Supervisory Stress Test Framework and Model Methodology

Analytical Framework

The Federal Reserve estimated the effect of the supervisory scenarios on the regulatory capital ratios of the 31 BHCs participating in DFAST 2015 ¹⁴ by projecting the balance sheet, RWAs, net income, and resulting capital for each BHC over the nine-quarter planning horizon, which for DFAST 2015 begins in the fourth quarter of 2014 and ends in the fourth quarter of 2016. Projected net income, adjusted for the effect of taxes, is combined with capital action assumptions to project changes in equity capital. The approach followed is consistent with U.S. generally accepted accounting principles (GAAP) and regulatory capital rules.¹⁵ Figure 8 illustrates the framework used to calculate changes in net income and regulatory capital.

 

Projected net income for the 31 BHCs is generated from projections of revenue, expenses, and various types of losses and provisions that flow into pre-tax net income, including

• pre-provision net revenue (PPNR);
• loan losses and changes in the allowance for loan and lease losses (ALLL);
• losses on loans held for sale and measured under the fair-value option;
• other-than-temporary impairment (OTTI) losses on investment securities in the available-for-sale (AFS) and held-to-maturity (HTM) portfolios;
• for BHCs with large trading and private equity exposures, losses on those exposures resulting from a global market shock; and,
• for BHCs with substantial trading, processing, or custodial operations, losses from the default of their largest counterparty.

The projection of PPNR includes net interest income plus noninterest income minus noninterest expense. Consistent with U.S. GAAP, the projection of PPNR incorporates projected losses generated by operational-risk events such as fraud, computer system or other operating disruptions, and litigation-related costs; mortgage repurchase related losses; and expenses related to the disposition of foreclosed properties (other real estate owned (OREO) expenses).

Provisions for loan and lease losses equal projected loan losses for the quarter plus the amount needed for the ending ALLL to be at an appropriate level to account for projected future loan losses. The amount of provisions over and above loan losses may be negative--representing a drawdown of the ALLL (an ALLL release, increasing net income)--or positive--representing a need to build the ALLL (an additional provision, decreasing net income).

Because the loss projections follow U.S. GAAP and regulatory guidelines, they incorporate any differences in the way these guidelines recognize income and losses based on where assets are held on the BHCs' balance sheets. As a result, losses projected for similar or identical assets held in different portfolios can sometimes differ. For example, losses on loans held in accrual portfolio equal credit losses due to failure to pay obligations (cash flow losses resulting in net charge-offs). For similar loans that are held for sale, projected losses represent the change in fair value of the underlying assets in the supervisory scenario.

Following this approach, changes in both the fair value of AFS securities and OTTI losses on securities are separately projected over the nine-quarter planning horizon. Under U.S. GAAP, changes in the fair value of AFS securities are reflected in changes in accumulated other comprehensive income (AOCI) but do not flow through net income. In addition, if a security becomes OTTI, all or a portion of the difference between the fair value and amortized cost of the security must be recognized in earnings.¹⁶ Consistent with U.S. GAAP, OTTI projections incorporate other-than-temporary differences between book value and fair value due to credit impairment but generally do not incorporate differences reflecting changes in liquidity or market conditions.

For the six BHCs subject to the global market shock, the losses on trading and private equity positions as well as the credit valuation adjustment are projected assuming an instantaneous re-pricing of these positions under the global market shock (see Global Market Shock and Counterparty Default Components). Losses from the global market shock are assumed to occur in the first quarter of the planning horizon. No subsequent recoveries on these positions are assumed, nor are there offsetting changes such as reductions in compensation or other expenses in reaction to the global market shock. In addition, incremental losses from potential defaults of obligors underlying BHCs' trading positions are projected over the planning horizon.

For the eight BHCs subject to the counterparty default component, the losses associated with the instantaneous and unexpected default of the largest counterparty across derivatives and securities financing transaction (SFT) activities are projected. These losses are assumed to occur in the first quarter of the planning horizon.

