Executive Summary

The Federal Reserve expects large, complex bank holding companies (BHCs) to hold sufficient capital to continue lending to support real economic activity, even under adverse economic conditions. Stress testing is one tool that helps bank supervisors measure whether a BHC has enough capital to support its operations throughout periods of stress. The Federal Reserve previously highlighted the use of stress tests as a means of assessing capital sufficiency under stress during the 2009 Supervisory Capital Assessment Program (SCAP) and the 2011 and 2012 Comprehensive Capital Analysis and Review (CCAR) exercises.¹

In the wake of the financial crisis, the Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), ² which requires the Federal Reserve to conduct an annual stress test of large BHCs and all nonbank financial companies designated by the Financial Stability Oversight Council (FSOC) for Federal Reserve supervision to evaluate whether they have sufficient capital to absorb losses resulting from adverse economic conditions. The Dodd-Frank Act also requires BHCs and other financial companies supervised by the Federal Reserve to conduct their own stress tests. The Federal Reserve adopted rules implementing these requirements in October 2012. Under the rules, 18 BHCs are part of the Dodd-Frank Act supervisory stress tests this year (DFAST 2013).³

This report describes the hypothetical, severely adverse scenario designed by the Federal Reserve; provides an overview of the analytical framework and methods used to generate the projections of revenues, expenses, losses, and the resulting post-stress capital ratios for each of the 18 BHCs; and discloses the results of the 2013 Dodd-Frank Act supervisory stress test. The Federal Reserve believes that disclosure of stress test results provides valuable information to market participants and the public, enhances transparency, and promotes market discipline. The projections provide a unique perspective on the robustness of the capital positions of these firms because they incorporate detailed information about the risk characteristics and business activities of each BHC and because they are estimated using a consistent approach across all the BHCs, providing comparable results across firms. The Federal Reserve also believes that providing information about the methodology used to produce the results will offer useful context to interpret those results.

The projections were calculated using input data provided by the 18 BHCs and a set of models developed or selected by the Federal Reserve, ⁴ based on a hypothetical, severely adverse macroeconomic and financial market scenario developed by the Federal Reserve. The severely adverse scenario features a deep recession in the United States, Europe, and Japan, significant declines in asset prices and increases in risk premia, and a marked economic slowdown in developing Asia. The Federal Reserve also applied a separate global market shock to six BHCs with large trading, private equity, and counterparty exposures from derivatives and financing transactions.⁵

The models project revenues, expenses, losses, and the resulting post-stress capital ratios for each BHC over a nine-quarter planning horizon extending through the end of 2014. The Federal Reserve's projections should not be interpreted as expected or likely outcomes for these firms, but rather as possible results under hypothetical, severely adverse conditions. These projections incorporate a number of conservative modeling assumptions, but do not make explicit behavioral assumptions about the possible actions of a BHC's creditors and counterparties in the scenario, except through the severely adverse scenario's characterizations of financial asset prices and economic activity.

To make the projections of post-stress capital ratios more comparable across BHCs, the projections reflect assumptions about capital distributions prescribed in the Dodd-Frank Act stress test rule. Over the nine-quarter planning horizon, each BHC maintains its common stock dividend payments at the same level as the previous year, but repurchases and issuance of common stock is assumed to be zero except for common stock issuance associated with expensed employee compensation.⁶

The results of these projections suggest that, in the aggregate, the 18 BHCs would experience substantial losses under the severely adverse scenario. Over the nine quarters of the planning horizon, losses at the 18 BHCs under the severely adverse scenario are projected to be $462 billion, including losses across loan portfolios, losses on securities held in the BHCs' investment portfolios, trading and counterparty credit losses from the global market shock, and other losses. Projected net revenue before provisions for loan and lease losses (pre-provision net revenue, or PPNR) at the 18 BHCs over the nine quarters of the planning horizon under the severely adverse scenario is $268 billion, which is net of losses related to operational-risk events and mortgage repurchases, as well as expenses related to disposition of owned real estate of $101 billion. Taken together, the high projected losses and low projected PPNR at the 18 BHCs results in projected net income before taxes of -$194 billion.

These net income projections result in substantial projected declines in regulatory capital ratios for nearly all of the BHCs under the severely adverse scenario. As illustrated in figure 1, the aggregate tier 1 common ratio would fall from an actual 11.1 percent in the third quarter of 2012 to a post-stress level of 7.7 percent in the fourth quarter of 2014, including assumed capital actions for the 18 BHCs.

Errata

References

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