Stress Testing Policy Statement, 6664-6671 [2019-03503]

Agencies

• FEDERAL RESERVE SYSTEM

[Federal Register Volume 84, Number 40 (Thursday, February 28, 2019)]
[Rules and Regulations]
[Pages 6664-6671]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2019-03503]


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FEDERAL RESERVE SYSTEM

12 CFR Part 252

[Regulation YY; Docket No. R-1649]
RIN 7100-AF 38


Stress Testing Policy Statement

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

ACTION: Final rule.

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SUMMARY: The Board is adopting a final policy statement on the approach 
to supervisory stress testing conducted under the Board's stress 
testing rules and the Board's capital plan rule.

DATES: Effective April 1, 2019.

FOR FURTHER INFORMATION CONTACT: Lisa Ryu, Associate Director, (202) 
263-4833, Kathleen Johnson, Assistant Director, (202) 452-3644, Robert 
Sarama, Assistant Director, (202) 973-7436, Joseph Cox, Senior 
Supervisory Financial Analyst, (202) 452-3216, Aurite Werman, Senior 
Financial Analyst, (202) 263-4802, Division of Supervision and 
Regulation; Benjamin W. McDonough, Assistant General Counsel, (202) 
452-2036, Julie Anthony, Senior Counsel, (202) 475-6682, or Asad 
Kudiya, Counsel, (202) 475-6358, Legal Division, Board of Governors of 
the Federal Reserve System, 20th Street and Constitution Avenue NW, 
Washington, DC 20551. Users of Telecommunication Device for Deaf (TDD) 
only, call (202) 263-4869.

SUPPLEMENTARY INFORMATION: 

Table of Contents

I. Background
II. Description of Stress Testing Policy Statement
III. Summary of Comments Received and Revisions to the Stress 
Testing Policy Statement
    A. Principles of Supervisory Stress Testing
    1. Independence
    2. Robustness and Stability
    3. Conservatism
    B. Supervisory Stress Test Model Policies
    1. Disclosure of Information Related to the Supervisory Stress 
Test
    2. Phasing in of Highly Material Model Changes
    3. Limiting Reliance on Past Outcomes
    4. Credit Supply Maintenance
    C. Principles and Policies of Supervisory Stress Test Model 
Validation
IV. Administrative Law Matters
    A. Use of Plain Language
    B. Paperwork Reduction Act Analysis
    C. Regulatory Flexibility Act Analysis

I. Background

    Supervisory stress testing is a tool that allows the Board to 
assess whether the largest and most complex financial firms are 
sufficiently capitalized to absorb losses in stressful economic 
conditions while continuing to meet obligations to creditors and other 
counterparties and to lend to households and businesses.
    The Board's approach to supervisory stress testing has evolved 
since the Supervisory Capital Assessment Program (SCAP) in 2009, which 
was the first evaluation of capital levels of bank holding companies 
(BHCs) on a forward-looking basis under stress. The lessons from SCAP 
encouraged the creation, pursuant to the Dodd-Frank Wall Street Reform 
and Consumer Protection Act (Dodd-Frank Act),\1\ of the Dodd-Frank Act 
Stress Test (DFAST), a forward-looking, quantitative evaluation of the 
impact of stressful economic and financial market conditions on firms' 
capital. Supervisory stress test models are used to produce estimates 
of post-stress capital ratios for covered companies,\2\ pursuant to the 
Dodd-Frank Act and the Board's stress test rules.\3\
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    \1\ 77 FR 62377 (October 12, 2012) (Stress Test rules). See 12 
CFR part 252, subparts E and F.
    \2\ Covered companies are BHCs with average total consolidated 
assets of $50 billion or more, U.S. intermediate holding companies 
of foreign banking organizations, and any nonbank financial company 
supervised by the Board. On July 6, 2018, the Board issued a public 
statement regarding the impact of the Economic Growth, Regulatory 
Relief, and Consumer Protection Act (EGRRCPA) (Pub. L. 115-174, 132 
Stat. 1296 (2018)). The Board stated, consistent with the EGRRCPA, 
that it will not take action to require BHCs with total consolidated 
assets greater than or equal to $50 billion but less than $100 
billion to comply with the Board's capital plan rule (12 CFR 225.8) 
or the Board's supervisory stress test and company-run stress test 
rules (12 CFR 252, subparts E and F). https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20180706b1.pdf.
    \3\ Public Law 111-203, 124 Stat. 1376 (2010); 12 CFR part 252, 
subpart E.
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    The supervisory models are also used in the Comprehensive Capital 
Analysis and Review (CCAR), a related supervisory program, pursuant to 
the Board's capital plan rule.\4\ CCAR focuses on forward-looking 
capital planning and the use of stress testing to assess firms' capital 
adequacy.\5\ By assessing the capital adequacy of a firm under severe 
projected economic and financial stress, the supervisory stress test 
complements minimum regulatory capital ratios, which reflect the firm's 
current condition.
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    \4\ 12 CFR 225.8.
    \5\ Id. CCAR also includes a qualitative assessment of capital 
planning practices at the largest and most complex firms, which is 
not the subject of this proposed Policy Statement.
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II. Description of Stress Testing Policy Statement

