General Approach: The Recession Approach 33 More recently, a monthly measure of GDP has been added to the list of indicators. E:\FR\FM\29NOR1.SGM 29NOR1 71444 Federal Register / Vol. 78, No. 230 / Friday, November 29, 2013 / Rules and Regulations sroberts on DSK5SPTVN1PROD with RULES severity by the absolute level of and relative increase in the unemployment rate.34 c. 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). d. 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 largescale 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. 4.2.2 Setting the Unemployment Rate Under the Severely Adverse Scenario a. The Board anticipates that the severely adverse scenario will feature an unemployment rate that increases between 3 to 5 percentage points from its initial level over the course of 6 to 8 calendar quarters.35 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 34 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 3d percent and the unemployment rate moving up a total of about 4 percentage points. 35 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. VerDate Mar<15>2010 20:31 Nov 27, 2013 Jkt 232001 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. b. This methodology is intended to generate scenarios that feature stressful outcomes but do not induce greater procyclicality in the financial system and macroeconomy. When the economy is in the early stages of a recovery, the unemployment rate in a baseline scenario generally trends downward, resulting in a larger difference between the path of the unemployment rate in the severely adverse scenario and the baseline scenario and a severely adverse scenario that is relatively more intense. Conversely, in a sustained strong expansion—when the unemployment rate may be below the level consistent with full employment—the unemployment in a baseline scenario generally trends upward, resulting in a smaller difference between the path of the unemployment rate in the severely adverse scenario and the baseline scenario and a severely adverse scenario that is relatively less intense. Historically, a 3 to 5 percentage point increase in unemployment rate is reflective of stressful conditions. As illustrated in Table 1, over the last half-century, the U.S. economy has experienced four severe post-war recessions. In all four of these recessions the unemployment rate increased 3 to 5 percentage points and in the three most recent of these recessions the unemployment rate reached a level between 9 percent and 11 percent. c. Under this method, if the initial unemployment rate were low—as it would be after a sustained long expansion—the unemployment rate in the scenario would increase to a level as high as what has been seen in past severe recessions. However, if the initial unemployment rate were already high—as would be the case in the early stages of a recovery—the unemployment rate would exhibit a change as large as what has been seen in past severe recessions. d. The Board believes that the typical increase in the unemployment rate in the severely adverse scenario will be about 4 percentage points. However, the Board will calibrate the increase in unemployment based on its views of the status of cyclical systemic risk. The Board intends to set the unemployment rate at the higher end of the range if the Board believed that cyclical systemic risks were high (as it would be after a sustained long expansion), and to the lower end of the range if cyclical systemic risks were low (as it would be in the earlier stages of a recovery). This may result in a scenario that is slightly more intense than normal if the Board believed that cyclical systemic risks were increasing in a period of robust expansion.36 Conversely, it will allow the 36 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. PO 00000 Frm 00010 Fmt 4700 Sfmt 4700 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 will still feature an increase in the unemployment rate similar to what has been seen in about half of the severe recessions of the last 50 years. e. As indicated previously, if a 3 to 5 percentage point increase in the unemployment rate does not raise the level of the unemployment rate to 10 percent—the average level to which it has increased in the most recent three severe recessions—the path of the unemployment rate will be specified so as to raise the unemployment rate to 10 percent. Setting a floor for the unemployment rate at 10 percent recognizes the fact that not only do cyclical systemic risks build up at financial intermediaries during robust expansions but that these risks are also easily obscured by the buoyant environment. f. In setting the increase in the unemployment rate, the Board will consider the extent to which analysis by economists, supervisors, and financial market experts finds cyclical systemic risks to be elevated (but difficult to be captured more precisely in one of the scenario’s other variables). In addition, the Board—in light of impending shocks to the economy and financial system—will also take into consideration the extent to which a scenario of some increased severity might be necessary for the results of the stress test and the associated supervisory actions to sustain confidence in financial institutions. g. While the approach to specifying the severely adverse scenario is designed to avoid adding sources of procyclicality to the financial system, it is not designed to explicitly offset any existing procyclical tendencies in the financial system. The purpose of the stress test scenarios is to make sure that the companies are properly capitalized to withstand severe economic and financial conditions, not to serve as an explicit countercyclical offset to the financial system. h. In developing the approach to the unemployment rate, the Board also considered a method that would increase the unemployment rate to some fairly elevated fixed level over the course of 6 to 8 quarters. This will result in scenarios being more severe in robust expansions (when the unemployment rate is low) and less severe in the early stages of a recovery (when the unemployment rate is high) and so would not result in pro-cyclicality. Depending on the initial level of the unemployment rate, this approach could lead to only a very modest increase in the unemployment rate—or even a decline. As a result, this approach—while not procyclical—could result in scenarios not featuring stressful macroeconomic outcomes. 4.2.3 Setting the Other Variables in the Severely Adverse Scenario a. Generally, all other variables in the severely adverse scenario will be specified to be consistent with the increase in the unemployment rate. The approach for specifying the paths of these variables in the scenario will be a combination of (1) how E:\FR\FM\29NOR1.SGM 29NOR1 sroberts on DSK5SPTVN1PROD with RULES Federal Register / Vol. 78, No. 230 / Friday, November 29, 2013 / Rules and Regulations economic models suggest that these variables should evolve given the path of the unemployment rate, (2) how these variables have typically evolved in past U.S. recessions, and (3) and evaluation of these and other factors. b. Economic models—such as mediumscale 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 company’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—will be appropriate. c. In addition, judgment is necessary in projecting the path of a scenario’s international variables. Recessions that occur simultaneously across countries are an important source of stress to the balance sheets of companies with notable international exposures but are not an invariable feature of the international economy. As a result, simply adopting the typical path of international variables in a severe U.S. recession would likely underestimate the risks stemming from the international economy. Consequently, an approach like that used for projecting house prices is followed where judgment and economic models together inform the path of international variables. 4.2.4 Adding Salient Risks to the Severely Adverse Scenario a. The severely adverse scenario will be developed to reflect specific risks to the economic and financial outlook that are especially salient but will feature minimally in the scenario if the Board were only to use approaches that looked to past recessions or relied on historical relationships between variables. b. There are some important instances when it will be appropriate to augment the recession approach with salient risks. For example, if an asset price were especially elevated and thus potentially vulnerable to an abrupt and potentially destabilizing decline, it would be appropriate to include such a decline in the scenario even if such a large drop were not typical in a severe recession. Likewise, if economic developments abroad were particularly unfavorable, assuming a weakening in international conditions larger than what typically occurs in severe U.S. recessions would likely also be appropriate. c. Clearly, while the recession component of the severely adverse scenario is within VerDate Mar<15>2010 20:31 Nov 27, 2013 Jkt 232001 some predictable range, the salient risk aspect of the scenario is far less so, and therefore, needs an annual assessment. Each year, the Board will identify the risks to the financial system and the domestic and international economic outlooks that appear more elevated than usual, using its internal analysis and supervisory information and in consultation with the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC). Using the same information, the Board will then calibrate the paths of the macroeconomic and financial variables in the scenario to reflect these risks. d. Detecting risks that have the potential to weaken the banking sector is particularly difficult when economic conditions are buoyant, as a boom can obscure the weaknesses present in the system. In sustained robust expansions, therefore, the selection of salient risks to augment the scenario will err on the side of including risks of uncertain significance. e. The Board will factor in particular risks to the domestic and international macroeconomic outlook identified by its economists, bank supervisors, and financial market experts and make appropriate adjustments to the paths of specific economic variables. These adjustments will not be reflected in the general severity of the recession and, thus, all macroeconomic variables; rather, the adjustments will apply to a subset of variables to reflect 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.37 4.3 Approach for Formulating Macroeconomic Assumptions in the Adverse Scenario a. The adverse scenario can be developed in a number of different ways, and the selected approach will depend on a number of factors, including how the Board intends to use the results of the adverse scenario.38 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 37 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. 38 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. PO 00000 Frm 00011 Fmt 4700 Sfmt 4700 71445 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. b. The simplest method to specify the adverse scenario is to develop a less severe version of the severely adverse scenario. For example, the adverse scenario could be formulated such that the deviations of the paths of the variables relative to the baseline were simply one-half of or two-thirds of the deviations of the paths of the variables relative to the baseline in the severely adverse scenario. A priori, specifying the adverse scenario in this way may appear unlikely to provide the greatest possible informational value to supervisors—given that it is just a less severe version of the severely adverse scenario. However, to the extent that the effect of macroeconomic variables on company loss positions and incomes are nonlinear, there could be potential value from this approach. c. Another method to specify the adverse scenario is to capture risks in the adverse scenario that the Board believes should be understood better or should be monitored, but does not believe should be included in the severely adverse scenario, perhaps because these risks would render the scenario implausibly severe. For instance, the adverse scenario could feature sizable increases in oil or natural gas prices or shifts in the yield curve that are atypical in a recession. The adverse scenario might also feature less acute, but still consequential, adverse outcomes, such as a disruptive slowdown in growth from emerging-market economies. d. Under the Board’s stress test rules, covered companies are required to develop their own scenarios for mid-cycle companyrun stress tests.39 A particular combination of risks included in these scenarios may inform the design of the adverse scenario for annual stress tests. In this same vein, another possibility would be to use modified versions of the circumstances that companies describe in their living wills as being able to cause their failures. e. It might also be informative to periodically use a stable adverse scenario, at least for a few consecutive years. Even if the scenario used for the stress test does not change over the credit cycle, if companies tighten and relax lending standards over the cycle, their loss rates under the adverse scenario—and indirectly the projected changes to capital—would decrease and increase, respectively. A consistent scenario would allow the direct observation of how capital fluctuates to reflect growing cyclical risks. f. The Board may consider specifying the adverse scenario using the probabilistic approach described in section 4.2.1 (that is, with a specified lower probability of occurring than the severely adverse scenario but a greater probability of occurring than the baseline scenario). The approach has some intuitive appeal despite its shortcomings. For 39 12 E:\FR\FM\29NOR1.SGM CFR 252.145. 29NOR1 71446 Federal Register / Vol. 78, No. 230 / Friday, November 29, 2013 / Rules and Regulations example, using this approach for the adverse scenario could allow the Board to explore an alternative approach to develop stress testing scenarios and their effect on a company’s net income and capital. g. Finally, the Board could design the adverse scenario based on a menu of historical experiences—such as, a moderate recession (e.g., the 1990–1991 recession); a stagflation event (e.g., stagflation during 1974); an emerging markets crisis (e.g., the Asian currency crisis of 1997–1998); an oil price shock (e.g., the shock during the run up to the 1990–1991 recession); or high inflation shock (e.g., the inflation pressures of 1977– 1979). The Board believes these are important stresses that should be understood; however, there may be notable benefits from formulating the adverse scenario following other approaches—specifically, those described previously in this section—and consequently the Board does not believe that the adverse scenario should be limited to historical episodes only. h. With the exception of cases in which the probabilistic approach is used to generate the adverse scenario, the adverse scenario will at a minimum contain a mild to moderate recession. This is because most of the value from investigating the implications of the risks described above is likely to be obtained from considering them in the context of balance sheets of companies that are under some stress. sroberts on DSK5SPTVN1PROD with RULES 5. Approach for Formulating the Market Shock Component a. This section discusses the approach the Board proposes to adopt for developing the market shock component of the adverse and severely adverse scenarios appropriate for companies with significant trading activities. The design and specification of the market shock component differs from that of the macroeconomic scenarios because profits and losses from trading are measured in mark-tomarket terms, while revenues and losses from traditional banking are generally measured using the accrual method. As noted above, another critical difference is the timeevolution of the market shock component. The market shock component consists of an instantaneous ‘‘shock’’ to a large number of risk factors that determine the mark-tomarket value of trading positions, while the macroeconomic scenarios supply a projected path of economic variables that affect traditional banking activities over the entire planning period. b. The development of the market shock component that are detailed in this section are as follows: baseline (subsection 5.1), severely adverse (subsection 5.2), and adverse (subsection 5.3). 5.1 Approach for Formulating the Market Shock Component Under the Baseline Scenario By definition, market shocks are large, previously unanticipated moves in asset prices and rates. Because asset prices should, broadly speaking, reflect consensus opinions about the future evolution of the economy, large price movements, as envisioned in the market shock, should not occur along the baseline path. As a result, the market shock will not be included in the baseline scenario. VerDate Mar<15>2010 20:31 Nov 27, 2013 Jkt 232001 5.2 Approach for Formulating the Market Shock Component Under the Severely Adverse Scenario This section addresses possible approaches to designing the market shock component in the severely adverse scenario, including important considerations for scenario design, possible approaches to designing scenarios, and a development strategy for implementing the preferred approach. 5.2.1 Design Considerations for Market Shocks a. The general market practice for stressing a trading portfolio is to specify market shocks either in terms of extreme moves in observable, broad market indicators and risk factors or directly as large changes to the mark-to-market values of financial instruments. These moves can be specified either in relative terms or absolute terms. Supplying values of risk factors after a ‘‘shock’’ is roughly equivalent to the macroeconomic scenarios, which supply values for a set of economic and financial variables; however, trading stress testing differs from macroeconomic stress testing in several critical ways. b. In the past, the Board used one of two approaches to specify market shocks. During SCAP and CCAR in 2011, the Board used a very general approach to market shocks and required companies to stress their trading positions using changes in market prices and rates experienced during the second half of 2008, without specifying risk factor shocks. This broad guidance resulted in inconsistency across companies both in terms of the severity and the application of shocks. In certain areas companies were permitted to use their own experience during the second half of 2008 to define shocks. This resulted in significant variation in shock severity across companies. c. To enhance the consistency and comparability in market shocks for the stress tests in 2012 and 2013, the Board provided to each trading company more than 35,000 specific risk factor shocks, primarily based on market moves in the second half of 2008. While the number of risk factors used in companies’ pricing and stress-testing models still typically exceed that provided in the Board’s scenarios, the greater specificity resulted in more consistency in the scenario across companies. The benefit of the comprehensiveness of risk factor shocks is at least partly offset by potential difficulty in creating shocks that are coherent and internally consistent, particularly as the framework for developing market shocks deviates from historical events. d. Also importantly, the ultimate losses associated with a given market shock will depend on a company’s trading positions, which can make it difficult to rank order, ex ante, the severity of the scenarios. In certain instances, market shocks that include large market moves may not be particularly stressful for a given company. Aligning the market shock with the macroeconomic scenario for consistency may result in certain companies actually benefiting from risk factor moves of larger magnitude in the market scenario if the companies are hedging against salient risks to other parts of their PO 00000 Frm 00012 Fmt 4700 Sfmt 4700 business. Thus, the severity of market shocks must be calibrated to take into account how a complex set of risks, such as directional risks and basis risks, interacts with each other, given the companies’ trading positions at the time of stress. For instance, a large depreciation in a foreign currency would benefit companies with net short positions in the currency while hurting those with net long positions. In addition, longer maturity positions may move differently from shorter maturity positions, adding further complexity. e. The instantaneous nature of market shocks and the immediate recognition of mark-to-market losses add another element to the design of market shocks, and to determining the appropriate severity of shocks. For instance, in previous stress tests, the Board assumed that market moves that occurred over the six-month period in late 2008 would occur instantaneously. The design of the market shocks must factor in appropriate assumptions around the period of time during which market events will unfold and any associated market responses. 