Over the planning horizon, the Federal Reserve projects quarter-end amounts for the components of the balance sheet. These projections are made under the assumption that BHCs maintain credit supply at long-run historical levels. Any new balances implied by these projections are assumed to have the same risk characteristics as those held by the BHC at the start of the planning horizon except for loan age. Where applicable, new loans are assumed to be current, and BHCs are assumed not to originate types of loans that are no longer allowed under various regulations. The Federal Reserve also incorporates material changes in a BHC's business plan, such as a planned merger, acquisition, or divestiture.¹⁷ Only divestitures that had been completed or contractually agreed to prior to January 5, 2015, were incorporated. Once adjusted, assets are assumed to grow at the same rate as the pre-adjusted balance sheet.

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Modeling Approach

The Federal Reserve's projections of revenue, expenses, and various types of losses and provisions that flow into pre-tax net income are based on data provided by the 31 BHCs participating in DFAST 2015 and on models developed or selected by Federal Reserve staff and reviewed by an independent group of Federal Reserve economists and analysts. The models are intended to capture how the balance sheet, RWAs, and net income of each BHC are affected by the macroeconomic and financial conditions described in the supervisory scenarios, given the characteristics of the BHCs' loans and securities portfolios; trading, private equity, and counterparty exposures from derivatives and SFTs; business activities; and other relevant factors.¹⁸

Detail of model-specific methodology is provided in appendix B.

The Federal Reserve's approach to model design reflects the desire to produce supervisory stress test projections that

• are based on the same set of models and assumptions across BHCs;

• reflect an independent supervisory perspective;

• are forward-looking and may incorporate outcomes outside of historical experience; and

• are appropriately conservative and consistent with the purpose of a stress testing exercise.

With these objectives in mind, the models were developed using pooled historical data from many financial institutions and multiple data sources. As a result, the estimated parameters are the same for all BHCs and reflect the industrywide, portfolio-specific, and instrument-specific response to variation in the macroeconomic and financial market variables. This industrywide approach reflects both the challenge in estimating separate, statistically robust models for each of the 31 BHCs and the desire of the Federal Reserve not to assume that historical BHC-specific results will prevail in the future. This means that the projections made by the Federal Reserve will not necessarily match similar projections made by individual BHCs.

The Federal Reserve deviated from the industrywide modeling approach only in a very limited number of cases in which the historical data used to estimate the model were not sufficiently granular. In these cases, BHC-specific indicator variables (fixed effects) were included in the models. Additionally, in some cases, the projections of certain types of losses use sensitivities generated by the BHCs from their internal risk-measurement models.

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Model Methodology and Validation

A large majority of the models used for the supervisory stress test were developed by Federal Reserve analysts and economists, but a few are third-party models.¹⁹ Internally developed models draw on economic research and analysis as well as industry practice in modeling the effect of borrower, instrument, collateral characteristics, and macroeconomic factors on revenue, expenses, and losses. The approaches mostly build on work done by the Federal Reserve in previous stress tests. In some cases, the models represent significant refinement and advancement of earlier work, reflecting advances in modeling technique, richer and more detailed data, and longer histories of performance in both adverse and more benign economic settings (see box 1).

All models are reviewed each year by an independent model validation team composed of economists and analysts from across the Federal Reserve System with a focus on the design, estimation, and implementation of the models. Model reviewers are primarily Federal Reserve subject-matter experts who are not involved in model development and who report to a different oversight group than model developers. Additionally, control procedures surrounding the model design and implementation processes are reviewed by process control experts.

Loan losses are estimated separately for different categories of loans, based on the type of obligor (e.g., consumer or commercial and industrial), collateral (e.g., residential real estate, commercial real estate), loan structure (e.g., revolving credit lines), and accounting treatment (accrual or fair value). These categories generally follow the classifications of the Consolidated Financial Statements for Holding Companies (FR Y-9C) regulatory report, though some loss projections are made for more granular loan categories.²⁰

Two general approaches are taken to model losses on the accrual loan portfolio. In the first approach, the models estimate expected losses under the macroeconomic scenario. These models generally involve projections of the probability of default, loss given default, and exposure at default for each loan or segment of loans in the portfolio, given conditions in the scenario. In the second approach, the models capture the historical behavior of net charge-offs relative to changes in macroeconomic and financial market variables.