    On December 15, 2017, the Board invited comment on a proposal to 
adopt a stress testing policy statement (Policy Statement).\6\ The 
proposed Policy Statement would have described the Board's approach to 
the development, implementation, use, and validation of the Federal 
Reserve's supervisory stress test models, and would have complemented 
the Board's policy statement on scenario design.\7\ The proposal would 
have included seven principles that have guided decisions regarding 
supervisory stress test modeling in the past and that would continue to 
guide the development of the modeling framework. In addition, the 
proposed Policy Statement would have established procedures and 
policies designed to adhere to at least one of the foundational 
principles of supervisory stress testing. These policies and procedures 
would have included modeling-specific policies and associated 
assumptions, such as the policy of credit supply maintenance. Finally, 
the proposed Policy Statement would have addressed principles and 
policies of supervisory model validation, which is integral to the 
credibility of the supervisory stress test. By establishing these 
principles, policies, and procedures, the proposed Policy Statement 
would have increased transparency around the Federal Reserve's approach 
to supervisory modeling.
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    \6\ 82 FR 59528 (December 15, 2017).
    \7\ See 12 CFR 252, Appendix A.
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III. Summary of Comments Received and Revisions to the Stress Testing 
Policy Statement

    The Board received twelve comments in response to the proposal. 
Commenters included public interest groups, academics, individual 
banking organizations, and trade and industry groups. Commenters 
generally supported the elements of the proposed Policy Statement, and 
provided alternative views on certain principles and policies 
described.

A. Principles of Supervisory Stress Testing

1. Independence
    The proposed Policy Statement would have emphasized the use of 
independent supervisory models for assessing covered companies' capital 
adequacy. Supervisory models developed internally and independently

[[Page 6665]]