5.2.2 Approaches to Market Shock Design a. As an additional component of the adverse and severely adverse scenarios, the Board plans to use a standardized set of market shocks that apply to all companies with significant trading activity. The market shocks could be based on a single historical episode, multiple historical periods, hypothetical (but plausible) events, or some combination of historical episodes and hypothetical events (hybrid approach). Depending on the type of hypothetical events, a scenario based on such events may result in changes in risk factors that were not previously observed. In the supervisory scenarios for 2012 and 2013, the shocks were largely based on relative moves in asset prices and rates during the second half of 2008, but also included some additional considerations to factor in the widening of spreads for European sovereigns and financial companies based on actual observation during the latter part of 2011. b. For the market shock component in the severely adverse scenario, the Board plans to use the hybrid approach to develop shocks. The hybrid approach allows the Board to maintain certain core elements of consistency in market shocks each year while providing flexibility to add hypothetical elements based on market conditions at the time of the stress tests. In addition, this approach will help ensure internal consistency in the scenario because of its basis in historical episodes; however, combining the historical episode and hypothetical events may require small adjustments to ensure mutual consistency of the joint moves. In general, the hybrid approach provides considerable flexibility in developing scenarios that are relevant each year, and by introducing variations in the scenario, the approach will also reduce the ability of companies with significant trading activity to modify or shift their portfolios to minimize expected losses in the severely adverse market shock. c. The Board has considered a number of alternative approaches for the design of market shocks. For example, the Board explored an option of providing tailored E:\FR\FM\29NOR1.SGM 29NOR1 sroberts on DSK5SPTVN1PROD with RULES Federal Register / Vol. 78, No. 230 / Friday, November 29, 2013 / Rules and Regulations market shocks for each trading company, using information on the companies’ portfolio gathered through ongoing supervision, or other means. By specifically targeting known or potential vulnerabilities in a company’s trading position, the tailored approach will be useful in assessing each company’s capital adequacy as it relates to the company’s idiosyncratic risk. However, the Board does not believe this approach to be well-suited for the stress tests required by regulation. Consistency and comparability are key features of annual supervisory stress tests and annual company-run stress tests required in the stress test rules. It would be difficult to use the information on the companies’ portfolio to design a common set of shocks that are universally stressful for all covered companies. As a result, this approach will be better suited to more customized, tailored stress tests that are part of the company’s internal capital planning process or to other supervisory efforts outside of the stress tests conducted under the capital rule and the stress test rules. 5.2.3 Development of the Market Shock a. Consistent with the approach described above, the market shock component for the severely adverse scenario will incorporate key elements of market developments during the second half of 2008, but also incorporate observations from other periods or price and rate movements in certain markets that the Board deems to be plausible though such movements may not have been observed historically. Over time the Board also expects to rely less on market events of the second half of 2008 and more on hypothetical events or other historical episodes to develop the market shock. b. The developments in the credit markets during the second half of 2008 were unprecedented, providing a reasonable basis for market shocks in the severely adverse scenario. During this period, key risk factors in virtually all asset classes experienced extremely large shocks; the collective breadth and intensity of the moves have no parallels in modern financial history and, on that basis, it seems likely that this episode will continue to be the most relevant historical scenario, although experience during other historical episodes may also guide the severity of the market shock component of the severely adverse scenario. Moreover, the risk factor moves during this episode are directly consistent with the ‘‘recession’’ approach that underlies the macroeconomic assumptions. However, market shocks based only on historical events could become stale and less relevant over time as the company’s positions change, particularly if more salient features are not added each year. c. While the market shocks based on the second half of 2008 are of unparalleled magnitude, the shocks may become less relevant over time as the companies’ trading positions change. In addition, more recent events could highlight the companies’ vulnerability to certain market events. For example, in 2011, Eurozone credit spreads in the sovereign and financial sectors surpassed those observed during the second half of 2008, necessitating the modification of the severely adverse market shock in 2012 and 2013 to reflect a salient source of stress to VerDate Mar<15>2010 20:31 Nov 27, 2013 Jkt 232001 trading positions. As a result, it is important to incorporate both historical and hypothetical outcomes into market shocks for the severely adverse scenario. For the time being, the development of market shocks in the severely adverse scenario will begin with the risk factor movements in a particular historical period, such as the second half of 2008. The Board will then consider hypothetical but plausible outcomes, based on financial stability reports, supervisory information, and internal and external assessments of market risks and potential flash points. The hypothetical outcomes could originate from major geopolitical, economic, or financial market events with potentially significant impacts on market risk factors. The severity of these hypothetical moves will likely be guided by similar historical events, assumptions embedded in the companies’ internal stress tests or market participants, and other available information. d. Once broad market scenarios are agreed upon, specific risk factor groups will be targeted as the source of the trading stress. For example, a scenario involving the failure of a large, interconnected globally active financial institution could begin with a sharp increase in credit default swap spreads and a precipitous decline in asset prices across multiple markets, as investors become more risk averse and market liquidity evaporates. These broad market movements will be extrapolated to the granular level for all risk factors by examining transmission channels and the historical relationships between variables, though in some cases, the movement in particular risk factors may be amplified based on theoretical relationships, market observations, or the saliency to company trading books. If there is a disagreement between the risk factor movements in the historical event used in the scenario and the hypothetical event, the Board will reconcile the differences by assessing a priori expectation based on financial and economic theory and the importance of the risk factors to the trading positions of the covered companies. 5.3 Approach for Formulating the Market Shock Under the Adverse Scenario a. The market shock component included in the adverse scenario will feature risk factor movements that are generally less significant than the market shock component of the severely adverse scenario. However, the adverse market shock may also feature risk factor shocks that are substantively different from those included in the severely adverse scenario, in order to provide useful information to supervisors. As in the case of the macroeconomic scenario, the market shock component in the adverse scenario can be developed in a number of different ways. b. The adverse scenario could be differentiated from the severely adverse scenario by the absolute size of the shock, the scenario design process (e.g., historical events versus hypothetical events), or some other criteria. The Board expects that as the market shock component of the adverse scenario may differ qualitatively from the market shock component of the severely adverse scenario, the results of adverse scenarios may be useful in identifying a PO 00000 Frm 00013 Fmt 4700 Sfmt 4700 71447 particularly vulnerable area in a trading company’s positions. c. There are several possibilities for the adverse scenario and the Board may use a different approach each year to better explore the vulnerabilities of companies with significant trading activity. One approach is to use a scenario based on some combination of historical events. This approach is similar to the one used for for the market shock in 2012, where the market shock component was largely based on the second half of 2008, but also included a number of risk factor shocks that reflected the significant widening of spreads for European sovereigns and financials in late 2011. This approach will provide some consistency each year and provide an internally consistent scenario with minimal implementation burden. Having a relatively consistent adverse scenario may be useful as it potentially serves as a benchmark against the results of the severely adverse scenario and can be compared to past stress tests. d. Another approach is to have an adverse scenario that is identical to the severely adverse scenario, except that the shocks are smaller in magnitude (e.g., 100 basis points for adverse versus 200 basis points for severely adverse). This ‘‘scaling approach’’ generally fits well with an intuitive interpretation of ‘‘adverse’’ and ‘‘severely adverse.’’ Moreover, since the nature of the moves will be identical between the two classes of scenarios, there will be at least directional consistency in the risk factor inputs between scenarios. While under this approach the adverse scenario will be superficially identical to the severely adverse, the logic underlying the severely adverse scenario may not be applicable. For example, if the severely adverse scenario was based on a historical scenario, the same could not be said of the adverse scenario. It is also remains possible, although unlikely, that a scaled adverse scenario actually will result in greater losses, for some companies, than the severely adverse scenario with similar moves of greater magnitude. For example, if some companies are hedging against tail outcomes then the more extreme trading book dollar losses may not correspond to the most extreme market moves. The market shock component of the adverse scenario in 2013 was largely based on the scaling approach where a majority of risk factor shocks were smaller in magnitude than the severely adverse scenario, but it also featured long-term interest rate shocks that were not part of the severely adverse market shock. e. Alternatively, the market shock component of an adverse scenario could differ substantially from the severely adverse scenario with respect to the sizes and nature of the shocks. Under this approach, the market shock component could be constructed using some combination of historical and hypothetical events, similar to the severely adverse scenario. As a result, the market shock component of the adverse scenario could be viewed as an alternative to the severely adverse scenario and, therefore, it is possible that the adverse scenario could have larger losses for some companies than the severely adverse scenario. E:\FR\FM\29NOR1.SGM 29NOR1 71448 Federal Register / Vol. 78, No. 230 / Friday, November 29, 2013 / Rules and Regulations f. Finally, the design of the adverse scenario for annual stress tests could be informed by the companies’ own trading scenarios used for their BHC-designed scenarios in CCAR and in their mid-cycle company-run stress tests.40 6. Consistency Between the Macroeconomic Scenarios and the Market Shock a. As discussed earlier, the market shock comprises a set of movements in a very large number of risk factors that are realized instantaneously. Among the risk factors specified in the market shock are several variables also specified in the macroeconomic scenarios, such as short- and long-maturity interest rates on Treasury and corporate debt, the level and volatility of U.S. stock prices, and exchange rates. b. The market shock component is an addon to the macroeconomic scenarios that is applied to a subset of companies, with no assumed effect on other aspects of the stress tests such as balances, revenues, or other losses. As a result, the market shock component may not be always directionally consistent with the macroeconomic scenario. Because the market shock is designed, in part, to mimic the effects of a sudden market dislocation, while the macroeconomic scenarios are designed to provide a description of the evolution of the real economy over two or more years, assumed economic conditions can move in significantly different ways. In effect, the market shock can simulate a market panic, during which financial asset prices move rapidly in unexpected directions, and the macroeconomic assumptions can simulate the severe recession that follows. Indeed, the pattern of a financial crisis, characterized by a short period of wild swings in asset prices followed by a prolonged period of moribund activity, and a subsequent severe recession is familiar and plausible. c. As discussed in section 4.2.4, the Board may feature a particularly salient risk in the macroeconomic assumptions for the severely adverse scenario, such as a fall in an elevated asset price. In such instances, the Board may also seek to reflect the same risk in one of the market shocks. For example, if the macroeconomic scenario were to feature a substantial decline in house prices, it may seem plausible for the market shock to also feature a significant decline in market values of any securities that are closely tied to the housing sector or residential mortgages. d. In addition, as discussed in section 4.3, the Board may specify the macroeconomic assumptions in the adverse scenario in such a way as to explore risks qualitatively different from those in the severely adverse scenario. Depending on the nature and type of such risks, the Board may also seek to reflect these risks in one of the market shocks as appropriate. 7. Timeline for Scenario Publication a. The Board will provide a description of the macroeconomic scenarios by no later than 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. b. The Board expects to provide a broad overview of the market shock component along with the macroeconomic scenarios. The Board will publish the market shock templates by no later than December 1 of each year, and intends to publish the market shock earlier in the stress test and capital plan cycles to allow companies more time to conduct their stress tests. TABLE 1—CLASSIFICATION OF U.S. RECESSIONS Duration (quarters) Peak Trough Severity 1957Q3 ............. 1960Q2 ............. 1969Q4 ............. 1973Q4 ............. 1980Q1 ............. 1981Q3 ............. 1990Q3 ............. 2001Q1 ............. 2007Q4 ............. Average ............ Average ............ Average ............ 1958Q2 ............. 1961Q1 ............. 1970Q4 ............. 1975Q1 ............. 1980Q3 ............. 1982Q4 ............. 1991Q1 ............. 2001Q4 ............. 2009Q2 ............. ........................... ........................... ........................... Severe ............................. Moderate .......................... Moderate .......................... Severe ............................. Moderate .......................... Severe ............................. Mild .................................. Mild .................................. Severe ............................. Severe ............................. Moderate .......................... Mild .................................. 4 4 5 6 3 6 3 4 7 6 4 3 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 ¥3.6 ¥1.0 ¥0.2 ¥3.1 ¥2.2 ¥2.8 ¥1.3 0.2 ¥4.3 ¥3.5 ¥1.1 ¥0.6 (Medium) ...................... (Medium) ...................... (Medium) ...................... (Long) ........................... (Short) ........................... (Long) ........................... (Short) ........................... (Medium) ...................... (Long) ........................... ....................................... ....................................... ....................................... Source: Bureau of Economic Analysis, National Income and Product Accounts, Comprehensive Revision on July 31, 2013. By order of the Board of Governors of the Federal Reserve System, November 6, 2013. Robert deV. Frierson, Secretary of the Board. [FR Doc. 2013–27009 Filed 11–27–13; 8:45 am] Federal Energy Regulatory Commission 18 CFR Part 40 BILLING CODE 6210–01–P sroberts on DSK5SPTVN1PROD with RULES [Docket No. RM13–13–000; Order No. 789] Regional Reliability Standard BAL– 002–WECC–2—Contingency Reserve Federal Energy Regulatory Commission, DOE. ACTION: Final rule. AGENCY: 40 12 Under section 215 of the Federal Power Act, the Federal Energy Regulatory Commission (Commission) approves regional Reliability Standard BAL–002–WECC–2 (Contingency Reserve). The North American Electric Reliability Corporation (NERC) and Western Electricity Coordinating Council (WECC) submitted the regional Reliability Standard to the Commission for approval. The regional Reliability Standard applies to balancing authorities and reserve sharing groups in the WECC Region and is meant to specify the quantity and types of SUMMARY: DEPARTMENT OF ENERGY CFR 252.145. VerDate Mar<15>2010 20:31 Nov 27, 2013 Jkt 232001 PO 00000 Frm 00014 Fmt 4700 Sfmt 4700 E:\FR\FM\29NOR1.SGM 29NOR1

