Board of Governors of the Federal Reserve System

Introduction

The Dodd-Frank Wall Street Reform and Consumer Protection Act requires the Board of Governors of the Federal Reserve System (Board) to conduct an annual supervisory stress test of bank holding companies (BHCs) and U.S. intermediate holding companies of foreign banking organizations (IHCs) (collectively, firms) with $50 billion or greater in total consolidated assets, and to require firms and state member banks with total consolidated assets of more than $10 billion to conduct company-run stress tests at least once a year.¹ This publication describes the three supervisory scenarios--baseline, adverse, and severely adverse--that the Board will use in its supervisory stress test this year; that a firm or state member bank must use in conducting its annual company-run stress test; and that a firm must use to estimate projected revenues, losses, reserves, and pro forma capital levels as part of its 2018 capital plan submission.² The publication also details additional components that the largest and most complex firms will be required to incorporate into the supervisory scenarios--the global market shock component and the counterparty default component--and the additional scenario components to which certain IHCs will be subject (market risk components).

Supervisory Scenarios

The adverse and severely adverse scenarios describe hypothetical sets of conditions designed to assess the strength of banking organizations and their resilience to adverse economic environments. The baseline scenario follows a profile similar to the average projections from a survey of economic forecasters. The scenarios are not forecasts of the Federal Reserve.³

The scenarios start in the first quarter of 2018 and extend through the first quarter of 2021. Each scenario includes 28 variables; this set of variables is the same as the set provided in last year's supervisory scenarios. The variables describing economic developments within the United States include:

• Six measures of economic activity and prices: percent changes (at an annual rate) in real and nominal gross domestic product (GDP); the unemployment rate of the civilian non-institutional population aged 16 years and over; percent changes (at an annual rate) in real and nominal disposable personal income; and the percent change (at an annual rate) in the consumer price index (CPI);
• Four aggregate measures of asset prices or financial conditions: indexes of house prices, commercial real estate prices, equity prices, and U.S. stock market volatility; and
• Six measures of interest rates: the rate on the 3-month Treasury bill; the yield on the 5-year Treasury bond; the yield on the 10-year Treasury bond; the yield on a 10-year BBB corporate security; the interest rate associated with a conforming, conventional, 30-year fixed-rate mortgage; and the prime rate.

The variables describing international economic conditions in each scenario include three variables in four countries or country blocks:

• The three variables for each country or country block: the percent change (at an annual rate) in real GDP, the percent change (at an annual rate) in the CPI or local equivalent, and the level of the U.S. dollar exchange rate.
• The four countries or country blocks included: the euro area (the 19 European Union member states that have adopted the euro as their common currency), the United Kingdom, developing Asia (the nominal GDP-weighted aggregate of China, India, South Korea, Hong Kong Special Administrative Region, and Taiwan), and Japan.

Baseline, Adverse, and Severely Adverse Scenarios

The following sections describe the baseline, adverse, and severely adverse scenarios. The variables included in these scenarios are provided in tables at the end of this document. They can also be downloaded (together with the historical time series of the variables) from the Board's website, at www.federalreserve.gov/bankinforeg/dfa-stress-tests.htm. Historical data for the domestic and the international variables are reported in Tables 1.A and 1.B, respectively.

Baseline Scenario

The baseline outlook for U.S. real activity, inflation, and interest rates (see Table 2.A) is similar to the January 2018 consensus projections from Blue Chip Economic Indicators.⁴ This scenario does not represent the forecast of the Federal Reserve.

The baseline scenario for the United States is a moderate economic expansion through the projection period. Real GDP grows on average between 2 and 2-1/2 percent over the scenario period, with slightly stronger growth during 2018. The unemployment rate falls below 4 percent in the second half of 2018, remains below 4 percent through the first half of 2020, and rises to a little above 4 percent thereafter. CPI inflation averages 2 percent in 2018 and 2-1/4 percent through the end of the scenario period.

Accompanying the moderate economic expansion, Treasury yields are assumed to rise modestly across the maturity spectrum for most of the scenario period before leveling off. Short-term Treasury rates increase from about 1-1/2 percent at the beginning of 2018 to about 2-1/2 percent by the second half of 2019, while yields on 10-year Treasury securities rise from 2-1/2 percent to about 3-1/2 percent by the beginning of 2020. The prime rate increases in line with short-term Treasury rates and mortgage rates rise in line with long-term Treasury yields. Reflecting steady growth and stable economic conditions, spreads between yields on investment-grade corporate bonds and yields on long-term Treasury securities widen only slightly over the scenario period. Equity prices rise about 5 percent on average each year over the scenario period. Equity market volatility rises modestly. Nominal house prices rise about 2-1/2 percent in 2018 and 2019, and an average of about 3 percent per year thereafter. Commercial real estate prices rise about 5 percent in 2018 and 2019, and an average of about 3 percent per year through the end of the scenario period.

