Supervisory Scenarios
On February 3, 2017, the Federal Reserve released the three supervisory scenarios: baseline, adverse, and severely adverse.19 This section describes the adverse and severely adverse scenarios that were used for the projections contained in this report. These scenarios were developed using the approach described in the Board's Policy Statement on the Scenario Design Framework for Stress Testing.20 The adverse and severely adverse scenarios are not forecasts, but rather hypothetical scenarios designed to assess the strength of banking organizations and their resilience to an unfavorable economic environment.
Supervisory scenarios include trajectories for 28 variables. These include 16 variables that capture economic activity, asset prices, and interest rates in the U.S. economy and financial markets and three variables (real gross domestic product (GDP) growth, inflation, and the U.S./foreign currency exchange rate) in each of the four countries/country blocks.
Similar to last year, the Federal Reserve applied a global market shock to the trading portfolio of six BHCs with large trading and private equity exposures and a counterparty default scenario component to eight BHCs with substantial trading, processing, or custodial operations (see Global Market Shock and Counterparty Default Components).
Severely Adverse Scenario
Figures 2 through 7 illustrate the hypothetical trajectories for some of the key variables describing U.S. economic activity and asset prices under the severely adverse scenario.
Figure 2. Unemployment rate in the severely adverse and adverse scenarios, 2012:Q1-2020:Q1
Source: Bureau of Labor Statistics and Federal Reserve assumptions in the supervisory scenarios.
Figure 3. Real GDP growth rate in the severely adverse and adverse scenarios, 2012:Q1-2020:Q1
Source: Bureau of Economic Analysis and Federal Reserve assumptions in the supervisory scenarios.
Figure 4. Dow Jones Total Stock Market Index, end of quarter, in the severely adverse and adverse scenarios, 2012:Q1-2020:Q1
Source: Dow Jones and Federal Reserve assumptions in the supervisory scenarios.
Figure 5. National House Price Index in the severely adverse and adverse scenarios, 2012:Q1-2020:Q1
Source: CoreLogic (seasonally adjusted by Federal Reserve) and Federal Reserve assumptions in the supervisory scenarios.
Figure 6. U.S. BBB corporate yield, quarterly average in the severely adverse and adverse scenarios, 2012:Q1-2020:Q1
Source: Merrill Lynch (adjusted by Federal Reserve using a Nelson-Siegel smoothed yield curve model) and Federal Reserve assumptions in the supervisory scenarios.
Figure 7. U.S. Market Volatility Index (VIX) in the severely adverse and adverse scenarios, 2012:Q1-2020:Q1
Source: Chicago Board Options Exchange (converted to quarterly by Federal Reserve using the maximum quarterly close-of-day value) and Federal Reserve assumptions in the supervisory scenarios.
The severely adverse scenario is characterized by a severe global recession that is accompanied by a period of heightened stress in corporate loan markets and commercial real estate markets. In this scenario, the level of U.S. real GDP begins to decline in the first quarter of 2017 and reaches a trough in the second quarter of 2018 that is about 6-1/2 percent below the pre-recession peak. The unemployment rate increases by about 5-1/4 percentage points, to 10 percent, by the third quarter of 2018. Headline consumer price inflation falls to about 1-1/4 percent at an annual rate by the second quarter of 2017 and then rises to about 1-3/4 percent at an annual rate by the middle of 2018.
As a result of the severe decline in real activity, short-term Treasury rates fall and remain near zero through the end of the scenario period. The 10-year Treasury yield drops to 3/4 percent in the first quarter of 2017, rising gradually thereafter to around 1-1/2 percent by the first quarter of 2019 and to about 1-3/4 percent by the first quarter of 2020. Financial conditions in corporate and real estate lending markets are stressed severely. The spread between yields on investment-grade corporate bonds and yields on long-term Treasury securities widens to about 5-1/2 percentage points by the end of 2017, an increase of 3-1/2 percentage points relative to the fourth quarter of 2016. The spread between mortgage rates and 10-year Treasury yields widens to over 3-1/2 percentage points over the same time period.
Asset prices drop sharply in this scenario. Equity prices fall by 50 percent through the end of 2017, accompanied by a surge in equity market volatility, which approaches the levels attained in 2008. House prices and commercial real estate prices also experience large declines, with house prices and commercial real estate prices falling by 25 percent and 35 percent, respectively, through the first quarter of 2019.
The international component of this scenario features severe recessions in the euro area, the United Kingdom, and Japan and a marked growth slowdown in developing Asia. As a result of the sharp contraction in economic activity, all foreign economies included in the scenario experience a decline in consumer prices. As in this year's adverse scenario, the U.S. dollar appreciates against the euro, the pound sterling, and the currencies of developing Asia but depreciates modestly against the yen because of flight-to-safety capital flows.