Agencies

[Federal Register Volume 78, Number 230 (Friday, November 29, 2013)]
[Rules and Regulations]
[Pages 71435-71448]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2013-27009]



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Rules and Regulations
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Federal Register / Vol. 78, No. 230 / Friday, November 29, 2013 / 
Rules and Regulations

[[Page 71435]]



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: Final rule; policy statement.

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

SUMMARY: The Board is adopting a final policy statement on the approach 
to scenario design for stress testing that will 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: This rule will be effective on January 1, 2014.

FOR FURTHER INFORMATION CONTACT: Tim Clark, Senior Associate Director, 
(202) 452-5264, Lisa Ryu, Deputy Associate Director, (202) 263-4833, 
David Palmer, Senior Supervisory Financial Analyst, (202) 452-2904, or 
Joseph Cox, Financial Analyst, (202) 452-3216, Division of Banking 
Supervision and Regulation; Benjamin W. McDonough, Senior Counsel, 
(202) 452-2036, or Jeremy Kress, Attorney, (202) 872-7589, Legal 
Division; or Andreas Lehnert, Deputy Director, (202) 452-3325, or 
Rochelle Edge, Assistant Director, (202) 452-2339, Office of Financial 
Stability Policy and Research.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Background
II. Proposed Policy Statement
III. Summary of Comments
    A. Design of Stress Test Scenarios
    B. Additional Variables
    C. Severely Adverse Scenario Development
    D. Adverse Scenario Development
    E. Market Shock and Additional Scenarios or Components of 
Scenarios
    F. Transparency and Timing
    G. Public Disclosure
IV. 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 
financial company measure the sufficiency of capital available to 
support the financial company'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 financial company's potential risk 
exposures.\2\
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    \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.
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    In particular, building on its experience during the financial 
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 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 financial companies for 
measuring capital needs and for managing and allocating capital 
resources.
    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. This procedure allows the Board to assess 
whether the bank holding companies have robust, forward-looking capital 
planning processes and have sufficient capital to continue operations 
throughout times of economic and financial stress.\3\
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    \3\ See Capital Plans, 76 FR 74631 (Dec. 1, 2011) (codified at 
12 CFR 225.8).
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    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--

[[Page 71436]]

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.
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    \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).
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    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\
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    \6\ 12 U.S.C. 5365(i)(2).
    \7\ 77 FR 62398 (October 12, 2012); 12 CFR part 252, subparts F-
H.
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    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 financial companies 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 has required large 
banking organizations with significant trading activities to include 
trading and counterparty components (the ``market shock,'' 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).
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    \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.
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    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 
financial company's business model, which would also greatly affect 
projected revenue, losses, and capital.

II. Proposed Policy Statement

    In order to enhance the transparency of the scenario design 
process, on November 23, 2012, the Board published for public comment a 
proposed policy statement (proposed policy statement) that would be 
used to develop scenarios for annual supervisory and company-run stress 
tests under the stress testing rules issued under the Dodd-Frank Act 
and the capital plan rule.\12\ The proposed policy statement outlined 
the characteristics of the supervisory stress test scenarios and 
explained the considerations and procedures that underlie the 
formulation of these scenarios. The considerations and procedures 
described in the proposed 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).
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    \12\ 77 FR 70124.
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    The proposed policy statement provided a broad description of the 
baseline, adverse, and severely adverse scenarios and described the 
types of variables that the Board would expect to include in the 
macroeconomic scenarios and in the market shock component of the stress 
test scenarios applicable to companies with significant trading 
activity. The proposed policy statement also described the Board's 
approach to developing the macroeconomic scenarios and market shocks, 
as well as the relationship between the macroeconomic scenario and the 
market shock components. The Board noted that it may determine that 
material modifications to the proposed policy statement are appropriate 
if the supervisory stress test framework expands materially to include 
additional components or other scenarios that are currently not 
captured.\13\
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    \13\ 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).
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III. Summary of Comments

    The Board received seven comments on the proposed policy statement. 
Commenters included financial companies, trade organizations, and 
public interest groups. In general, commenters supported the proposed 
policy statement and commended the Board for enhancing the transparency 
of the scenario design framework. Commenters provided a number of 
suggestions for improving the proposed framework, including by 
incorporating additional risks into the supervisory scenarios, 
providing additional scenarios and variables that would capture salient 
risks to financial companies, making the scenarios more predictable, 
and further enhancing the transparency of the scenario design process 
and stress testing in general. In response to these comments, the Board 
has modified certain aspects of the proposed policy statement, 
including expanding the information included in the narrative to be 
published with the macroeconomic scenarios; adding an historical-based 
approach to the adverse scenario; and providing additional information 
about the process for designing the path of international variables. 
The Board generally has retained the overall principles underlying the 
policy statement and its overall organization.

A. Design of Stress Test Scenarios

    Commenters suggested a variety of ways for the Board to alter or 
improve the design of stress test scenarios, including by making the 
process more predictable, using a variety of stress testing approaches 
to more fully capture salient risks, tailoring the scenario for nonbank 
financial companies, and coordinating with the other federal banking 
regulators.
    Some commenters advocated for making the scenarios more predictable 
by anchoring them more firmly in historical episodes or using a 
probabilistic approach with a specified tail percentile for severity. 
One commenter asserted that the predictability of the design framework 
was diminished by the proposed policy statement noting that scenarios 
would vary in relation to changes in the outlook for economic and 
financial conditions and changes to specific risks or vulnerabilities.