The baseline scenario for international variables (see Table 2.B) is similar to that reported in the January 2018 Blue Chip Economic Indicatorsand the International Monetary Fund's October 2017 World Economic Outlook.⁵ It features an expansion in international economic activity, albeit one that proceeds at different rates in the four countries or country blocks under consideration. Real GDP growth in developing Asia averages about 6 percent in 2018, slowing slightly to about 5-3/4 percent per year through the end of the scenario period; similarly, real GDP growth in Japan averages about 1-1/4 percent in 2018 and slows to slightly less than 1 percent by the end of 2019; real GDP growth in the euro area averages slightly above 2 percent in 2018 and slows gradually to 1-1/2 percent at the end of the scenario period. Finally, growth in the United Kingdom averages about 1-1/2 percent per year through the scenario period.

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 rapid declines in long-term rates and flattening yield curves in the United States and the four countries/country blocks in the scenario. It is important to note that this is a hypothetical scenario designed to assess the strength of banking organizations and their resilience to adverse economic conditions. This scenario does not represent a forecast of the Federal Reserve.

In the adverse scenario, the U.S. economy experiences a moderate recession that begins in the first quarter of 2018 (see Table 3.A). Real GDP falls slightly more than 2-1/4 percent from the pre-recession peak in the fourth quarter of 2017 to the recession trough in the first quarter of 2019, while the unemployment rate rises steadily, peaking at 7 percent in the third quarter of 2019. The U.S. recession is accompanied by an initial fall in inflation in the first two quarters of 2018. The rate of increase in consumer prices then rises steadily before leveling off at around 2 percent by the second half of 2019.

Reflecting weak economic conditions, short-term interest rates in the United States decline to nearly zero, where they remain for the rest of the scenario period. Yields on 10-year Treasury securities drop to around 3/4 of a percent in the first quarter of 2018 as the yield curve flattens, and then gradually rise to slightly less than 2 percent by the end of the scenario. Financial conditions tighten for corporations and households during the recession. Spreads between investment-grade corporate bond yields and 10-year Treasury yields gradually rise to about 3-3/4 percentage points by early 2019, while spreads between mortgage rates and 10-year Treasury yields widen to about 2-3/4 percentage points over the same period.

Asset prices decline in the adverse scenario. Equity prices fall approximately 30 percent by early 2019, accompanied by a rise in equity market volatility. Nominal house prices and commercial real estate prices experience sustained declines; house prices fall 12 percent and commercial real estate prices fall 15 percent by the first quarter of 2020.

Following the recession, U.S. real activity picks up slowly at first and then gains momentum; growth in U.S. real GDP increases from 3/4 of a percent in 2019 to about 3 percent in 2020. The unemployment rate declines modestly, to about 6-1/4 percent by the end of the scenario period. Consumer price inflation remains at roughly 2 percent through the end of the scenario period. Yields on 10-year Treasury securities continue to rise gradually to slightly less than 2 percent by the end of the scenario period.

Outside of the United States, the adverse scenario features moderate recessions in the euro area and the United Kingdom, a pronounced and protracted recession in Japan, as well as below-trend growth in developing Asia (see Table 3.B). Weakness in global demand results in slowing inflation in all of the foreign economies under consideration and the onset of deflationary episodes in Japan and--more modestly--developing Asia. 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.

Comparison of the 2018 Adverse Scenario and the 2017 Adverse Scenario

The main difference relative to the 2017 adverse scenario is that this year's adverse scenario features lower long-term interest rates and a flatter yield curve across all of the economies included in the scenario. This different profile of interest rates is associated with a less pronounced decline in the U.S. equity price index in this year's scenario.

Additional Key Features of the Adverse Scenario

As in last year's adverse scenario, the slowdown in euro area economic activity reflects a broad-based contraction in euro area demand, not a contraction that is concentrated in a few specific economies. Similarly, the slowdown in developing Asia reflects a weakening in economic conditions across emerging market economies, not merely a weakening in Asia-specific conditions. Declines in aggregate U.S. residential real estate prices and commercial real estate prices should be assumed to be concentrated in regions that have experienced rapid price gains over the past two years. Declines in prices of U.S. housing and commercial real estate should also be assumed to be representative of risks to house prices and commercial real estate prices in foreign regions and economies that have experienced rapid price gains over the past two years.