Accrual loan losses are projected using detailed loan information, including borrower characteristics, collateral characteristics, characteristics of the loans or credit facilities, amounts outstanding and yet to be drawn down (for credit lines), payment history, and current payment status.

Data are collected on individual loans or credit facilities for wholesale loan, domestic retail credit card, and residential mortgage portfolios. For other domestic and international retail loans, the data are collected based on segments of the portfolio (e.g. segments defined by borrower credit score, geographic location, and loan-to-value (LTV) ratio).

Losses on retail loans for which a BHC chose the fair-value option accounting treatment and loans carried at the lower of cost or market value (i.e. loans held for sale and held for investment) are estimated over the nine quarters of the planning horizon using a duration-based approach. Losses on wholesale loans held for sale or measured under the fair-value option are estimated by revaluing each loan or commitment each quarter of the planning horizon.

Losses on securities held in the AFS and HTM portfolios are estimated using models that incorporate other-than-temporary differences between amortized cost and fair market value due to credit impairment but generally do not incorporate differences reflecting changes in liquidity or market conditions. Some securities, including U.S. Treasury and U.S. government agency obligations and U.S. government agency mortgage-backed securities, are assumed not to be at risk for the kind of credit impairment that results in OTTI charges. For securitized obligations, models estimate delinquency, default, severity, and prepayment on the underlying pool of collateral. OTTI on direct obligations such as corporate bonds is based on an assessment of the probability of default or severe credit deterioration of the security issuer or group of issuers over the planning horizon. The models use securities data collected at the individual security (CUSIP) level, including the amortized cost, market value, and any OTTI taken on the security to date.

Losses related to the global market shock and the counterparty default components are estimated using BHC-estimated sensitivities to various market factors of trading positions, private equity, and other fair-value assets held in the trading book and the revaluations of counterparty exposures and credit valuation adjustment based on the global market shock. These estimates are based on BHCs' internal models and methodologies and are provided to the Federal Reserve by the BHCs (see Global Market Shock and Counterparty Default Components).

PPNR is projected using a series of models that relate the components of a BHC's revenues and non-credit-related expenses, expressed as a share of relevant asset or liability balances, to BHC characteristics and to macroeconomic variables. Most components are projected using data on historical revenues and operating and other non-credit-related expenses reported on the FR Y-9C report. Separate data are collected about mortgage loans that were sold or securitized but expose a BHC to potential put-back risk and the BHCs' historical losses related to operational-risk events, which are modeled separately from other components of PPNR.

The balance sheet projections are derived using a common framework for determining the effect of the scenarios on balance sheet growth, and, as noted, incorporate assumptions about credit supply that limit aggregate credit contraction. These sets of projections are based on historical data from the Federal Reserve's national flow of funds accounts, consolidated balance sheet information for each BHC, and additional data collected by the Federal Reserve.

Once pre-tax net income is determined using the above components, a consistent tax rate is applied to calculate after-tax net income.²¹ After-tax net income also includes other tax effects, such as changes in the valuation allowance applied to deferred tax assets, and BHC-reported information about extraordinary income items and income attributable to minority interests.

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Data Inputs

The models are developed and executed with data collected by the Federal Reserve on regulatory reports as well as proprietary third-party industry data.

Certain projections rely on aggregate information from the Financial Accounts of the United States (Z.1) statistical release, which is a quarterly publication by the Federal Reserve of national flow of funds; balance sheets; and integrated macroeconomic accounts by sector, such as households and nonfinancial corporate businesses.²² Others rely on the FR Y-9C report, which contains consolidated income statement and balance sheet information for each BHC. Additionally, FR Y-9C includes off-balance sheet items and other supporting schedules, such as the components of RWA and regulatory capital.

Most of the data used in the Federal Reserve's projections are collected through the Capital Assessments and Stress Testing (FR Y-14A/Q/M) reports, which include a set of annual, quarterly, or monthly schedules.²³ These reports collect detailed data on PPNR, loans, securities, trading and counterparty risk, and losses related to operational-risk events. Each of the 31 BHCs participating in DFAST 2015 submitted data as of September 30, 2014, through the FR Y-14M and FR Y-14Q schedules in October and November of 2014 and the FR Y-14A schedules, which also include projected data, on January 5, 2015.