[[Page 71437]]

    The Board believes it is important that scenario development remain 
flexible in order to ensure that the stress tests have the ability to 
capture emerging risks or elevated systemic risk. Some commenters noted 
that it was important for supervisors to retain sufficient discretion 
in order to prevent the scenario from becoming stale or irrelevant. For 
these reasons, the final policy statement outlines the general range of 
scenarios that may be implemented, as well as their overall severity, 
but the Board retains the flexibility to incorporate developing risks 
and vary the scenario in response to the Board's views regarding the 
level of systemic and other risks.
    One commenter advocated the use of a variety of approaches to 
scenario development, including using sensitivity analysis and 
recommended changing the correlations and dependencies between risk 
factors given that the relationships between risk factors observed in 
normal times may not apply during stressful conditions.
    The final policy statement allows for a variety of approaches to 
scenario development and for flexibility in changing correlations and 
dependencies between risk factors. For example, the final policy 
statement allows for the adverse scenario to follow either a recession 
approach, a probabilistic approach, or an approach based on historical 
experiences, with the possibility of including additional risks that 
the Board believes should be understood and monitored. Further, the 
final policy statement allows the Board to augment the severely adverse 
scenario to reflect salient risks that would not be captured under the 
recession approach that is used to develop the severely adverse 
scenario. Augmenting the severely adverse scenario to include salient 
risks and the possibility of including additional risks in the adverse 
scenario allows for correlations and dependencies between risk factors 
to be further altered to capture specific stressful outcomes that are 
identified by economists, bank supervisors, and financial market 
experts as representing particularly relevant risks.
    One commenter urged the Board to account in its scenario design 
framework for unique risks faced by nonbank financial companies 
supervised by the Board. The commenter asserted that the scenarios for 
nonbank financial companies should de-emphasize shocks arising from 
traditional banking activities, as such risks would be less salient for 
nonbank financial companies. The Board expects to take into account 
differences among bank holding companies and nonbank covered companies 
supervised by the Board when applying the stress testing 
requirements.\14\ As the nonbank financial companies implement the 
stress testing requirements, the Board may tailor the application for 
those companies, including by updating its framework for developing 
supervisory scenarios. The Board will continue to consult with other 
supervisory authorities, including the Federal Insurance Office, as 
appropriate.
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    \14\ To date, the Financial Stability Oversight Council has 
designated three nonbank financial companies for supervision by the 
Board: General Electric Capital Corporation, American International 
Group, Inc., and Prudential Financial Inc. These companies will be 
subject to the Board's stress testing rules beginning with the 
stress cycle that commences in the calendar year after the year in 
which the company first becomes subject to the Board's minimum 
regulatory capital requirements, unless the Board accelerates or 
extends the compliance date.
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    Finally, some commenters stressed the importance of coordination 
between the Board, the Federal Deposit Insurance Corporation (FDIC), 
and the Office of the Comptroller of the Currency (OCC) in developing a 
common scenario in order to prevent the stress testing process from 
becoming overly complex and burdensome. In addition, commenters 
suggested that different scenarios from each agency would make the 
public disclosure of company-run stress test results more difficult to 
interpret. As noted previously in the stress test rules and in the 
proposed policy statement, the Board plans to develop scenarios each 
year in close consultation with the primary federal financial 
regulatory agencies. The Board, FDIC, and OCC followed this approach 
both in 2012 and 2013. This coordinated approach allows a common set of 
scenarios to be used for the annual company-run stress tests across 
various banking entities within the same organizational structure. The 
Board plans to continue to develop the annual set of scenarios in 
consultation with the OCC and the FDIC to reduce the burden that could 
arise from having the agencies establish inconsistent scenarios.

B. Additional Variables

    Several commenters supported adding additional variables to the 
supervisory scenarios. A few commenters noted that it would be helpful 
for the Board to provide companies with a broader suite of variables. 
In particular, one company noted that in order to run its stress tests 
under the supervisory scenarios, it had to forecast hundreds of 
additional variables. One commenter noted that requiring companies to 
project the paths of additional variables could create inconsistency 
between the scenarios that companies use in their stress tests, 
reducing the industry-wide comparability of the exercise.
    Several commenters requested specific variables, including 
additional country-specific international variables. Commenters 
requested that the Board include variables on more countries and more 
scenario variables for each country, including information on 
unemployment rates, equity market indexes, and home values. One 
commenter provided tables of suggested variables that many companies 
use for their own internal processes. Finally, one commenter urged the 
Board to provide all the factors used in its own models in the 
supervisory stress test to improve macroprudential supervision and 
increase the consistency of scenario assumptions and the comparability 
of results across companies.
    In defining the supervisory scenarios, the Board expects to provide 
the variables the Board considers to be the most important descriptors 
of the scenarios' economic and financial conditions. However, in 
response to comments, the Board will provide a narrative with the 
supervisory scenarios each year to aid companies in projecting other 
variables based on the variables provided in the scenarios. The 
narrative will include descriptions of the paths of many additional 
variables companies may need to project for their company-run stress 
tests. The Board may add additional variables to the scenarios in the 
future if the Board determines that the variables provide additional 
information about the conditions in the scenarios that cannot be 
inferred from the other variables in the supervisory scenarios. For 
example, this year the Board plans to provide two additional interest 
rate variables, the yield on 5-year Treasury bonds and the prime rate, 
that were specifically requested by one commenter. However, large and 
complex financial companies should be able to identify their key risks 
and relate them to the external environment by translating the 
supervisory scenario into additional variables.
    Several commenters suggested that the variables from the market 
shock component of the adverse and severely adverse scenarios should be 
provided to all companies subject to stress tests. One industry 
commenter requested that the market shock to be released to all 
companies at the same time as the macroeconomic scenario so the 
companies can use variables from the market shock in their company-run 
stress tests.

[[Page 71438]]

    In order to enhance the transparency of the supervisory and 
company-run stress tests, the Board expects to publish the market shock 
component annually.\15\ However, only companies with significant 
trading activity, as determined by the Board and specified in the 
Capital Assessments and Stress Testing report (FR Y-14) (trading 
companies) are subject to the market shock component.\16\ Companies 
that are not subject to the market shock should not incorporate the 
market shock component into their stress tests or complete the 
Securities AFS Market Shock tab on the FR Y-14A Summary Schedule. 
Moreover, unlike the scenarios, the market shock is not a time series 
but rather is assumed to be an instantaneous event. Companies should 
not assume that the risk factor moves in the market shock are 
appropriate for inclusion in their stress tests as a complement to the 
macroeconomic scenarios.
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    \15\ On March 7, 2013 the Board published the market shock 
components of the supervisory adverse and severely adverse scenarios 
that were used for the stress test cycle commencing on November 15, 
2012. The severely adverse market shock is available online at: 
http://www.federalreserve.gov/bankinforeg/accessible-2013-ccar-severely-adverse-market-shocks.htm.
    \16\ Consistent with the instructions to the FR Y-14A, bank 
holding companies with greater than $500 billion in total 
consolidated assets that are subject to the amended market risk rule 
are considered to have significant trading activity.
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C. Severely Adverse Scenario Development

    Several commenters provided feedback on the proposed approach for 
developing the severely adverse scenario. Some commenters suggested 
alternative frameworks that would limit the variability in the severity 
of the scenario. An industry participant suggested that the Board 
should avoid volatility in scenario severity based on the economic 
conditions at the starting point of the exercise, as variation in the 
scenario severity would cause stress losses and capital requirements to 
vary considerably. Another commenter supported the historical approach 
to designing the severely adverse scenario, asserting that it would 
constrain the scenario to a plausible range and make the scenario more 
predictable.
    One commenter expressed a preference for the probabilistic approach 
and advocated for a consistent probabilistic severity (i.e., the same 
tail percentile) with idiosyncratic differences in risk factor 
movements to reflect existing and emerging concerns. The commenter 
acknowledged the drawbacks that the Board identified with the 
probabilistic approach but suggested that these problems could be 
overcome with rigor in calibration and supervisory discretion in 
picking variables and paths of variables. Finally, the commenter 
suggested that the supervisory judgment required to use the 
probabilistic approach will ensure a proactive and prudential 
supervisory scenario design process.
    As noted in the proposed policy statement, the Board intends to 
offset natural procyclical tendencies in its scenario design framework 
by using an approach that ensures the scenarios reach a minimum 
severity level. The Board believes that setting a floor for the 
severity of the scenario is appropriate in light of cyclical systemic 
risks that build up at financial intermediaries during robust 
expansions that may be obscured by the strength of the overall 
environment. The Board also believes that varying the scenario severity 
in response to systemic risks is aligned with the goals of scenario 
design and stress testing. As such, the Board believes varying the 
severity of the severely adverse scenario based on current 
macroeconomic conditions--in the same manner as described in the 
proposed policy statement--better meets the goals of scenario design 
and stress testing than alternative methods of specifying the severity 
of the supervisory scenarios.

D. Adverse Scenario Development

    One commenter suggested that the process for designing the adverse 
scenario should be constrained, perhaps by historical experience, so 
that the scenario does not change drastically from year to year. The 
commenter noted that an exception could be granted for cases where the 
Board has identified material emerging risks not captured in adverse 
historical precedents. The commenter suggested that the Board select 
from a menu of historical macroeconomic events or derive the paths of 
adverse scenario variables from a combination of the historical events, 
which would allow the adverse scenario variables to fluctuate within a 
more predictable range.
    The Board does not believe that predictability of the scenarios 
from year to year should be the overriding factor determining the 
specification of the adverse scenario. Other factors are also important 
in determining the specification of the adverse scenario, including, 
but not limited to, improved understanding of relevant risks to the 
banking industry (that may not captured in the severely adverse 
scenario), nonlinearities in the effect of macroeconomic conditions on 
the companies' financial condition, and risks identified by the 
companies in their living wills or in the company-developed scenarios 
for the CCAR or mid-cycle company-run stress tests.
    The Board believes that adverse scenarios based on historical 
experiences represent important stresses to financial companies and has 
added this approach to the list of possible approaches used to 
formulate the adverse scenario. However, the Board believes that there 
are notable benefits from formulating the adverse scenario following 
other approaches. Varying the approach the Board uses for the adverse 
scenario each year--by incorporating specific risks or by using the 
probabilistic approach, for instance--permits flexibility so that the 
results of the scenario provide the most value to supervisors, in light 
of current economic conditions. Consequently, the adverse scenario 
design framework in the final policy statement contains a range of 
options and is not limited only to historical episodes.

E. Market Shock and Additional Scenarios or Components of Scenarios

    The Board did not receive comments on its proposed framework for 
designing the market shock scenario component. However, several 
commenters advocated for the inclusion of additional scenarios and 
components of scenarios in the stress tests. One commenter urged the 
Board to include operational risk because, in the commenter's view, 
operational risk failures can allow for the accretion of credit and 
market risk. Another commenter focused on the need for a supervisory 
scenario that included liquidity risk, even in a capital stress test. 
The commenter noted that short-term funding risk was a major 
contributor to the financial crisis due to the interrelationship 
between capital and liquidity. The commenter advocated for supervisory 
scenarios that take into account the potential for asset shocks that 
reduce capital to also cause a company to lose access to certain 
funding markets. Finally, one commenter suggested that the Board 
incorporate all possible risks in a single scenario or combine separate 
stress testing exercises appropriately to create a comprehensive and 
coherent stress test.
    While operational risk and funding risk are material risks to some 
financial companies, no single stress test can incorporate all risks 
that affect a financial company. Companies should supplement stress 
tests conducted pursuant to the Dodd-Frank Act and capital plan rule 
with other stress tests and other risk measurement tools. For

[[Page 71439]]

example, as part of its supervisory process, the Board evaluates 
liquidity risk, including through stress testing, and the Board has 
proposed a rule that would require large bank holding companies and 
nonbank financial companies supervised by the Board to conduct 
liquidity stress tests.\17\ Companies should conduct additional stress 
testing, as needed, to ensure that all risks and vulnerabilities, 
including funding and operational risk, are addressed--as described in 
the stress testing guidance issued by the agencies in May 2012.\18\ If 
the Board requires companies to apply additional scenarios or 
components of scenarios on a regular basis--including for operational 
risk or the relationship between liquidity and capital risk--then the 
Board may update the final policy statement to include the process for 
designing those scenarios or components of scenarios.
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    \17\ See Notice of Proposed Rulemaking on Enhanced Prudential 
Standards and Early Remediation Requirements for Covered Companies, 
(January 5, 2012) (77 FR 594).
    \18\ See Supervisory Guidance on Stress Testing for Banking 
Organizations With More Than $10 Billion in Total Consolidated 
Assets, (May 17, 2012) (codified at 77 FR 29458).
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F. Transparency and Timing

