Federal Reserve Supervisory Stress Test Framework and Model Methodology

Federal Reserve Supervisory Stress Test Results

This section describes the Federal Reserve's severely adverse scenario projections of losses, revenue, expenses, and capital positions for the 18 BHCs participating in DFAST 2013. The projections presented in this section are based on the severely adverse scenario developed by the Federal Reserve.

The results include projections of post-stress capital ratios for each of the 18 BHCs over the nine-quarter planning horizon spanning the fourth quarter of 2012 to the end of 2014. These ratios include the ratio of the common equity component of tier 1 capital to risk-weighted assets (the tier 1 common ratio), the ratio of tier 1 capital to risk-weighted assets (the tier 1 capital ratio), the ratio of total regulatory capital to risk-weighted assets (the total risk-based capital ratio), and the ratio of tier 1 capital to average assets (the tier 1 leverage ratio).²² The results also include projections of the components of net income before taxes, including revenues, provisions, and losses, as well as components of loan losses.

The Federal Reserve's projections assume the capital actions prescribed in the Dodd-Frank stress test rules. According to these assumptions, over the nine-quarter planning horizon, each BHC maintains its common stock dividend payments at the same level as the previous year; scheduled dividend, interest, or principal payments on any other capital instrument eligible for inclusion in the numerator of a regulatory capital ratio are assumed to be paid; but repurchases of such capital instruments and issuance of stock is assumed to be zero. As a result, the Federal Reserve's projections do not incorporate any changes in capital actions that BHCs might undertake in reaction to stressed financial conditions. The assumed capital actions also do not incorporate any increases in distributions that BHCs might be planning to make over the nine-quarter planning horizon.

These results are presented both in the aggregate for the 18 BHCs and for individual BHCs. The aggregate results provide a sense of the stringency of the severely adverse scenario projections and the sensitivity of these BHCs as a group to the stressed economic and financial market conditions contained in that scenario. The range of results across individual BHCs reflects differences in business focus, asset composition, revenue and expense sources, as well as differences in portfolio risk characteristics. In addition, the post-stress capital ratio projections reflect differences in capital actions across the BHCs prescribed in the Dodd-Frank stress test final rules. The comprehensive results for individual BHCs are reported in appendix C.

Stressed Regulatory Capital Ratios

The projections suggest significant declines in regulatory capital ratios for nearly all the BHCs under the severely adverse scenario. Overall, the total amount of tier 1 common capital held by the 18 BHCs is estimated to fall by more than $240 billion, or about 31 percent, from the third quarter of 2012 to the fourth quarter of 2014 under the severely adverse scenario and with prescribed capital actions over this period. As shown in table 1, in the aggregate each of the four capital ratios decline over the course of the planning horizon, with year-end 2014 levels ranging from 2.1 percentage points to 4.0 percentage points lower than at the start of the planning horizon.Table 2 presents these ratios for each of the 18 BHCs.

Table 3 shows estimates of the minimum tier 1 common ratio during the severely adverse scenario for each of the 18 BHCs with all prescribed capital actions through the fourth quarter of 2014.

The changes in post-stress regulatory capital ratios vary considerably across BHCs (see figures 8 and 9 and table 2). Overall, post-stress regulatory capital ratios decline from the beginning to the end of the planning horizon for all but two of the BHCs. The post-stress capital ratios incorporate projected levels of total average assets and risk-weighted assets over the planning horizon, based on projections provided by the BHCs in their FR Y-14 submissions. Because the Federal Reserve's projections of losses and PPNR also reflect the projected growth or reduction of risk-weighted assets and total assets for each BHC, projected changes in risk-weighted assets and total assets do not always have a straightforward effect on projected stressed capital ratios.