BHCs were required to submit detailed loan and securities information for all material portfolios, where the portfolio is deemed to be "material" if the size of the portfolio exceeds either 5 percent of the BHC's tier 1 capital or $5 billion. The portfolio categories are defined in the FR Y-14M and Y-14Q instructions. For portfolios falling below these thresholds, the BHCs had the option to submit or not submit the detailed data. Portfolios for which the Federal Reserve did not receive detailed data were assigned a loss rate equal to a high percentile of the loss rates projected for BHCs that did submit data for that category of loan or security.

While BHCs are responsible for ensuring the completeness and accuracy of data reported on the FR Y-14, the Federal Reserve made considerable efforts to validate BHC-reported data and requested resubmissions of data where errors were identified. In certain instances, loans with insufficient or unreliable data were assigned a loss rate at or near the 90th percentile of the loss rates projected for the relevant loan segment for the BHCs that did provide reliable data. Where certain data elements were unreported, conservative values were assigned (e.g., high LTV values or low credit scores).²⁴ These assumptions are intended to reflect a conservative view of the risk characteristics of the portfolios, given insufficient information to make more risk-sensitive projections.

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Capital Action Assumptions and Regulatory Capital Ratios

After-tax net income and AOCI are combined with prescribed capital actions to estimate components of equity capital. Changes in the equity capital components are the primary drivers in changes in capital levels and ratios over the planning horizon. In addition to the equity capital components, the calculation of capital ratios accounts for taxes and items subject to adjustment or deduction, limits the recognition of certain intangible assets, and imposes other restrictions as specified in the Board's regulatory capital rules.

The Dodd-Frank Act company-run stress test rules prescribe consistent capital action assumptions for all BHCs. In its supervisory stress tests, the Board generally followed these capital action assumptions. For the first quarter of the planning horizon, capital actions for each BHC are assumed to be the actual actions taken by the BHC during that quarter. Over the remaining eight quarters, common stock dividend payments are assumed to be the average of the first quarter of the planning horizon and the three preceding calendar quarters. Also, BHCs are assumed to pay scheduled dividend, interest, or principal payments on any other capital instrument eligible for inclusion in the numerator of a regulatory capital ratio. However, repurchases of such capital instruments and issuance of stock are assumed to be zero, except for common-stock issuance associated with expensed employee compensation or in connection with a planned merger or acquisition.

The four regulatory capital ratios in DFAST 2015 are common equity tier 1, tier 1 risk-based capital, total risk-based capital, and tier 1 leverage. A BHC's regulatory capital ratios are calculated in accordance with the Board's regulatory capital rules using Federal Reserve projections of assets and RWAs. In 2013, the Board adopted revisions to its regulatory capital framework to address shortcomings in capital requirements that became apparent during the financial crisis.²⁵ The revisions to the regulatory capital framework introduce a new common equity tier 1 capital ratio, strengthen the eligibility criteria for capital, and otherwise increase the quantity and quality of capital that banking organizations are required to hold. These revisions are being phased in between 2014 and 2019. Calculations of regulatory capital for a given BHC are in accordance with the regulatory requirements that will be in effect during a particular quarter of the planning horizon for that BHC.

The applicable transition arrangements for the regulatory capital ratios vary depending on whether a BHC is an "advanced approaches BHC," which is defined as a BHC that has total consolidated assets greater than or equal to $250 billion, or total consolidated on-balance sheet foreign exposures of at least $10 billion. Specifically, advanced approaches BHCs became subject to a common equity tier 1 ratio and an increased tier 1 risk-based capital ratio in 2014, while all other BHCs became subject to these requirements beginning in 2015.²⁶

Starting in 2015, the regulatory capital framework introduces a new standardized approach for calculating risk-weighted assets, which replaces the calculation of risk weights using the general risk-based capital approach set forth in the Board's capital adequacy guidelines (general risk-based capital approach).²⁷ For this stress test cycle, the denominator of each BHC's regulatory capital ratios was calculated using the general risk-based capital approach for the first quarter of the planning horizon (the fourth quarter of 2014) and using the standardized approach for the remaining quarters of the planning horizon.