    The Board received several comments on enhancing the transparency 
of the scenario design process, improving communication about the 
scenarios, and on the timing of when the scenarios are provided to the 
companies. Several commenters requested additional information about 
how the Board develops the scenarios or specific aspects of the 
scenarios. For instance, some commenters requested additional 
clarification on the process and assumptions for developing the 
international variables in the macroeconomic scenarios. In response to 
these comments, the final policy statement contains additional 
information on how the Board develops the scenarios. Section 4.2.3 of 
the final policy statement includes a description of the process and 
assumptions for developing the paths of international variables in the 
supervisory scenarios.
    Some commenters requested that the Board include additional 
narrative information in its scenario release. One commenter requested 
the Board provide more description around the adverse and severely 
adverse scenarios, especially in cases where the scenarios do not 
derive from observable historical events, to aid companies in 
developing a deeper understanding of the economic situation that the 
data describes and the relationships between and among variables. The 
commenter suggested that without a fuller narrative it is difficult for 
companies to project additional variables in a manner that is 
consistent with the scenario, leading to inconsistent assumptions and 
variables across companies. More narrative information on the 
international variables was specifically requested, including 
information on whether the international scenarios are intended to 
reflect global conditions or whether they are designed to reflect 
idiosyncratic stresses at the country level.
    Each year, to accompany the release of its supervisory scenarios, 
the Board has published a brief narrative summary of the macroeconomic 
scenarios. This narrative describes the supervisory scenarios and 
explains how they have changed relative to the previous year. In 
response to comments, the Board will also provide in the narrative a 
description of the economic situation underlying the scenario, 
including for the international environment in the scenarios.
    In addition, to assist companies in projecting the paths of 
additional variables in a manner consistent with the scenario, the 
narrative accompanying the supervisory scenarios will also provide 
descriptions of the general path of some additional variables. These 
descriptions will be general--that is, they will describe developments 
for broad classes of variables rather than for specific variables--and 
will specify the intensity and direction of variable changes but not 
numeric magnitudes. These descriptions should provide guidance that 
will be useful to companies in specifying the paths of the additional 
variables for their company-run stress tests. In practice, it will not 
be possible for the narrative to include descriptions on all of the 
additional variables that companies may need to for their company-run 
stress tests.
    One commenter requested that the Board communicate, in advance of 
the scenario release, any additional risks or vulnerabilities that 
would cause the scenario to vary due to changes in the outlook for 
economic and financial conditions. The Board expects that if a scenario 
varies in response to additional risks or vulnerabilities identified by 
the Board, then those risks and vulnerabilities would be communicated 
through the narrative that accompanies the supervisory scenarios.
    Several commenters addressed the timeline for supervisory scenario 
development. A few commenters requested that the Board provide the 
supervisory scenarios to the companies earlier in order to provide 
adequate time for companies to evaluate the scenarios, develop 
additional required variables, and initiate the stress testing and 
capital planning processes. One commenter noted that providing the 
supervisory scenarios two weeks before November 15 would extend the 
time to companies have to conduct stress tests by 25 to 30 percent. 
Another commenter felt the current timetable is extremely aggressive 
and precludes companies from performing more comprehensive due 
diligence. One commenter acknowledged the concern that a scenario may 
become dated if it is released too early, but the commenter asserted 
that this concern is mitigated because only five quarters of the 
planning horizon will elapse before there is another annual stress test 
and capital planning exercise.
    The Board recognizes the importance of providing covered companies 
adequate time to implement the company-run stress tests. The Board 
intends to release the scenarios as soon as it is possible to 
incorporate the relevant data on economic and financial conditions as 
of the end of the third quarter, but no later than November 15 of each 
year.
    One commenter requested that the market shock and the macroeconomic 
scenarios be released concurrently. The commenter asserted that delays 
in processing the effect of the scenarios on capital markets positions 
affects all other processes downstream in the stress tests, including 
calculation of the company's capital position.
    Because the market shock component is an instantaneous shock 
layered onto the stress test conducted under the macroeconomic 
scenario, it should not affect most other aspects of a company's stress 
test. However, in recognition of companies' constraints in conducting 
the company-run stress tests, the Board will seek to release the market 
shock before the deadline of December 1 of each year.
    The Board has sought to improve the transparency around its stress 
testing practices, for example by releasing the stress scenarios with 
an accompanying narrative in advance of the stress test, publicly 
disclosing a detailed description of the framework and methodology 
employed in its supervisory stress test, and publishing for comment 
this policy statement on its framework for scenario design. In the 
future, the Board will continue to look for opportunities to provide 
additional transparency around its stress testing processes, while 
balancing the need to not reduce the incentives for companies to 
develop better internal stress test models that factor in their 
idiosyncratic risks and to consider the results of such

[[Page 71440]]

models in their capital planning process.

G. Public Disclosure

    One commenter requested a broader disclosure of the methods and 
data that are used in stress tests to enhance the public's 
understanding of the process and results. The commenter recommended 
disclosure of the specification, statistical fit, and out-of-sample 
forecasting properties of the risk models used in stress testing. As 
noted previously, the Board has sought to improve the transparency of 
its supervisory stress testing methodologies and practices, and has 
required companies subject to Dodd-Frank Act stress tests to publicly 
disclose some information about their company-run stress tests. The 
Board expects to revisit the scope of stress testing disclosure from 
time to time.
    Another commenter suggested that public disclosure of the results 
of stress tests conducted by nonbank financial companies may not 
provide the marketplace with useful information concerning a company's 
overall risk profile or response to stressed conditions. The Board 
notes that section 165(i) of the Dodd-Frank Act requires the 
publication of a summary of the results of supervisory and company-run 
stress tests of each company, including nonbank financial companies. 
Moreover, the Board believes that public disclosure is a key component 
of stress testing that helps to provide valuable information to market 
participants, enhance transparency, and promote market discipline.
    As noted above, the final policy statement will be effective on 
January 1, 2014. The scenarios for the stress test cycle that commenced 
on October 1, 2013, which the Board recently published, were designed 
in a manner generally consistent with the final policy statement. The 
final policy statement will be effective for supervisory scenarios that 
govern the resubmission of any stress tests for the cycle that 
commenced on October 1, 2013, as the Board may require.

IV. Administrative Law Matters

A. Use of Plain Language

    Section 722 of the Gramm-Leach-Bliley Act (Pub. L. 106-102, 113 
Stat. 1338, 1471, 12 U.S.C. 4809) requires the Federal banking agencies 
to use plain language in all proposed and final rules published after 
January 1, 2000. The Board invited comment on whether the proposed 
policy statement was written plainly and clearly, or whether there were 
ways the Board could make the rule easier to understand. The Board 
received no comment on these matters and believes that the final policy 
statement is written plainly and clearly.

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 policy statement 
to assess any information collections. There are no collections of 
information as defined by the Paperwork Reduction Act in this policy 
statement.

C. Regulatory Flexibility Act Analysis

    In accordance with the Regulatory Flexibility Act, 5 U.S.C. 601 et 
seq. (``RFA''), the Board is publishing a final regulatory flexibility 
analysis for this policy statement. Based on its analysis and for the 
reasons stated below, the Board believes that the policy statement will 
not have a significant economic impact on a substantial number of small 
entities. Nevertheless, the Board is publishing a regulatory 
flexibility analysis.
    The Board is adopting a policy statement on the approach to 
scenario design for stress testing that will be used in connection with 
the supervisory and company-run stress tests conducted under the 
Board's Regulation YY (12 CFR part 252, subparts F, G, and H) pursuant 
to the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-
Frank Act or Act) and the Board's capital plan rule (12 CFR 225.8). To 
enhance the transparency of the scenario design process, the policy 
statement outlines the characteristics of the supervisory stress test 
scenarios and explains the considerations and procedures that underlie 
the formulation of these scenarios.
    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 $35 million or 
less to $500 million or less.\19\ As discussed in the Supplementary 
Information, the policy statement generally would affect the scenario 
design framework used in regulations that apply to bank holding 
companies with $10 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 policy statement therefore substantially exceed the $500 million 
total asset threshold at which a company is considered a ``small 
entity'' under SBA regulations.
---------------------------------------------------------------------------

    \19\ 13 CFR 121.201.
---------------------------------------------------------------------------

    The 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.\20\ It is therefore unlikely that a financial firm that 
is at or below the $500 million asset threshold would be designated by 
the Council under section 113 of the Dodd-Frank Act because material 
financial distress at such companies, or the nature, scope, size, 
scale, concentration, interconnectedness, or mix of it activities, is 
not likely to pose a threat to the financial stability of the United 
States.
---------------------------------------------------------------------------

    \20\ See 76 FR 4555 (January 26, 2011).
---------------------------------------------------------------------------

    Because the final policy statement is not likely to apply to any 
company with assets of $500 million or less, it is not expected to 
affect any small entity for purposes of the RFA. The Board does not 
believe that the policy statement duplicates, overlaps, or conflicts 
with any other Federal rules. The policy statement is unlikely to 
impose any new recordkeeping, reporting, or other compliance 
requirements or otherwise affect a small banking entity. In light of 
the foregoing, the Board does not believe that the policy statement 
will have a significant economic impact on a substantial number of 
small entities.

List of Subjects in 12 CFR Part 252

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

Authority and Issuance

    For the reasons stated in the SUPPLEMENTARY INFORMATION, the Board 
of Governors of the Federal Reserve System amends 12 CFR chapter II as 
follows:

PART 252--ENHANCED PRUDENTIAL STANDARDS (REGULATION YY)

0
1. The authority citation for part 252 continues to read as follows:

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

[[Page 71441]]


0
2. Appendix A to part 252 is added to read as follows:

Appendix A to Part 252--Policy Statement on the Scenario Design 
Framework for Stress Testing

1. Background

    a. The Board has imposed stress testing requirements through its 
regulations (stress test rules) implementing section 165(i) of the 
Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-
Frank Act or Act) and through its capital plan rule (12 CFR 225.8). 
Under the stress test rules issued under section 165(i)(1) of the 
Act, the Board conducts an annual stress test (supervisory stress 
tests), on a consolidated basis, of each bank holding company with 
total consolidated assets of $50 billion or more and each nonbank 
financial company that the Financial Stability Oversight Council has 
designated for supervision by the Board (together, covered 
companies).\21\ 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).\22\ The Board will 
provide for at least three different sets of conditions (each set, a 
scenario), including baseline, adverse, and severely adverse 
scenarios for both supervisory and company-run stress tests 
(macroeconomic scenarios).\23\
---------------------------------------------------------------------------

    \21\ 12 U.S.C. 5365(i)(1); 12 CFR part 252, subpart F.
    \22\ 12 U.S.C. 5365(i)(2); 12 CFR part 252, subparts G and H.
    \23\ 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).
---------------------------------------------------------------------------

    b. The stress test rules provide that the Board will notify 
covered companies by no later than November 15 of each year of the 
scenarios it will use to conduct its annual supervisory stress tests 
and provide, also by no later than November 15, covered companies 
and other financial companies subject to the final rules the set of 
scenarios they must use to conduct their annual company-run stress 
tests.\24\ 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.\25\ For example, 
the Board expects to require large banking organizations with 
significant trading activities to include a trading and counterparty 
component (market shock, described in the following sections) in 
their adverse and severely adverse scenarios. The Board will provide 
any additional components or scenario by no later than December 1 of 
each year.\26\ 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).
---------------------------------------------------------------------------