rely on detailed portfolio data provided by covered companies, but do 
not rely on models or estimates provided by covered companies to the 
greatest extent possible.
    Commenters were divided in their views on the use of independent 
supervisory models. Several commenters expressed the view that the 
stress testing program should be tailored to each covered company, and 
recommended that the Federal Reserve consider increasing its reliance 
on firms' own models. A commenter expressed the view that the Board is 
not required to use DFAST stress testing results in the CCAR 
quantitative assessment in order to treat firms consistently, and 
recommended that the Federal Reserve use its own models for the DFAST 
assessment and covered companies' models for the CCAR quantitative 
assessment.
    Other commenters strongly supported the principle of independence, 
and recommended that the Board maintain independently developed models 
separate from covered companies' models for use in the supervisory 
stress test. One commenter expressed the view that the Federal Reserve 
has an effective framework for carrying out stress tests of the largest 
firms, and another asserted that the failure of firms' internal models 
during the financial crisis showed the need for better model risk 
governance and a strong independent check on firm models.
    The Board will maintain independence as a central principle of 
supervisory stress testing. Supervisory models provide an independent 
check on firm risk management, and the use of consistent supervisory 
models in both the DFAST assessment and CCAR quantitative assessments 
is critical to ensuring that resulting capital requirements are based 
on a comparable assessment. Studies have found that covered companies' 
own models often produce materially different estimates of expected 
losses for the same set of portfolios.\8\ As a result, relying on those 
models could result in material differences in the assessment of post-
stress capital ratios across firms with similar risk profiles.
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    \8\ See Financial Services Authority, 2012, ``Results of 2011 
Hypothetical Portfolio Exercise for Sovereigns, Banks and Large 
Corporates,'' January 25, available at https://www.fsa.gov.uk/static/pubs/international/2011hpe.pdf; and Simon Firestone and Marcelo 
Rezende, ``Are Banks' Internal Risk Parameters Consistent? Evidence 
From Syndicated Loans,'' Journal of Financial Services Research, 
vol. 50, issue 2 (October 2016) pp. 211-242.
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    Independent models that are not specifically tailored to each 
individual institution are still appropriate for assessing risk, as 
such models do capture differences in risk when estimated on 
sufficiently granular data. Many of the supervisory models are 
estimated on a pooled set of loan- or securities-level data, and as a 
result, can capture differences in portfolio risk characteristics 
across firms in a consistent manner. Board staff regularly meets with 
covered companies and industry representatives to solicit input on how 
best to collect data, and the Board has in the past modified its 
information collection requirements based on feedback received.
2. Robustness and Stability
    Robustness and stability were described as key principles of 
supervisory stress testing in the proposed Policy Statement. 
Specifically, supervisory models should be robust and stable, such that 
changes in model projections over time are not driven by transitory 
factors.
    The estimates of post-stress capital produced by the supervisory 
stress test provide information regarding covered companies' capital 
adequacy to market participants, firms, and the general public. 
Adherence to the principle of robustness and stability helps to ensure 
that changes in these model projections over time are not driven by 
temporary variations in model performance or inputs.
    A commenter expressed concern about the inclusion of this 
principle, asserting that elevating stability to a central principle is 
likely to reinforce a tendency toward an excessively static stress 
test, and that incorporating new data in supervisory stress testing 
models could be important in capturing new risks.
    In response to the comment, the Board is maintaining an emphasis on 
robustness and stability as key principles of stress testing. This 
emphasis is intended not to limit the dynamism of the stress test as a 
supervisory tool, but rather to ensure that any changes in model 
projections reflect underlying risk factors, scenarios, and model 
enhancements. Supervisory models will continue to be recalibrated with 
newly available input data each year, and these data will affect 
supervisory model projections, particularly when the data reflect 
evolving risks. Generally, however, model recalibrations due to newly 
available data should not be the principal driver of year-over-year 
changes in results.
3. Conservatism
    The proposed Policy Statement would have established conservatism 
as a central principle of supervisory stress testing. Commenters 
generally supported the principle, asserting that the massive economic 
costs of a financial collapse argue for a commitment to erring on the 
conservative side. Accordingly, the final Policy Statement will reflect 
the Board's commitment, given a reasonable set of assumptions or 
approaches, to use those results that result in relatively more 
significant losses or lower revenue, all other things being equal.
4. Other Principles of Supervisory Stress Testing
    The Board sought comment on several other principles of supervisory 
stress testing described in the proposed Policy Statement. The proposed 
Policy Statement would have described a system of models designed to 
result in projections that are not only independent, robust and stable, 
and conservative, but also forward-looking, consistent and comparable 
across covered companies, generated from simpler and more transparent 
approaches, and able to capture the impact of economic stress. The 
Board did not receive comments specific to those proposed principles.
    One commenter recommended that the Board incorporate counter-
cyclicality as a stated principle of stress testing, noting that 
projected capital losses in the stress tests have improved in recent 
years even as economic conditions have improved and scenario severity 
has increased. Improvements in projected post-stress capital in recent 
stress test cycles do not solely reflect the Board's principles of 
supervisory stress test modeling and scenario design. Rather, a number 
of factors drive projected capital losses in the supervisory stress 
test. Year-over-year changes in the supervisory stress test results 
reflect not only the scenarios and supervisory models, but also 
portfolio composition and risk characteristics and the starting capital 
positions of firms, which tend to be procyclical. The Board already 
strives to limit procyclicality in the supervisory stress test through 
scenario design, and describes that goal in its policy statement on 
scenario design. Accordingly, the final Policy Statement will reflect 
the principles of supervisory stress testing as proposed.

B. Supervisory Stress Test Model Policies

    The proposed Policy Statement would have established policies and 
procedures to guide the development, implementation, and use of all 
models used in supervisory stress test projections. These policies 
would have

[[Page 6666]]