This year's severely adverse scenario features a slightly more severe downturn in the U.S. economy as compared to the DFAST 2016 scenario. Under the scenario design framework, the unemployment rate in the severely adverse scenario will reach a peak of at least 10 percent, which leads to a progressively greater increase in the unemployment rate the further the starting unemployment rate is below 6 percent. Furthermore, this year's scenario does not feature a path of negative short-term U.S. Treasury rates that was featured in last year's scenario. In addition, this year's severely adverse scenario features a larger decline in commercial real estate prices. The international dimension of the scenarios shows recessionary episodes that, relative to last year's scenario, are more severe in the euro area and United Kingdom but less severe in developing Asia.
Adverse Scenario
Figures 2 through 7 illustrate the hypothetical trajectories for some of the key variables describing U.S. economic activity and asset prices under the adverse scenario.
The adverse scenario is characterized by weakening economic activity across all of the economies included in the scenario. This economic downturn is accompanied by a global aversion to long-term fixed-income assets that, despite lower short rates, brings about a near-term rise in long-term rates and steepening yield curves in the United States and the four countries/country blocks in the scenario.
In the adverse scenario, the U.S. economy experiences a moderate recession that begins in the first quarter of 2017. Real GDP falls slightly more than 2 percent from the pre-recession peak in the fourth quarter of 2016 to the recession trough in the first quarter of 2018, while the unemployment rate rises steadily, peaking at about 7-1/4 percent in the third quarter of 2018. The U.S. recession is accompanied by an initial fall in inflation through the third quarter of 2017, with the rate of increase in consumer prices then rising steadily and reaching 2 percent by the middle of 2018.
Reflecting weak economic conditions, short-term interest rates in the United States fall and remain near zero for the rest of the scenario period. With the increase in term premiums, 10-year Treasury yields gradually rise to a little less than 2-3/4 percent by the second half of 2018. Financial conditions tighten for corporations and households during the recession. Spreads between investment-grade corporate bond yields and 10-year Treasury yields widen to about 3-3/4 percentage points by the end of 2017, while spreads between mortgage rates and 10-year Treasury yields widen to about 2-1/2 percentage points over the same period.
Asset prices decline in the adverse scenario. Equity prices fall approximately 40 percent through the fourth quarter of 2017, accompanied by a rise in equity market volatility. Aggregate house prices and commercial real estate prices experience less sizable but more sustained declines compared to equity prices; house prices fall 12 percent through the first quarter of 2019 and commercial real estate prices fall 15 percent through the fourth quarter of 2018.
Following the recession in the United States, real activity picks up slowly at first and then gains momentum; growth in real U.S. GDP accelerates from an increase of 1 percent at an annual rate in the second quarter of 2018 to an increase of 3 percent at an annual rate by the middle of 2019. The unemployment rate declines modestly, from its peak of about 7-1/4 percent in the third quarter of 2018 to under 7 percent by the end of the scenario period. Consumer price inflation remains at roughly 2 percent from the middle of 2018 through the end of the scenario period. Ten-year Treasury yields show little change after the second half of 2018 and remain around 2-3/4 percent.
Outside of the United States, the adverse scenario features recessions in the euro area, the United Kingdom, and Japan, as well as below-trend growth in developing Asia. The declines in activity in the euro area and the United Kingdom are broadly similar and less pronounced than in Japan.
Weakness in global demand results in a slowing in inflation in all of the foreign economies under consideration. Japan experiences outright deflation through the first quarter of 2019. Reflecting flight-to-safety capital flows, the U.S. dollar appreciates against the euro, the pound sterling, and the currencies of developing Asia. The dollar depreciates modestly against the yen, also in line with flight-to-safety capital flows.
The main difference relative to the 2016 adverse scenario is that this year's adverse scenario features higher long-term rates and a steeper yield curve across all of the economies during the recession. Another difference from last year's scenario is the incidence and extent of deflationary episodes. The 2016 adverse scenario featured wide-spread deflation across all of the economies included in the scenario. In this year's adverse scenario, deflation is regionally concentrated--more pronounced in Japan, less severe in the euro area and developing Asia, and absent in the United Kingdom and United States.
Global Market Shock and Counterparty Default Components
The Federal Reserve applied a global market shock to the trading portfolios of six BHCs with large trading and private equity exposures.21 In addition, the Federal Reserve applied a counterparty default component, which assumes the default of a BHC's largest counterparty under the global market shock, to the same six BHCs and two other BHCs with substantial trading, processing, or custodial operations.22 These components are an add-on to the economic conditions and financial market environment specified in the adverse and severely adverse scenarios.