    \24\ 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.
    \25\ 12 CFR 252.144(b), 154(b).
    \26\ Id.
---------------------------------------------------------------------------

    c. In addition, Sec.  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.\27\
---------------------------------------------------------------------------

    \27\ See Capital plans, 76 FR 74631 (Dec. 1, 2011) (codified at 
12 CFR 225.8).
---------------------------------------------------------------------------

    d. Stress tests required under the stress test rules and under 
the capital plan rule require the Board and financial companies to 
calculate pro-forma capital levels--rather than ``current'' or 
actual levels--over a specified planning horizon under baseline and 
stressful scenarios. This approach integrates key lessons of the 
2007-2009 financial crisis into the Board's supervisory framework. 
During the financial crisis, investor and counterparty confidence in 
the capitalization of financial companies eroded rapidly in the face 
of changes in the current and expected economic and financial 
conditions, and this loss in market confidence imperiled companies' 
ability to access funding, continue operations, serve as a credit 
intermediary, and meet obligations to creditors and counterparties. 
Importantly, such a loss in confidence occurred even when a 
financial institution's capital ratios were in excess of regulatory 
minimums. This is because the institution's capital ratios were 
perceived as lagging indicators of its financial condition, 
particularly when conditions were changing.
    e. The stress tests required under the stress test rules and 
capital plan rule are a valuable supervisory tool that provides a 
forward-looking assessment of large financial companies' capital 
adequacy under hypothetical economic and financial market 
conditions. Currently, these stress tests primarily focus on credit 
risk and market risk--that is, risk of mark-to-market losses 
associated with companies' trading and counterparty positions--and 
not on other types of risk, such as liquidity risk. Pressures 
stemming from these sources are considered in separate supervisory 
exercises. No single supervisory tool, including the stress tests, 
can provide an assessment of a company's ability to withstand every 
potential source of risk.
    f. Selecting appropriate scenarios is an especially significant 
consideration for stress tests required under the capital plan rule, 
which ties the review of a 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, however; it will 
depend on factors that are specific to a given company, such as 
underwriting standards and the company's business model, which would 
also greatly affect projected revenue, losses, and capital.

2. Overview and Scope

    a. This policy statement provides more detail on the 
characteristics of the stress test scenarios and explains the 
considerations and procedures that underlie the approach for 
formulating these scenarios. The considerations and procedures 
described in this policy statement apply to the Board's stress 
testing framework, including to the stress tests required under 12 
CFR part 252, subparts F, G, and H, as well as the Board's capital 
plan rule (12 CFR 225.8).\28\
---------------------------------------------------------------------------

    \28\ The Board may determine that modifications to the approach 
are appropriate, for instance, to address a broader range of risks, 
such as, operational risk.
---------------------------------------------------------------------------

    b. Although the Board does not envision that the broad approach 
used to develop scenarios will change from year to year, the stress 
test scenarios will reflect changes in the outlook for economic and 
financial conditions and changes to specific risks or 
vulnerabilities that the Board, in consultation with the other 
federal banking agencies, determines should be considered in the 
annual stress tests. The stress test scenarios should not be 
regarded as forecasts; rather, they are hypothetical paths of 
economic variables that will be used to assess the strength and 
resilience of the companies' capital in various economic and 
financial environments.
    c. The remainder of this policy statement is organized as 
follows. Section 3 provides a broad description of the baseline, 
adverse, and severely adverse scenarios and describes the types of 
variables that the Board expects to include in the macroeconomic 
scenarios and the market shock component of the stress test 
scenarios applicable to companies with significant trading activity. 
Section 4 describes the Board's approach for developing the 
macroeconomic scenarios, and section 5 describes the approach for 
the market shocks. Section 6 describes the relationship between the 
macroeconomic scenario and the market shock components. Section 7 
provides a timeline for the formulation and publication of the

[[Page 71442]]

macroeconomic assumptions and market shocks.

3. Content of the Stress Test Scenarios

    a. The Board will publish a minimum of three different 
scenarios, including baseline, adverse, and severely adverse 
conditions, for use in stress tests required in the stress test 
rules.\29\ 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.
---------------------------------------------------------------------------

    \29\ 12 CFR 252.134(b), 12 CFR 252.144(b), 12 CFR 252.154(b).
---------------------------------------------------------------------------

    b. While the Board generally expects to use the same scenarios 
for all companies subject to the final rule, it may require a subset 
of companies-- depending on a company's financial condition, size, 
complexity, risk profile, scope of operations, or activities, or 
risks to the U.S. economy--to include additional scenario components 
or additional scenarios that are designed to capture different 
effects of adverse events on revenue, losses, and capital. One 
example of such components is the market shock that applies only to 
companies with significant trading activity. Additional components 
or scenarios may also include other stress factors that may not 
necessarily be directly correlated to macroeconomic or financial 
assumptions but nevertheless can materially affect companies' risks, 
such as the unexpected default of a major counterparty.
    c. Early in each stress testing cycle, the Board plans to 
publish the macroeconomic scenarios along with a brief narrative 
summary that provides a description of the economic situation 
underlying the scenario and explains how the scenarios have changed 
relative to the previous year. In addition, to assist companies in 
projecting the paths of additional variables in a manner consistent 
with the scenario, the narrative will also provide descriptions of 
the general path of some additional variables. These descriptions 
will be general--that is, they will describe developments for broad 
classes of variables rather than for specific variables--and will 
specify the intensity and direction of variable changes but not 
numeric magnitudes. These descriptions should provide guidance that 
will be useful to companies in specifying the paths of the 
additional variables for their company-run stress tests. Note that 
in practice it will not be possible for the narrative to include 
descriptions on all of the additional variables that companies may 
need to for their company-run stress tests. In cases where scenarios 
are designed to reflect particular risks and vulnerabilities, the 
narrative will also explain the underlying motivation for these 
features of the scenario. The Board also plans to release a broad 
description of the market shock components.

3.1 Macroeconomic Scenarios

    a. The macroeconomic scenarios will consist of the future paths 
of a set of economic and financial variables.\30\ The economic and 
financial variables included in the scenarios will likely comprise 
those included in the ``2014 Supervisory Scenarios for Annual Stress 
Tests Required under the Dodd-Frank Act Stress Testing Rules and the 
Capital Plan Rule'' (2013 supervisory scenarios). The domestic U.S. 
variables provided for in the 2013 supervisory scenarios included:
---------------------------------------------------------------------------

    \30\ The future path of a variable refers to its specification 
over a given time period. For example, the path of unemployment can 
be described in percentage terms on a quarterly basis over the 
stress testing time horizon.
---------------------------------------------------------------------------

    i. Six measures of economic activity and prices: real and 
nominal gross domestic product (GDP) growth, the unemployment rate 
of the civilian non-institutional population aged 16 and over, real 
and nominal disposable personal income growth, and the Consumer 
Price Index (CPI) inflation rate;
    ii. Four measures of developments in equity and property 
markets: The Core Logic National House Price Index, the National 
Council for Real Estate Investment Fiduciaries Commercial Real 
Estate Price Index, the Dow Jones Total Stock Market Index, and the 
Chicago Board Options Exchange Market Volatility Index; and
    iii. Six measures of interest rates: the rate on the three-month 
Treasury bill, the yield on the 5-year Treasury bond, the yield on 
the 10-year Treasury bond, the yield on a 10-year BBB corporate 
security, the prime rate, and the interest rate associated with a 
conforming, conventional, fixed-rate, 30-year mortgage.
    b. The international variables provided for in the 2014 
supervisory scenarios included, for the euro area, the United 
Kingdom, developing Asia, and Japan:
    i. Percent change in real GDP;
    ii. Percent change in the Consumer Price Index or local 
equivalent; and
    iii. The U.S./foreign currency exchange rate.\31\
---------------------------------------------------------------------------

    \31\ The Board may increase the range of countries or regions 
included in future scenarios, as appropriate.
---------------------------------------------------------------------------

    c. The economic variables included in the scenarios influence 
key items affecting financial companies' net income, including pre-
provision net revenue and credit losses on loans and securities. 
Moreover, these variables exhibit fairly typical trends in adverse 
economic climates that can have unfavorable implications for 
companies' net income and, thus, capital positions.
    d. The economic variables included in the scenario may change 
over time. For example, the Board may add variables to a scenario if 
the international footprint of companies that are subject to the 
stress testing rules changed notably over time such that the 
variables already included in the scenario no longer sufficiently 
capture the material risks of these companies. Alternatively, 
historical relationships between macroeconomic variables could 
change over time such that one variable (e.g., disposable personal 
income growth) that previously provided a good proxy for another 
(e.g., light vehicle sales) in modeling companies' pre-provision net 
revenue or credit losses ceases to do so, resulting in the need to 
create a separate path, or alternative proxy, for the other 
variable. However, recognizing the amount of work required for 
companies to incorporate the scenario variables into their stress 
testing models, the Board expects to eliminate variables from the 
scenarios only in rare instances.
    e. The Board expects that the company may not use all of the 
variables provided in the scenario, if those variables are not 
appropriate to the company's line of business, or may add additional 
variables, as appropriate. The Board expects the companies will 
ensure that the paths of such additional variables are consistent 
with the scenarios the Board provided. For example, the companies 
may use, as part of their internal stress test models, local-level 
variables, such as state-level unemployment rates or city-level 
house prices. While the Board does not plan to include local-level 
macro variables in the stress test scenarios it provides, it expects 
the companies to evaluate the paths of local-level macro variables 
as needed for their internal models, and ensure internal consistency 
between these variables and their aggregate, macro-economic 
counterparts. The Board will provide the macroeconomic scenario 
component of the stress test scenarios for a period that spans a 
minimum of 13 quarters. The scenario horizon reflects the 
supervisory stress test approach that the Board plans to use. Under 
the stress test rules, the Board will assess the effect of different 
scenarios on the consolidated capital of each company over a 
forward-looking planning horizon of at least nine quarters.

3.2 Market Shock Component

    a. The market shock component of the adverse and severely 
adverse scenarios will only apply to companies with significant 
trading activity and their subsidiaries.\32\ The component consists 
of large moves in market prices and rates that would be expected to 
generate losses. Market shocks differ from macroeconomic scenarios 
in a number of ways, both in their design and application. For 
instance, market shocks that might typically be observed over an 
extended period (e.g., 6 months) are assumed to be an instantaneous 
event which immediately affects the market value of the companies' 
trading assets and liabilities. In addition, under the stress test 
rules, the as-of date for market shocks will differ from the 
quarter-end, and the Board will provide the as-of date for market 
shocks no later than December 1 of each year. Finally, as

[[Page 71443]]

described in section 4, the market shock includes a much larger set 
of risk factors than the set of economic and financial variables 
included in macroeconomic scenarios. Broadly, these risk factors 
include shocks to financial market variables that affect asset 
prices, such as a credit spread or the yield on a bond, and, in some 
cases, the value of the position itself (e.g., the market value of 
private equity positions).
---------------------------------------------------------------------------

    \32\ 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 financial company's trading activities 
evolve.
---------------------------------------------------------------------------

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

4. Approach for Formulating the Macroeconomic Assumptions for Scenarios

    a. This section describes the Board's approach for formulating 
macroeconomic assumptions for each scenario. The methodologies for 
formulating this part of each scenario differ by scenario, so these 
methodologies for the baseline, severely adverse, and the adverse 
scenarios are described separately in each of the following 
subsections.
    b. In general, the baseline scenario will reflect the most 
recently available consensus views of the macroeconomic outlook 
expressed by professional forecasters, government agencies, and 
other public-sector organizations as of the beginning of the annual 
stress-test cycle. The severely adverse scenario will consist of a 
set of economic and financial conditions that reflect the conditions 
of post-war U.S. recessions. The adverse scenario will consist of a 
set of economic and financial conditions that are more adverse than 
those associated with the baseline scenario but less severe than 
those associated with the severely adverse scenario.
    c. Each of these scenarios is described further in sections 
below as follows: baseline (subsection 4.1), severely adverse 
(subsection 4.2), and adverse (subsection 4.3)