facilitated adherence to at least one of the governing principles 
described in the Supervisory Stress Test Model Policies section.
1. Disclosure of Information Related to the Supervisory Stress Test
    The proposed Policy Statement included a policy of information 
parity, such that the Board does not disclose information related to 
the supervisory stress test or firm-specific results to covered 
companies if that information is not also publicly disclosed. The 
proposed Policy Statement noted that increasing public disclosure can 
help the public understand and interpret the results of the supervisory 
stress test by facilitating evaluation of the quality of the Board's 
assessment, while promoting equitable treatment of covered companies.
    Commenters were divided on the Board's proposed policy. A commenter 
recommended that the Board engage in a confidential supervisory 
dialogue with individual covered companies in specific instances, such 
as when the results of the supervisory stress test deviate from the 
results of the firm's company-run stress test. This commenter also 
requested that the Board share information about data deficiencies with 
firms. Another commenter supported the Board's proposed approach to 
disclosure of information related to the supervisory stress test.
    The final Policy Statement retains the proposed policy of not 
disclosing information to covered companies that the Board does not 
also share with the public. This approach ensures that no single 
institution has access to information about the supervisory stress test 
that is not also publicly accessible by other institutions. For 
example, under this approach, firms newly subject to the supervisory 
stress test would have the same information as firms that have been 
subject to the supervisory stress test since its inception.
    The Board will maintain its current practice of notifying covered 
companies of deficient data identified by the Federal Reserve, and 
providing covered companies with the opportunity to remedy those 
deficient data. In addition, the Board plans to provide the public with 
more information about conservative assumptions applied to deficient 
data than it has in prior disclosures. The Board intends to provide in 
the annual disclosure of DFAST results the conservative loss rates that 
are applied to portfolios that cannot be modeled because of missing 
data.
2. Phasing in of Highly Material Model Changes
    The proposed Policy Statement would have established the policy 
that the Board phase in the most material model changes over two years, 
in the interest of reducing model-driven volatility in stress testing 
results. Commenters were divided on the proposed policy. One commenter 
asserted that phasing in highly material model changes could delay 
incorporation of material new data into the modeling process. Another 
commenter requested that the Board phase in all material model changes 
over two years, as opposed to phasing in the most material model 
changes over two years.
    In response to comments, the Board will continue to phase in the 
most material model changes over two years, so as not to introduce 
excess volatility to supervisory results. The Board has revised the 
final Policy Statement to include a description of the materiality 
threshold that generally determines the model changes subject to phase-
in over two years. Specifically, in assessing the materiality of a 
model change, the Federal Reserve calculates the impact of using an 
enhanced model on post-stress capital ratios using data and scenarios 
from prior years' supervisory stress test exercises. Under the final 
Policy Statement, the use of an enhanced model is considered a highly 
material change if its use results in a change in the CET1 ratio of 50 
basis points or more for one or more firms, relative to the model used 
in prior years' supervisory exercises. In general, the phase-in 
threshold for highly material model changes applies only to conceptual 
changes to models. Model changes related to changes in accounting or 
regulatory capital rules and model parameter re-estimation based on 
newly available data are implemented with immediate effect. The Board 
will continue to evaluate the appropriateness of the threshold for the 
model phase-in, including the cumulative effect of all model changes in 
a given year.
3. Limiting Reliance on Past Outcomes
    The proposed Policy Statement would have established a policy of 
limiting reliance on past outcomes, and minimizing the use of firm-
specific fixed effects in supervisory models, to allow for the 
incorporation of events that have not occurred historically in 
supervisory stress test modeling. A commenter requested that, where 
applicable, the Board provide detail on, and examples of, firm-specific 
fixed effects. The Board is finalizing the policy as described in the 
proposed Policy Statement. In finalizing the notice of enhanced model 
disclosure,\9\ the Board intends to expand its description of 
supervisory models that use firm-specific fixed effects in its enhanced 
model disclosure.
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    \9\ 82 FR 59547 (December 15, 2017).
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4. Credit Supply Maintenance
    The Board invited comment on its policy of credit supply 
maintenance, described in Section 2.7 of the proposed Policy Statement, 
as the assumption that firms' balance sheets would remain consistent or 
would increase in magnitude. Commenters generally supported the 
proposed policy. A commenter asserted that it is not sufficient to 
assume that firms maintain their asset size throughout the projection 
horizon, and that it is conservative and safer to assume some increase 
in firms' asset size. Another commenter expressed the view that the 
assumption of a flat or growing balance sheet is pivotal, as it 
reflects the role of banks in providing additional credit in a troubled 
economy.
    Several commenters encouraged the Board to assume that firms' 
balance sheets and risk-weighted assets (RWAs) stay constant, rather 
than grow, over the projection horizon.\10\ Other commenters asserted 
that the flat-to-rising balance sheet assumption is not consistent with 
historical patterns, and requested that the Federal Reserve make the 
more realistic assumption that firms' balance sheets and RWAs grow 
smaller in a stressed environment, in order to reflect likely bank 
behavior.
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    \10\ On April 25, 2018, the Board issued a notice of proposed 
rulemaking, which would revise the Board's stress test rules and 
capital plan rule to use the results of the supervisory stress test 
to size a firm's stress capital buffer and stress leverage buffer. 
As part of the proposal, the Board proposed to revise section 2.7 of 
the Policy Statement relating to credit supply maintenance to 
provide that, in projecting a firm's balance sheet, the Federal 
Reserve will assume that the firm takes actions to maintain a 
constant level of assets, including loans, trading assets, and 
securities over the planning horizon. The proposal would also add a 
new section 3.4 to the Policy Statement regarding a simple approach 
for projecting risk-weighted assets (RWAs). In projecting RWAs under 
this proposed section, the Federal Reserve would generally assume 
that a covered company's RWAs remain unchanged over the planning 
horizon. Those changes are still being proposed and are not being 
finalized as part of this notice.
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    The Board is finalizing the credit supply maintenance assumption as 
described in the proposed Policy Statement. The assumption that 
aggregate credit supply does not contract during the stress period is 
key to the aim of supervisory stress testing, which is to assess 
whether firms are sufficiently capitalized to both absorb