Notably, eight BHCs began calculating their risk-weighted assets using the advanced approaches rule in the second quarter of 2014.²⁸ Under the regulatory capital rules, these firms are required to meet the minimum risk-based capital ratios under both the advanced approaches rules and under the generally applicable risk-based capital rules. However, DFAST 2015 does not incorporate measures of risk-weighted assets using the advanced approaches rules.²⁹

In addition to the four regulatory capital ratios, DFAST 2015 includes projections of a BHC's tier 1 common capital ratio. The tier 1 common capital ratio equals the common equity portion of tier 1 capital divided by RWAs calculated under the general risk-based capital approach.

Preserving the tier 1 common capital ratio maintains consistency with previous stress testing cycles during the phase-in of the new common equity tier 1 capital ratio. The tier 1 common capital ratio differs from the common equity tier 1 ratio in the following ways:

• For advanced approaches BHCs, most elements of AOCI flow through to common equity tier 1 but not to tier 1 common capital.
• More assets are subject to deduction from common equity tier 1 capital than from tier 1 common capital, including investments in unconsolidated financial institutions and all deferred tax assets that arise from operating losses and tax credit carryforwards.
• Beginning in 2015 (the second quarter of the planning horizon), the denominators of the two ratios use different approaches for calculating RWAs.

Table 1 shows the rules used to calculate the numerators and denominators of the capital ratios as well as the timing of implementation of these rules for advanced approaches and non-advanced approaches BHCs.

Table 1. Applicable capital ratios and calculations in the 2015 Dodd-Frank Act stress tests

Capital ratio	Aspect of ratio	2014:Q4	2015-16
Advanced approaches BHCs
Common equity tier 1 ratio	Capital in numerator	Revised capital framework	Revised capital framework
	Denominator	General approach RWAs	Standardized approach RWAs
Tier 1 ratio	Capital in numerator	Revised capital framework	Revised capital framework
	Denominator	General approach RWAs	Standardized approach RWAs
Total capital ratio	Capital in numerator	Revised capital framework	Revised capital framework
	Denominator	General approach RWAs	Standardized approach RWAs
Tier 1 leverage ratio	Capital in numerator	Revised capital framework	Revised capital framework
	Denominator	Average assets	Average assets
Tier 1 common ratio	Capital in numerator	Basel I-based capital	Basel I-based capital
	Denominator	General approach RWAs	General approach RWAs
Other BHCs
Common equity tier 1 ratio	Capital in numerator	n.a.	Revised capital framework
	Denominator	n.a.	Standardized approach RWAs
Tier 1 ratio	Capital in numerator	Basel I-based capital	Revised capital framework
	Denominator	General approach RWAs	Standardized approach RWAs
Total capital ratio	Capital in numerator	Basel I-based capital	Revised capital framework
	Denominator	General approach RWAs	Standardized approach RWAs
Tier 1 leverage ratio	Capital in numerator	Basel I-based capital	Revised capital framework
	Denominator	Average assets	Average assets
Tier 1 common ratio	Capital in numerator	Basel I-based capital	Basel I-based capital
	Denominator	General approach RWA	General approach RWA

"Basel I-based capital" indicates that regulatory capital is calculated under the rules in place before the implementation of the revised capital framework (see 12 CFR part 225, appendix A). "Revised capital framework" indicates that regulatory capital is calculated under the revised capital framework. "General Approach RWAs" indicates that risk-weighted assets are calculated using the approach under the general risk-based capital rules (see 12 CFR part 225, appendix A), while "Standardized approach RWAs" indicates that risk-weighted assets are calculated using the standardized approach under the revised capital framework. Not applicable (n.a.) indicates that the capital ratio was not calculated for that time period. An advanced approaches BHC includes any BHC that has consolidated assets greater than or equal to $250 billion or total consolidated on-balance sheet foreign exposure of at least $10 billion as of December 31, 2014. See 12 CFR 217.100(b)(1). Other BHCs include any BHC that is subject to 12 CFR 225.8 and is not an advanced approaches BHC.

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References

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