4.1 Approach for Formulating Macroeconomic Assumptions in the 
Baseline Scenario

    a. The stress test rules define the baseline scenario as a set 
of conditions that affect the U.S. economy or the financial 
condition of a banking organization, and that reflect the consensus 
views of the economic and financial outlook. Projections under a 
baseline scenario are used to evaluate how companies would perform 
in more likely economic and financial conditions. The baseline 
serves also as a point of comparison to the severely adverse and 
adverse scenarios, giving some sense of how much of the company's 
capital decline could be ascribed to the scenario as opposed to the 
company's capital adequacy under expected conditions.
    b. The baseline scenario will be developed around a 
macroeconomic projection that captures the prevailing views of 
private-sector forecasters (e.g. Blue Chip Consensus Forecasts and 
the Survey of Professional Forecasters), government agencies, and 
other public-sector organizations (e.g., the International Monetary 
Fund and the Organization for Economic Co-operation and Development) 
near the beginning of the annual stress-test cycle. The baseline 
scenario is designed to represent a consensus expectation of certain 
economic variables over the time period of the tests and it is not 
the Board's internal forecast for those economic variables. For 
example, the baseline path of short-term interest rates is 
constructed from consensus forecasts and may differ from that 
implied by the FOMC's Summary of Economic Projections.
    c. For some scenario variables--such as U.S. real GDP growth, 
the unemployment rate, and the consumer price index--there will be a 
large number of different forecasts available to project the paths 
of these variables in the baseline scenario. For others, a more 
limited number of forecasts will be available. If available 
forecasts diverge notably, the baseline scenario will reflect an 
assessment of the forecast that is deemed to be most plausible. In 
setting the paths of variables in the baseline scenario, particular 
care will be taken to ensure that, together, the paths present a 
coherent and plausible outlook for the U.S. and global economy, 
given the economic climate in which they are formulated.

4.2 Approach for Formulating the Macroeconomic Assumptions in the 
Severely Adverse Scenario

    The stress test rules define a severely adverse scenario as a 
set of conditions that affect the U.S. economy or the financial 
condition of a financial company and that overall are more severe 
than those associated with the adverse scenario. The financial 
company will be required to publicly disclose a summary of the 
results of its stress test under the severely adverse scenario, and 
the Board intends to publicly disclose the results of its analysis 
of the financial company under the adverse scenario and the severely 
adverse scenario.

4.2.1 General Approach: The Recession Approach

    a. The Board intends to use a recession approach to develop the 
severely adverse scenario. In the recession approach, the Board will 
specify the future paths of variables to reflect conditions that 
characterize post-war U.S. recessions, generating either a typical 
or specific recreation of a post-war U.S. recession. The Board chose 
this approach because it has observed that the conditions that 
typically occur in recessions--such as increasing unemployment, 
declining asset prices, and contracting loan demand--can put 
significant stress on companies' balance sheets. This stress can 
occur through a variety of channels, including higher loss 
provisions due to increased delinquencies and defaults; losses on 
trading positions through sharp moves in market prices; and lower 
bank income through reduced loan originations. For these reasons, 
the Board believes that the paths of economic and financial 
variables in the severely adverse scenario should, at a minimum, 
resemble the paths of those variables observed during a recession.
    b. This approach requires consideration of the type of recession 
to feature. All post-war U.S. recessions have not been identical: 
some recessions have been associated with very elevated interest 
rates, some have been associated with sizable asset price declines, 
and some have been relatively more global. The most common features 
of recessions, however, are increases in the unemployment rate and 
contractions in aggregate incomes and economic activity. For this 
and the following reasons, the Board intends to use the unemployment 
rate as the primary basis for specifying the severely adverse 
scenario. First, the unemployment rate is likely the most 
representative single summary indicator of adverse economic 
conditions. Second, in comparison to GDP, labor market data have 
traditionally featured more prominently than GDP in the set of 
indicators that the National Bureau of Economic Research reviews to 
inform its recession dates.\33\ 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

[[Page 71444]]

severity by the absolute level of and relative increase in the 
unemployment rate.\34\
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    \33\ More recently, a monthly measure of GDP has been added to 
the list of indicators.
    \34\ 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[frac34] percent and the unemployment rate moving up a 
total of about 4 percentage points.
---------------------------------------------------------------------------

    c. 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).
    d. 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

    a. The Board anticipates that the severely adverse scenario will 
feature an unemployment rate that increases between 3 to 5 
percentage points from its initial level over the course of 6 to 8 
calendar quarters.\35\ 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.
---------------------------------------------------------------------------

    \35\ Six to eight quarters is the average number of quarters for 
which a severe recession lasts plus the average number of subsequent 
quarters over which the unemployment rate continues to rise. The 
variable length of the timeframe reflects the different paths to the 
peak unemployment rate depending on the severity of the scenario.
---------------------------------------------------------------------------

    b. This methodology is intended to generate scenarios that 
feature stressful outcomes but do not induce greater procyclicality 
in the financial system and macroeconomy. When the economy is in the 
early stages of a recovery, the unemployment rate in a baseline 
scenario generally trends downward, resulting in a larger difference 
between the path of the unemployment rate in the severely adverse 
scenario and the baseline scenario and a severely adverse scenario 
that is relatively more intense. Conversely, in a sustained strong 
expansion--when the unemployment rate may be below the level 
consistent with full employment--the unemployment in a baseline 
scenario generally trends upward, resulting in a smaller difference 
between the path of the unemployment rate in the severely adverse 
scenario and the baseline scenario and a severely adverse scenario 
that is relatively less intense. Historically, a 3 to 5 percentage 
point increase in unemployment rate is reflective of stressful 
conditions. As illustrated in Table 1, over the last half-century, 
the U.S. economy has experienced four severe post-war recessions. In 
all four of these recessions the unemployment rate increased 3 to 5 
percentage points and in the three most recent of these recessions 
the unemployment rate reached a level between 9 percent and 11 
percent.
    c. Under this method, if the initial unemployment rate were 
low--as it would be after a sustained long expansion--the 
unemployment rate in the scenario would increase to a level as high 
as what has been seen in past severe recessions. However, if the 
initial unemployment rate were already high--as would be the case in 
the early stages of a recovery--the unemployment rate would exhibit 
a change as large as what has been seen in past severe recessions.
    d. The Board believes that the typical increase in the 
unemployment rate in the severely adverse scenario will be about 4 
percentage points. However, the Board will calibrate the increase in 
unemployment based on its views of the status of cyclical systemic 
risk. The Board intends to set the unemployment rate at the higher 
end of the range if the Board believed that cyclical systemic risks 
were high (as it would be after a sustained long expansion), and to 
the lower end of the range if cyclical systemic risks were low (as 
it would be in the earlier stages of a recovery). This may result in 
a scenario that is slightly more intense than normal if the Board 
believed that cyclical systemic risks were increasing in a period of 
robust expansion.\36\ Conversely, it will allow the Board to specify 
a scenario that is slightly less intense than normal in an 
environment where systemic risks appeared subdued, such as in the 
early stages of an expansion. However, even at the lower end of the 
range of unemployment-rate increases, the scenario will still 
feature an increase in the unemployment rate similar to what has 
been seen in about half of the severe recessions of the last 50 
years.
---------------------------------------------------------------------------

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

    e. As indicated previously, if a 3 to 5 percentage point 
increase in the unemployment rate does not raise the level of the 
unemployment rate to 10 percent--the average level to which it has 
increased in the most recent three severe recessions--the path of 
the unemployment rate will be specified so as to raise the 
unemployment rate to 10 percent. Setting a floor for the 
unemployment rate at 10 percent recognizes the fact that not only do 
cyclical systemic risks build up at financial intermediaries during 
robust expansions but that these risks are also easily obscured by 
the buoyant environment.
    f. In setting the increase in the unemployment rate, the Board 
will consider the extent to which analysis by economists, 
supervisors, and financial market experts finds cyclical systemic 
risks to be elevated (but difficult to be captured more precisely in 
one of the scenario's other variables). In addition, the Board--in 
light of impending shocks to the economy and financial system--will 
also take into consideration the extent to which a scenario of some 
increased severity might be necessary for the results of the stress 
test and the associated supervisory actions to sustain confidence in 
financial institutions.
    g. While the approach to specifying the severely adverse 
scenario is designed to avoid adding sources of procyclicality to 
the financial system, it is not designed to explicitly offset any 
existing procyclical tendencies in the financial system. The purpose 
of the stress test scenarios is to make sure that the companies are 
properly capitalized to withstand severe economic and financial 
conditions, not to serve as an explicit countercyclical offset to 
the financial system.
    h. In developing the approach to the unemployment rate, the 
Board also considered a method that would increase the unemployment 
rate to some fairly elevated fixed level over the course of 6 to 8 
quarters. This will result in scenarios being more severe in robust 
expansions (when the unemployment rate is low) and less severe in 
the early stages of a recovery (when the unemployment rate is high) 
and so would not result in pro-cyclicality. Depending on the initial 
level of the unemployment rate, this approach could lead to only a 
very modest increase in the unemployment rate--or even a decline. As 
a result, this approach--while not procyclical--could result in 
scenarios not featuring stressful macroeconomic outcomes.

4.2.3 Setting the Other Variables in the Severely Adverse Scenario

    a. Generally, all other variables in the severely adverse 
scenario will be specified to be consistent with the increase in the 
unemployment rate. The approach for specifying the paths of these 
variables in the scenario will be a combination of (1) how

[[Page 71445]]

economic models suggest that these variables should evolve given the 
path of the unemployment rate, (2) how these variables have 
typically evolved in past U.S. recessions, and (3) and evaluation of 
these and other factors.
    b. Economic models--such as medium-scale macroeconomic models--
should be able to generate plausible paths consistent with the 
unemployment rate for a number of scenario variables, such as real 
GDP growth, CPI inflation and short-term interest rates, which have 
relatively stable (direct or indirect) relationships with the 
unemployment rate (e.g., Okun's Law, the Phillips Curve, and 
interest rate feedback rules). For some other variables, specifying 
their paths will require a case-by-case consideration. For example, 
declining house prices, which are an important source of stress to a 
company's balance sheet, are not a steadfast feature of recessions, 
and the historical relationship of house prices with the 
unemployment rate 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--will be appropriate.
    c. In addition, judgment is necessary in projecting the path of 
a scenario's international variables. Recessions that occur 
simultaneously across countries are an important source of stress to 
the balance sheets of companies with notable international exposures 
but are not an invariable feature of the international economy. As a 
result, simply adopting the typical path of international variables 
in a severe U.S. recession would likely underestimate the risks 
stemming from the international economy. Consequently, an approach 
like that used for projecting house prices is followed where 
judgment and economic models together inform the path of 
international variables.