[[Page 6667]]

losses during times of economic stress and continue to lend to 
households and businesses and meet their obligations.
5. Other Supervisory Stress Test Model Policies
    The Board sought comment on several other supervisory stress test 
model policies described in the proposed Policy Statement. The proposed 
Policy Statement described policies and procedures related to soundness 
in model design, the treatment of the global market shock, 
incorporation of business plan changes, firm-specific overlays, 
treatment of missing or deficient data, and treatment of immaterial 
portfolios. The Board did not receive additional comments specific to 
those proposed policies and procedures.

C. Principles and Policies of Supervisory Model Validation

    Models used in the supervisory stress test are subject to ongoing 
review and validation by an independent unit within the Federal 
Reserve. The proposed Policy Statement described principles of model 
validation, central to the credibility of supervisory models and of the 
stress test exercise. The Board did not receive comments on its 
principles of supervisory model validation and is adopting the 
principles without change.

IV. Administrative Law Matters

A. Use of Plain Language

    Section 722 of the Gramm-Leach-Bliley Act (Pub. L. No 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 received no comments on these matters and 
believes 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 final policy 
statement to assess any information collections. There are no 
collections of information as defined by the Paperwork Reduction Act in 
the final policy statement.

C. Regulatory Flexibility Act Analysis

    The Regulatory Flexibility Act (RFA), 5 U.S.C. 601 et seq., 
generally requires that, in connection with a proposed rulemaking, an 
agency prepare and make available for public comment an initial 
regulatory flexibility analysis (IRFA).\11\ The Board solicited public 
comment on this policy statement in a notice of proposed rulemaking 
\12\ and has since considered the potential impact of this policy 
statement on small entities in accordance with section 604 of the RFA. 
Based on the Board's analysis, and for the reasons stated below, the 
Board believes the final rule will not have a significant economic 
impact on a substantial number of small entities.
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    \11\ See 5 U.S.C. 603, 604 and 605.
    \12\ 82 FR 59533 (December 15, 2017).
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    The RFA requires an agency to prepare a final regulatory 
flexibility analysis (FRFA) unless the agency certifies that the rule 
will not, if promulgated, have a significant economic impact on a 
substantial number of small entities. The FRFA must contain: (1) A 
statement of the need for, and objectives of, the rule; (2) a statement 
of the significant issues raised by the public comments in response to 
the IRFA, a statement of the agency's assessment of such issues, and a 
statement of any changes made in the proposed rule as a result of such 
comments; (3) the response of the agency to any comments filed by the 
Chief Counsel for Advocacy of the Small Business Administration in 
response to the proposed rule, and a detailed statement of any changes 
made to the proposed rule in the final rule as a result of the 
comments; (4) a description of an estimate of the number of small 
entities to which the rule will apply or an explanation of why no such 
estimate is available; (5) a description of the projected reporting, 
recordkeeping and other compliance requirements of the rule, including 
an estimate of the classes of small entities which will be subject to 
the requirement and type of professional skills necessary for 
preparation of the report or record; and (6) a description of the steps 
the agency has taken to minimize the significant economic impact on 
small entities, including a statement for selecting or rejecting the 
other significant alternatives to the rule considered by the agency.
    The final policy statement outlines the key principles and policies 
governing the Board's approach to models used in supervisory stress 
testing. The final policy statement is intended to increase 
transparency around the development, implementation, and validation of 
these models. Commenters did not raise any issues in response to the 
IRFA. In addition, the Chief Counsel for Advocacy of the Small Business 
Administration did not file any comments in response to the proposed 
policy statement.
    Under regulations issued by the Small Business Administration 
(SBA), a ``small entity'' includes a depository institution, bank 
holding company, or savings and loan holding company with assets of 
$550 million or less (small banking organizations).\13\ As discussed in 
the SUPPLEMENTARY INFORMATION, the final policy statement generally 
would apply to bank holding companies with total consolidated assets of 
$100 billion or more and U.S. intermediate holding companies of foreign 
banking, which generally have at least total consolidated assets of $50 
billion or more. Companies that are subject to the final policy 
statement therefore substantially exceed the $550 million asset 
threshold at which a banking entity is considered a ``small entity'' 
under SBA regulations. Because the final policy statement does not 
apply to any company with assets of $550 million or less, the final 
policy statement does not apply to any ``small entity'' for purposes of 
the RFA.
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    \13\ See 13 CFR 121.201.
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    There are no projected reporting, recordkeeping, or other 
compliance requirements associated with the final policy statement. As 
discussed above, the final policy statement does not apply to small 
entities.
    The Board does not believe that the final policy statement 
duplicates, overlaps, or conflicts with any other Federal Rules. In 
addition, the Board does not believe there are significant alternatives 
to the final policy statement that have less economic impact on small 
entities. In light of the foregoing, the Board does not believe the 
final 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 preamble, 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 6668]]