Projected Losses

The Federal Reserve's severely adverse scenario projections suggest that the 18 BHCs as a group would experience significant losses under the severely adverse scenario. In this scenario, losses are projected to be $462 billion for the 18 BHCs in the aggregate over the nine quarters of the planning horizon. These losses include $317 billion in accrual loan portfolio losses, $13 billion in OTTI and other realized securities losses, $97 billion in trading and counterparty losses at the six BHCs with large trading portfolios, and $36 billion in additional losses from items such as loans measured under the fair-value option (losses on these loans were calculated based on the global market shock, consistent with the treatment of fair valued positions in the trading portfolio), and goodwill impairment charges. Table 1 presents these results in the aggregate, while table 4 presents them individually for each of the 18 BHCs.

The biggest sources of loss are losses on the accrual loan portfolios and trading and counterparty losses from the global market shock. Together, these two account for nearly 90 percent of the projected losses for the 18 BHCs under the severely adverse scenario (figure 10).

Loan Losses

Projected losses on consumer-related lending--domestic residential mortgages, credit cards, and other consumer loans--represent 67 percent of projected loan losses and 46 percent of total projected losses for the 18 BHCs (see figure 10 and table 1). This is consistent with both the share of these types of loans in the BHCs' loan portfolios--these loans represent 54 percent of the accrual loan portfolio at these firms as of the third quarter of 2012--and with the severely adverse scenario, which features very high unemployment rates and significant further declines in housing prices. Losses on domestic residential mortgage loans, including both first liens and junior liens/home equity, is the single largest category of losses, at $97 billion, representing 31 percent of total projected loan losses. Projected losses on credit card lending--at $87 billion--is the second largest category, representing 28 percent. The next largest category is projected losses on commercial and industrial loans, at $61 billion.

For the 18 BHCs as a group, the nine-quarter cumulative loss rate on the accrual loan portfolio is 7.5 percent, where the loss rate is calculated as total projected loan losses over the nine quarters of the planning horizon divided by average loan balances over the horizon. This rate is very high by historical standards, more severe than any U.S. recession since the 1930s. As illustrated in figure 11, total loan loss rates vary significantly across BHCs, ranging between 2.0 percent and 13.2 percent across these institutions.

The differences in total loan loss rates across the BHCs reflect differences in loan portfolio composition and differences in risk characteristics for each type of lending across these firms. Loan portfolio composition matters because projected loss rates vary significantly by loan type.²³ In the aggregate, nine-quarter cumulative loss rates range between 1.8 percent on other loans and 16.7 percent on credit cards, reflecting both differences in typical performance of these loans--some loan types tend to generate higher losses, though generally also higher revenue--and differences in the sensitivity of lending to the severely adverse scenario. In particular, lending categories whose performance is sensitive to unemployment rates or housing prices may experience high stressed loss rates due to the considerable stress on these factors in the severely adverse scenario.

Figures 12 through 18 present the nine-quarter cumulative loss rates on seven different categories of loans for each of the 18 BHCs. There are significant differences across BHCs in projected loan loss rates for similar types of loans. For example, while the median projected loss rate on domestic first-lien residential mortgages is 6.0 percent, the rates among BHCs with first lien mortgage portfolios vary from a low of 0.6 percent to a high of 10.3 percent. Similarly, for commercial and industrial loans, the range of projected loss rates is from 3.5 percent to 49.8 percent, with a median of 6.5 percent. Projected loss rates on most loan categories show similar dispersion across BHCs.²⁴

Differences in projected loss rates across BHCs primarily reflect differences in loan characteristics, such as loan-to-value ratio or debt service coverage ratio, and borrower characteristics, such as credit rating or FICO score. In addition, some BHCs have taken write-downs on portfolios of impaired loans either purchased or acquired through mergers. Losses on these loans are projected using the same loss models used for loans of the same type, and the resulting loss projections are reduced by the amount of such write-downs. For these BHCs, projected loss rates will be lower than for BHCs that hold similar loans not subject to purchase-related write-downs.