4.2.4 Adding Salient Risks to the Severely Adverse Scenario

    a. The severely adverse scenario will be developed to reflect 
specific risks to the economic and financial outlook that are 
especially salient but will feature minimally in the scenario if the 
Board were only to use approaches that looked to past recessions or 
relied on historical relationships between variables.
    b. There are some important instances when it will be 
appropriate to augment the recession approach with salient risks. 
For example, if an asset price were especially elevated and thus 
potentially vulnerable to an abrupt and potentially destabilizing 
decline, it would be appropriate to include such a decline in the 
scenario even if such a large drop were not typical in a severe 
recession. Likewise, if economic developments abroad were 
particularly unfavorable, assuming a weakening in international 
conditions larger than what typically occurs in severe U.S. 
recessions would likely also be appropriate.
    c. Clearly, while the recession component of the severely 
adverse scenario is within some predictable range, the salient risk 
aspect of the scenario is far less so, and therefore, needs an 
annual assessment. Each year, the Board will identify the risks to 
the financial system and the domestic and international economic 
outlooks that appear more elevated than usual, using its internal 
analysis and supervisory information and in consultation with the 
Federal Deposit Insurance Corporation (FDIC) and the Office of the 
Comptroller of the Currency (OCC). Using the same information, the 
Board will then calibrate the paths of the macroeconomic and 
financial variables in the scenario to reflect these risks.
    d. Detecting risks that have the potential to weaken the banking 
sector is particularly difficult when economic conditions are 
buoyant, as a boom can obscure the weaknesses present in the system. 
In sustained robust expansions, therefore, the selection of salient 
risks to augment the scenario will err on the side of including 
risks of uncertain significance.
    e. The Board will factor in particular risks to the domestic and 
international macroeconomic outlook identified by its economists, 
bank supervisors, and financial market experts and make appropriate 
adjustments to the paths of specific economic variables. These 
adjustments will not be reflected in the general severity of the 
recession and, thus, all macroeconomic variables; rather, the 
adjustments will apply to a subset of variables to reflect co-
movements in these variables that are historically less typical. The 
Board plans to discuss the motivation for the adjustments that it 
makes to variables to highlight systemic risks in the narrative 
describing the scenarios.\37\
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    \37\ The means of effecting an adjustment to the severely 
adverse scenario to address salient systemic risks differs from the 
means used to adjust the unemployment rate. For example, in 
adjusting the scenario for an increased unemployment rate, the Board 
would modify all variables such that the future paths of the 
variables are similar to how these variables have moved 
historically. In contrast, to address salient risks, the Board may 
only modify a small number of variables in the scenario and, as 
such, their future paths in the scenario would be somewhat more 
atypical, albeit not implausible, given existing risks.
---------------------------------------------------------------------------

4.3 Approach for Formulating Macroeconomic Assumptions in the 
Adverse Scenario

    a. The adverse scenario can be developed in a number of 
different ways, and the selected approach will depend on a number of 
factors, including how the Board intends to use the results of the 
adverse scenario.\38\ 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.
---------------------------------------------------------------------------

    \38\ 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.
---------------------------------------------------------------------------

    b. The simplest method to specify the adverse scenario is to 
develop a less severe version of the severely adverse scenario. For 
example, the adverse scenario could be formulated such that the 
deviations of the paths of the variables relative to the baseline 
were simply one-half of or two-thirds of the deviations of the paths 
of the variables relative to the baseline in the severely adverse 
scenario. A priori, specifying the adverse scenario in this way may 
appear unlikely to provide the greatest possible informational value 
to supervisors--given that it is just a less severe version of the 
severely adverse scenario. However, to the extent that the effect of 
macroeconomic variables on company loss positions and incomes are 
nonlinear, there could be potential value from this approach.
    c. Another method to specify the adverse scenario is to capture 
risks in the adverse scenario that the Board believes should be 
understood better or should be monitored, but does not believe 
should be included in the severely adverse scenario, perhaps because 
these risks would render the scenario implausibly severe. For 
instance, the adverse scenario could feature sizable increases in 
oil or natural gas prices or shifts in the yield curve that are 
atypical in a recession. The adverse scenario might also feature 
less acute, but still consequential, adverse outcomes, such as a 
disruptive slowdown in growth from emerging-market economies.
    d. Under the Board's stress test rules, covered companies are 
required to develop their own scenarios for mid-cycle company-run 
stress tests.\39\ A particular combination of risks included in 
these scenarios may inform the design of the adverse scenario for 
annual stress tests. In this same vein, another possibility would be 
to use modified versions of the circumstances that companies 
describe in their living wills as being able to cause their 
failures.
---------------------------------------------------------------------------

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

    e. It might also be informative to periodically use a stable 
adverse scenario, at least for a few consecutive years. Even if the 
scenario used for the stress test does not change over the credit 
cycle, if companies tighten and relax lending standards over the 
cycle, their loss rates under the adverse scenario--and indirectly 
the projected changes to capital--would decrease and increase, 
respectively. A consistent scenario would allow the direct 
observation of how capital fluctuates to reflect growing cyclical 
risks.
    f. The Board may consider specifying the adverse scenario using 
the probabilistic approach described in section 4.2.1 (that is, with 
a specified lower probability of occurring than the severely adverse 
scenario but a greater probability of occurring than the baseline 
scenario). The approach has some intuitive appeal despite its 
shortcomings. For

[[Page 71446]]

example, using this approach for the adverse scenario could allow 
the Board to explore an alternative approach to develop stress 
testing scenarios and their effect on a company's net income and 
capital.
    g. Finally, the Board could design the adverse scenario based on 
a menu of historical experiences--such as, a moderate recession 
(e.g., the 1990-1991 recession); a stagflation event (e.g., 
stagflation during 1974); an emerging markets crisis (e.g., the 
Asian currency crisis of 1997-1998); an oil price shock (e.g., the 
shock during the run up to the 1990-1991 recession); or high 
inflation shock (e.g., the inflation pressures of 1977-1979). The 
Board believes these are important stresses that should be 
understood; however, there may be notable benefits from formulating 
the adverse scenario following other approaches--specifically, those 
described previously in this section--and consequently the Board 
does not believe that the adverse scenario should be limited to 
historical episodes only.
    h. With the exception of cases in which the probabilistic 
approach is used to generate the adverse scenario, the adverse 
scenario will at a minimum contain a mild to moderate recession. 
This is because most of the value from investigating the 
implications of the risks described above is likely to be obtained 
from considering them in the context of balance sheets of companies 
that are under some stress.

5. Approach for Formulating the Market Shock Component

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

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

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

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

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

5.2.1 Design Considerations for Market Shocks

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

5.2.2 Approaches to Market Shock Design

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

[[Page 71447]]

market shocks for each trading company, using information on the 
companies' portfolio gathered through ongoing supervision, or other 
means. By specifically targeting known or potential vulnerabilities 
in a company's trading position, the tailored approach will be 
useful in assessing each company's capital adequacy as it relates to 
the company's idiosyncratic risk. However, the Board does not 
believe this approach to be well-suited for the stress tests 
required by regulation. Consistency and comparability are key 
features of annual supervisory stress tests and annual company-run 
stress tests required in the stress test rules. It would be 
difficult to use the information on the companies' portfolio to 
design a common set of shocks that are universally stressful for all 
covered companies. As a result, this approach will be better suited 
to more customized, tailored stress tests that are part of the 
company's internal capital planning process or to other supervisory 
efforts outside of the stress tests conducted under the capital rule 
and the stress test rules.

5.2.3 Development of the Market Shock

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

5.3 Approach for Formulating the Market Shock Under the Adverse 
Scenario

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

[[Page 71448]]

    f. Finally, the design of the adverse scenario for annual stress 
tests could be informed by the companies' own trading scenarios used 
for their BHC-designed scenarios in CCAR and in their mid-cycle 
company-run stress tests.\40\
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    \40\ 12 CFR 252.145.
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6. Consistency Between the Macroeconomic Scenarios and the Market Shock

    a. As discussed earlier, the market shock comprises a set of 
movements in a very large number of risk factors that are realized 
instantaneously. Among the risk factors specified in the market 
shock are several variables also specified in the macroeconomic 
scenarios, such as short- and long-maturity interest rates on 
Treasury and corporate debt, the level and volatility of U.S. stock 
prices, and exchange rates.
    b. The market shock component is an add-on to the macroeconomic 
scenarios that is applied to a subset of companies, with no assumed 
effect on other aspects of the stress tests such as balances, 
revenues, or other losses. As a result, the market shock component 
may not be always directionally consistent with the macroeconomic 
scenario. Because the market shock is designed, in part, to mimic 
the effects of a sudden market dislocation, while the macroeconomic 
scenarios are designed to provide a description of the evolution of 
the real economy over two or more years, assumed economic conditions 
can move in significantly different ways. In effect, the market 
shock can simulate a market panic, during which financial asset 
prices move rapidly in unexpected directions, and the macroeconomic 
assumptions can simulate the severe recession that follows. Indeed, 
the pattern of a financial crisis, characterized by a short period 
of wild swings in asset prices followed by a prolonged period of 
moribund activity, and a subsequent severe recession is familiar and 
plausible.
    c. As discussed in section 4.2.4, the Board may feature a 
particularly salient risk in the macroeconomic assumptions for the 
severely adverse scenario, such as a fall in an elevated asset 
price. In such instances, the Board may also seek to reflect the 
same risk in one of the market shocks. For example, if the 
macroeconomic scenario were to feature a substantial decline in 
house prices, it may seem plausible for the market shock to also 
feature a significant decline in market values of any securities 
that are closely tied to the housing sector or residential 
mortgages.
    d. In addition, as discussed in section 4.3, the Board may 
specify the macroeconomic assumptions in the adverse scenario in 
such a way as to explore risks qualitatively different from those in 
the severely adverse scenario. Depending on the nature and type of 
such risks, the Board may also seek to reflect these risks in one of 
the market shocks as appropriate.

7. Timeline for Scenario Publication

    a. The Board will provide a description of the macroeconomic 
scenarios by no later than 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.
    b. The Board expects to provide a broad overview of the market 
shock component along with the macroeconomic scenarios. The Board 
will publish the market shock templates by no later than December 1 
of each year, and intends to publish the market shock earlier in the 
stress test and capital plan cycles to allow companies more time to 
conduct their stress tests.

                                                       Table 1--Classification of U.S. Recessions
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                                           Total change
                                                                                                                           Change in the      in the
                                                                                                            Decline in     Unemployment    Unemployment
            Peak                        Trough                   Severity           Duration (quarters)      Real GDP       Rate during     rate (incl.
                                                                                                                           the Recession     after the
                                                                                                                                            Recession)
--------------------------------------------------------------------------------------------------------------------------------------------------------
1957Q3.....................  1958Q2.....................  Severe................  4 (Medium)............            -3.6             3.2             3.2
1960Q2.....................  1961Q1.....................  Moderate..............  4 (Medium)............            -1.0             1.6             1.8
1969Q4.....................  1970Q4.....................  Moderate..............  5 (Medium)............            -0.2             2.2             2.4
1973Q4.....................  1975Q1.....................  Severe................  6 (Long)..............            -3.1             3.4             4.1
1980Q1.....................  1980Q3.....................  Moderate..............  3 (Short).............            -2.2             1.4             1.4
1981Q3.....................  1982Q4.....................  Severe................  6 (Long)..............            -2.8             3.3             3.3
1990Q3.....................  1991Q1.....................  Mild..................  3 (Short).............            -1.3             0.9             1.9
2001Q1.....................  2001Q4.....................  Mild..................  4 (Medium)............             0.2             1.3             2.0
2007Q4.....................  2009Q2.....................  Severe................  7 (Long)..............            -4.3             4.5             5.1
Average....................  ...........................  Severe................  6.....................            -3.5             3.7             3.9
Average....................  ...........................  Moderate..............  4.....................            -1.1             1.8             1.8
Average....................  ...........................  Mild..................  3.....................            -0.6             1.1             1.9
--------------------------------------------------------------------------------------------------------------------------------------------------------
Source: Bureau of Economic Analysis, National Income and Product Accounts, Comprehensive Revision on July 31, 2013.


    By order of the Board of Governors of the Federal Reserve 
System, November 6, 2013.
Robert deV. Frierson,
Secretary of the Board.
[FR Doc. 2013-27009 Filed 11-27-13; 8:45 am]
BILLING CODE 6210-01-P