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

Appendix B--Stress Testing Policy Statement

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

1. Principles of Supervisory Stress Testing

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

1.1. Independence

    (a) In the supervisory stress test, the Federal Reserve uses 
supervisory models that are developed internally and independently 
(i.e., separate from models used by covered companies). The 
supervisory models rely on detailed portfolio data provided by 
covered companies but do not rely on models or estimates provided by 
covered companies to the greatest extent possible.
    (b) The Federal Reserve's stress testing framework is unique 
among regulators in its use of independent estimates of losses and 
revenues under stress. These estimates provide a perspective that is 
not formed in consultation with covered companies or influenced by 
firm-provided estimates and that is useful to the public in its 
evaluation of covered companies' capital adequacy. This perspective 
is also valuable to covered companies, who may benefit from external 
assessments of their own losses and revenues under stress, and from 
the degree of credibility that independence confers upon supervisory 
stress test results.
    (c) The independence of the supervisory stress test allows 
stress test projections to adhere to the other key principles 
described in the Policy Statement. The use of independent models 
allows for consistent treatment across firms. Losses and revenues 
under stress are estimated using the same modeling assumptions for 
all covered companies, enabling comparisons across supervisory 
stress test results. Differences in covered companies' results 
reflect differences in firm-specific risks and input data instead of 
differences in modeling assumptions. The use of independent models 
also ensures that stress test results are produced by stress-focused 
models, designed to project the performance of covered companies in 
adverse economic conditions.
    (d) In instances in which it is not possible or appropriate to 
create a supervisory model for use in the stress test, including 
when supervisory data are insufficient to support a modeled estimate 
of losses or revenues, the Federal Reserve may use firm-provided 
estimates or third-party models or data. For example, in order to 
project trading and counterparty losses, sensitivities to risk 
factors and other information generated by covered companies' 
internal models are used. In the cases where firm-provided or third-
party model estimates are used, the Federal Reserve monitors the 
quality and performance of the estimates through targeted 
examination, additional data collection, or benchmarking. The Board 
releases a list of the providers of third-party models or data used 
in the stress test exercise in the annual disclosure of quantitative 
results.

1.2. Forward-Looking

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

1.3. Consistency and Comparability

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

1.4. Simplicity

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

1.5. Robustness and Stability

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

1.6. Conservatism

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

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

    In evaluating whether supervisory models are appropriate for use 
in a stress testing exercise, the Federal Reserve places particular 
emphasis on supervisory models' abilities to project outcomes in 
stressed economic environments. In the supervisory stress test, the 
Federal Reserve also seeks to capture risks to capital that arise 
specifically in times of economic stress, and that would not be 
prevalent in more typical economic environments. For example, the 
Federal Reserve includes losses stemming from the default of a 
covered company's largest counterparty in its projections of post-
stress capital for firms with substantial trading or processing and 
custodian operations. The default of a company's largest 
counterparty is more likely to occur in times of severe economic 
stress than in normal economic conditions.

2. Supervisory Stress Test Model Policies

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

2.1. Soundness in Model Design

    (a) During development, the Federal Reserve (i) subjects 
supervisory models to extensive review of model theory and logic and 
general conceptual soundness; (ii) examines and evaluates 
justifications for modeling assumptions; and (iii) tests models to 
establish the accuracy and stability of the estimates and forecasts 
that they produce.
    (b) After development, the Federal Reserve continues to subject 
supervisory models to scrutiny during implementation to ensure that 
the models remain appropriate for use in the stress test exercise. 
The Federal Reserve monitors changes in the economic environment, 
the structure of covered

[[Page 6669]]

companies and their portfolios, and the structure of the stress 
testing exercise, if applicable, to verify that a model in use 
continues to serve the purposes for which it was designed. 
Generally, the same principles, rigor, and standards for evaluating 
the suitability of supervisory models that apply in model 
development and design will apply in ongoing monitoring of 
supervisory models.