Losses on Trading, Private Equity, and Derivatives Positions

The severely adverse scenario results include $97 billion in trading and counterparty credit losses from the global market shock at the six BHCs with large trading, private equity, and counterparty exposures from derivatives and financing transactions. Trading and counterparty credit losses range between $7 billion and $25 billion across the six BHCs (see table 4), with the largest losses at those BHCs with the most significant trading activities. Even so, the relative size of losses across firms depends not on nominal portfolio size, but rather on the specific risk characteristics of each BHC's trading positions, inclusive of hedges. Importantly, projected losses related to the global market shock are based on the trading positions held by these firms on a single date (November 14, 2012) and could have differed, perhaps significantly over the nine-quarter planning horizon, based on trading positions from a different date.

Projected Pre-Provision Net Revenue and Net Income

In the aggregate, the 18 BHCs are projected to generate $268 billion in PPNR cumulatively over the nine quarters of the planning horizon, equal to 2.4 percent of average assets for these firms (see table 1). Relatively low PPNR projections reflect low levels of net interest income because of the effect of low interest rates and further flattening of the yield curve in the early part of the severely adverse scenario, given the BHCs' current and projected balance sheet composition. The results also reflect low levels of non-interest income, consistent with the falling asset prices and sharply contracting economic activity in the severely adverse scenario. In addition, the PPNR projections incorporate elevated levels of losses from operational-risk events such as fraud, employee lawsuits, or computer system or other operating disruptions and expenses related to put-backs of mortgages, netted against reserves already taken by the BHCs.²⁵

The ratio of projected cumulative PPNR to average assets varies across BHCs (see figure 19 and table 4). A significant portion of this variation reflects differences in business focus across the institutions. For instance, the ratio of PPNR to assets tends to be higher at BHCs focusing on credit card lending, reflecting the higher net interest income that credit cards generally produce relative to other forms of lending.²⁶ Lower PPNR rates do not necessarily imply lower net income, however, since the same business focus and revenue risk characteristics determining differences in PPNR across firms could also result in offsetting differences in projected losses.

Projected PPNR and losses are the primary determinants of projected net income. Table 1 presents aggregate projections of the components of pre-tax net income, including provisions into the ALLL and one-time income and expense and extraordinary items, under the severely adverse scenario. Table 4 presents these projections for each of the 18 BHCs. The projections are cumulative for the nine quarters of the planning horizon.

Of note, following U.S. GAAP, the net income projections incorporate loan losses indirectly through provisions, which equal projected loan losses plus the amount needed for the ALLL to be at an appropriate level at the end of each quarter. The slightly more than $317 billion in total provisions reported in table 1 is the result of slightly less than $317 billion in net charge-offs and almost no net change in the ALLL over the nine-quarter planning horizon. Table 1 is cumulative over the planning horizon, and masks variation in the ALLL during the course of the nine quarters. Specifically, the projected ALLL increases during the early quarters of the planning horizon, given the increased economic stress in the severely adverse scenario, and then declines as the economic stress abates.

The Federal Reserve's projections of pre-tax net income under the severely adverse scenario imply negative net income at most of the 18 BHCs individually, and for the BHCs as a group, over the nine quarter planning horizon. As table 1 shows, projected net income before taxes ("pre-tax net income") is -$194 billion over the planning horizon for the 18 BHCs.

Figure 20 illustrates the ratio of pre-tax net income to average assets for each of the 18 BHCs. The ratio ranges between -7.1 percent and 1.6 percent. Projected cumulative net income for most of the BHCs (13 of 18) is negative over the planning horizon. Differences across the firms reflect differences in the sensitivity of the various components of net income to the economic and financial market conditions in the severely adverse scenario. Projected net income for the six BHCs with large trading operations is also affected by the effect of the global market shock on their trading, private equity, and counterparty exposures from derivatives and financing transactions, introducing some additional variation in projected net income between these six BHCs and the other firms participating in DFAST 2013.

References

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