The global market shock is a set of instantaneous, hypothetical shocks to a large set of risk factors. Generally, these shocks involve large and sudden changes in asset prices, interest rates, and spreads, reflecting general market dislocation and heightened uncertainty.23 The Federal Reserve published the global market shock for the adverse and severely adverse scenarios on February 3, 2017; the as-of date for the global market shock and the counterparty default is January 3, 2017.
The severely adverse scenario's global market shock is designed around three main elements: a sudden sharp increase in general risk premiums and credit risk; significant market illiquidity; and the distress of one or more large entities that rapidly sell a variety of assets into an already fragile market. Liquidity deterioration is most severe in those asset markets that are typically less liquid, such as non-agency securitized products, corporate debt, and private equity, and is less pronounced in those markets that are typically more liquid, such as foreign exchange, publicly traded equity, and U.S. Treasury markets.
Markets facing a significant deterioration in liquidity experience conditions that are generally comparable to the peak-to-trough changes in asset valuations during the 2007-2009 period. The severity of deterioration reflects the market conditions that could occur in the event of a significant pullback in market liquidity in which market participants are less able to engage in market transactions that could offset or moderate the price dislocations. Worsening liquidity also leads prices of related assets that would ordinarily be expected to move together to diverge markedly.
In particular, the valuation of certain cash market securities and their derivative counterparts fail to move together because the normal market mechanics that would ordinarily result in small pricing differentials are impeded by a lack of market liquidity. Notably, option-adjusted spreads on agency mortgage-backed securities (MBSs) increase significantly.
Globally, government bond yield curves undergo marked shifts in level and shape due to market participants' increased risk aversion. The flight-to-quality and lack of liquidity in affected markets push risk-free rates down in the United States. The yield curves for government bonds flatten or invert across Europe and Asia while volatility increases across the term structure. Emerging market countries with deteriorating economic and fiscal accounts would also experience a sharp increase in sovereign spreads.
The major differences between the global market shock under the 2017 and 2016 severely adverse scenarios include (1) dampened shocks to interest rates and other liquid markets, (2) increased shocks to select commodities and equities basis risks, and (3) a less severe widening in spreads between agency MBSs and to-be-announced (TBA) forwards.
The global market shock component for the adverse scenario simulates an extended low-growth environment and muted market volatility across most asset classes and term structures. Generally, domestic government yields and associated volatility move lower, while swap spreads widen. Due to reduced demand, global commodity prices decline moderately, while MBSs and domestic credit spreads widen moderately. Select currency markets also experience small flight-to-quality moves. Equity markets experience a mild correction with a measured increase in volatility. The 2017 adverse scenario addresses themes similar to those of the 2016 adverse scenario.
The eight BHCs with substantial trading or custodial operations were also required to incorporate a counterparty default scenario component into their supervisory adverse and severely adverse stress scenarios. These BHCs were required to estimate and report the potential losses and related effects on capital associated with the instantaneous and unexpected default of the counterparty that would generate the largest losses across their derivatives and securities financing activities, including securities lending and repurchase or reverse-repurchase agreement activities.
References
19. See Board of Governors of the Federal Reserve System (2017), "2017 Supervisory Scenarios for Annual Stress Tests Required under the Dodd-Frank Act Stress Testing Rules and the Capital Plan Rule" (Washington, DC: Board of Governors, February 3), https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20170203a5.pdf for additional information and for the details of the supervisory scenarios. Return to text
20. CFR part 252, appendix A. Return to text
21. The six BHCs subject to the global market shock are Bank of America Corporation; Citigroup Inc.; The Goldman Sachs Group, Inc.; JPMorgan Chase & Co.; Morgan Stanley; and Wells Fargo & Co. See 12 CFR 252.54(b)(2). Return to text
22. The eight BHCs subject to the counterparty default component are Bank of America Corporation; The Bank of New York Mellon Corporation; Citigroup Inc.; The Goldman Sachs Group, Inc.; JPMorgan Chase & Co.; Morgan Stanley; State Street Corporation; and Wells Fargo & Co. See 12 CFR 252.54(b)(2). Return to text
23. See CCAR 2017: Severely Adverse Global Market Shocks at https://www.federalreserve.gov/econres/files/ccar-2017-severely-adverse-market-shocks.xlsx, and CCAR 2017: Adverse Global Market Shocks at https://www.federalreserve.gov/econres/files/ccar-2017-adverse-market-shocks.xlsx. Return to text