2.2. Disclosure of Information Related to the Supervisory Stress 
Test

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

2.3. Phasing in of Highly Material Model Changes

    (a) The Federal Reserve may revise its supervisory stress test 
models to include advances in modeling techniques, enhancements in 
response to model validation findings, incorporation of richer and 
more detailed data, public comment, and identification of models 
with improved performance, particularly under adverse economic 
conditions. Revisions to supervisory stress models may at times have 
material impact on modeled outcomes.
    (b) In order to mitigate sudden and unexpected changes to the 
supervisory stress test results, the Federal Reserve follows a 
general policy of phasing highly material model changes into the 
supervisory stress test over two years. The Federal Reserve assesses 
whether a model change would have a highly significant impact on the 
projections of losses, components of revenue, or post-stress capital 
ratios for covered companies. In these instances, in the first year 
when the model change is first implemented, estimates produced by 
the enhanced model are averaged with estimates produced by the model 
used in the previous stress test exercise. In the second and 
subsequent years, the supervisory stress test exercise will reflect 
only estimates produced by the enhanced model. This policy 
contributes to the stability of the results of the supervisory 
stress test. By implementing highly material model changes over the 
course of two stress test cycles, the Federal Reserve seeks to 
ensure that changes in model projections primarily reflect changes 
in underlying risk factors and scenarios, year over year.
    (c) In general, phase-in thresholds for highly material model 
changes apply only to conceptual changes to models. Model changes 
related to changes in accounting or regulatory capital rules and 
model parameter re-estimation based on newly available data are 
implemented with immediate effect.
    (d) In assessing the materiality of a model change, the Federal 
Reserve calculates the impact of using an enhanced model on post-
stress capital ratios using data and scenarios from prior years' 
supervisory stress test exercises. The use of an enhanced model is 
considered a highly material change if its use results in a change 
in the CET1 ratio of 50 basis points or more for one or more firms, 
relative to the model used in prior years' supervisory exercises.

2.4. Limiting Reliance on Past Outcomes

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

2.5. Treatment of Global Market Shock and Counterparty Default 
Component

    (a) Both the global market shock and counterparty default 
components are exogenous components of the supervisory stress 
scenarios that are independent of the macroeconomic and financial 
market environment specified in those scenarios, and do not affect 
projections of risk-weighted assets or balances. The global market 
shock, which specifies movements in numerous market factors,\14\ 
applies only to covered companies with significant trading exposure. 
The counterparty default scenario component applies only to covered 
companies with substantial trading or processing and custodian 
operations. Though these stress factors may not be directly 
correlated to macroeconomic or financial assumptions, they can 
materially affect covered companies' risks. Losses from both 
components are therefore considered in addition to the estimates of 
losses under the macroeconomic scenario.
---------------------------------------------------------------------------

    \14\ See 12 CFR part 252, appendix A, ``Policy Statement on the 
Scenario Design Framework for Stress Testing,'' for a detailed 
description of the global market shock.
---------------------------------------------------------------------------

    (b) Counterparty credit risk on derivatives and repo-style 
activities is incorporated in supervisory modeling in part by 
assuming the default of the single counterparty to which the covered 
firm would be most exposed in the global market shock event.\15\

[[Page 6670]]

Requiring covered companies subject to the large counterparty 
default component to estimate and report the potential losses and 
effects on capital associated with such an instantaneous default is 
a simple method for capturing an important risk to capital for firms 
with large trading and custodian or processing activities. 
Engagement in substantial trading or custodial operations makes the 
covered companies subject to the counterparty default scenario 
component particularly vulnerable to the default of their major 
counterparty or their clients' counterparty, in transactions for 
which the covered companies act as agents. The large counterparty 
default component is consistent with the purpose of a stress testing 
exercise, as discussed in the principle about the focus on the 
ability to evaluate the impact of severe economic stress. The 
default of a covered company's largest counterparty is a salient 
risk in a macroeconomic and financial crisis, and generally less 
likely to occur in times of economic stability. This approach seeks 
to ensure that covered companies can absorb losses associated with 
the default of any counterparty, in addition to losses associated 
with adverse economic conditions, in an environment of economic 
uncertainty.
---------------------------------------------------------------------------

    \15\ In addition to incorporating counterparty credit risk by 
assuming the default of the covered company's largest counterparty, 
the Federal Reserve incorporates counterparty credit risk in the 
supervisory stress test by estimating mark-to-market losses, credit 
valuation adjustment (CVA) losses, and incremental default risk 
(IDR) losses associated with the global market shock.
---------------------------------------------------------------------------

    (c) The full effect of the global market shock and counterparty 
default components is realized in net income in the first quarter of 
the projection horizon in the supervisory stress test. The Board 
expects covered companies with material trading and counterparty 
exposures to be sufficiently capitalized to absorb losses stemming 
from these exposures that could occur during times of general 
macroeconomic stress.

2.6. Incorporation of Business Plan Changes

    (a) The Federal Reserve incorporates material changes in the 
business plans of covered companies, including mergers, 
acquisitions, and divestitures over the projection horizon, in the 
supervisory stress test projections. The incorporation of business 
plan changes in the supervisory stress test is a requirement of the 
capital plan rule,\16\ and captures a risk to the capital of covered 
companies. Allowing for the inclusion of mergers, acquisitions, and 
divestitures is forward-looking, as the Federal Reserve seeks to 
capture material impacts on a covered company's post-stress capital 
that may arise from a business plan change in the course of the 
projection horizon.
---------------------------------------------------------------------------

    \16\ 12 CFR 225.8(e)(2).
---------------------------------------------------------------------------

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

2.7. Credit Supply Maintenance

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

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

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

2.9. Treatment of Missing or Erroneous Data

    (a) Missing data, or data with deficiencies significant enough 
to preclude the use of supervisory models, create uncertainty around 
estimates of losses or components of revenue. If data that are 
direct inputs to supervisory models are not provided as required by 
the FR Y-14 information collection or are reported erroneously, then 
a conservative value will be assigned to the specific data based on 
all available data reported by covered companies, depending on the 
extent of data deficiency. If the data deficiency is severe enough 
that a modeled estimate cannot be produced for a portfolio segment 
or portfolio, then the Federal Reserve may assign a conservative 
rate (e.g., 10th or 90th percentile PPNR or loss rate, respectively) 
to that segment or portfolio.
    (b) This policy promotes the principle of conservatism, given a 
lack of information sufficient to produce a risk-sensitive estimate 
of losses or revenue components using information on the true 
characteristics of certain positions. This policy ensures consistent 
treatment for all covered companies that report data deemed 
insufficient to produce a modeled estimate. Finally, this policy is 
simple and transparent.

2.10. Treatment of Immaterial Portfolio Data

    (a) The Federal Reserve makes a distinction between insufficient 
data reported by covered companies for material portfolios and 
immaterial portfolios. To limit regulatory burden, the Federal 
Reserve allows covered companies not to report detailed loan-level 
or portfolio-level data for loan types that are not material as 
defined in the FR Y-14 reporting instructions. In these cases, a 
loss rate representing the median rates among covered companies for 
whom the rate is calculated will be applied to the immaterial 
portfolio. This approach is consistent across covered companies, 
simple, and transparent, and promotes the principles of consistency 
and comparability and simplicity.

3. Principles and Policies of Supervisory Model Validation

    (a) Independent and comprehensive model validation is key to the 
credibility of

[[Page 6671]]

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

3.1. Structural Independence

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

3.2. Technical Competence of Validation Staff

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

3.3. Stature of Validation Function

    (a) The validation program informs the Board of Governors about 
the state of model risk in the overall stress testing program, along 
with ongoing practices to control and mitigate model risk.
    (b) The model validation program communicates its findings and 
recommendations regarding model risk to relevant parties within the 
Federal Reserve System. Validators provide detailed feedback to 
model developers and provide thematic feedback or observations on 
the overall system of models to the management of the modeling 
teams. Model validation feedback is also communicated to the users 
of supervisory model output for use in their deliberations and 
decisions about supervisory stress testing. In addition, the 
Director of the Division of Supervision and Regulation approves all 
models used in the supervisory stress test in advance of each 
exercise, based on validators' recommendations, development 
responses, and suggestions for risk mitigants. In several cases, 
models have been modified or implemented differently based on 
validators' feedback. The Model Validation Council also contributes 
to the stature of the Federal Reserve's validation program, by 
providing an external point of view on modifications to supervisory 
models and on validation program governance.

    By order of the Board of Governors of the Federal Reserve 
System, February 22, 2019.
Ann Misback,
Secretary of the Board.
[FR Doc. 2019-03503 Filed 2-27-19; 8:45 am]
 BILLING CODE 6210-01-P