Severely Adverse Scenario

The severely adverse scenario is characterized by a severe global recession that is accompanied by a global aversion to long-term fixed-income assets. As a result, long-term rates do not fall and yield curves steepen in the United States and the four countries/country blocks in the scenario. In turn, these developments lead to a broad-based and deep correction in asset prices--including in the corporate bond and real estate markets. It is important to note that this is a hypothetical scenario designed to assess the strength of banking organizations and their resilience to unfavorable economic conditions. This scenario does not represent a forecast of the Federal Reserve.

In this scenario, the level of U.S. real GDP begins to decline in the first quarter of 2018 and reaches a trough in the third quarter of 2019 that is 7-1/2 percent below the pre-recession peak (see Table 4.A). The unemployment rate increases almost 6 percentage points, to 10 percent, by the third quarter of 2019. Headline consumer price inflation falls below 1 percent at an annual rate in the second quarter of 2018 and rises to about 1-1/2 percent at an annual rate by the end of the scenario.

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. However, investor aversion to long-term fixed-income assets keeps 10-year Treasury yields unchanged through the scenario period. 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 5-3/4 percentage points by the start of 2019, while the spread between mortgage rates and 10-year Treasury yields widens to about 3-1/2 percentage points over the same time period.

Asset prices drop sharply in this scenario. Equity prices fall 65 percent by early 2019, accompanied by a surge in equity market volatility. The VIX moves above 60 percent in the first half of 2018. Real estate prices also experience large declines, with house prices and commercial real estate prices falling 30 percent and 40 percent, respectively, by the third quarter of 2019.

The international component of this scenario features a sharp global downturn, with severe recessions in the euro area, the United Kingdom, and Japan and a shallow and brief recession in developing Asia (see Table 4.B). As a result of the sharp contraction in economic activity, all foreign economies included in the scenario experience a decline in consumer prices, with Japan experiencing a more significant deflation that persists through the end of the scenario period. 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.

Comparison of the 2018 Severely Adverse Scenario and the 2017 Severely Adverse Scenario

This year's severely adverse scenario features a more severe downturn in the U.S. economy as compared to last year's scenario. This increase in severity reflects the Federal Reserve's scenario design framework for stress testing, which includes elements that create a more severe test of the resilience of large firms when current economic conditions are especially strong.⁶ Under this 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 if the starting unemployment rate is below 6 percent. Furthermore, this year's scenario incorporates a steepening of the yield curve and a deeper correction in prices for a broad set of assets, including equities, housing, and commercial real estate. The international dimension of the scenario shows a recessionary episode that, relative to last year's scenario, is more severe in developing Asia and Japan but less severe in the euro area and the United Kingdom.

Additional Key Features of the Severely Adverse Scenario

As in the adverse scenario, the weakness in euro area economic conditions reflects a broad-based contraction in euro area demand, although this contraction should be assumed to be more protracted in countries with less room for fiscal policy stabilization. The sharp slowdown in developing Asia is distributed unevenly across countries, with more pronounced decelerations in the larger economies. Economic conditions in developing Asia should be assumed to be representative of conditions across emerging market economies.

As in the adverse scenario, declines in aggregate U.S. residential real estate prices and commercial real estate prices should be assumed to be concentrated in regions that have experienced rapid price gains over the past two years. Declines in prices of U.S. housing and commercial real estate should also be assumed to be representative of risks to house prices and commercial real estate prices in foreign regions and economies that have experienced rapid price gains over the past two years.

Global Market Shock Component for Supervisory 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 distress and heightened uncertainty.⁷ Firms with significant trading activity will be required to include the global market shock as part of their supervisory adverse and severely adverse scenarios.⁸ In addition, as discussed below, certain large and highly interconnected firms must apply the same global market shock to their counterparty exposures to project losses under the counterparty default scenario component. The as-of date for the global market shock is December 4, 2017.⁹

2018 Adverse Scenario

The global market shock component for the adverse scenario simulates a marked decline in the economic outlook for developing Asian markets. As a result, sovereign credit spreads widen and currencies generally depreciate significantly in these markets. This shock spreads to other global markets, which results in increases in general risk premiums and credit risk. U.S. interest rates move lower across the term structure. Due to a sharp reduction in demand from developing Asia, most global commodity prices and currencies of commodity exporters decline significantly. Equity markets decline broadly.

The major difference relative to the 2017 adverse scenario is a regional focus on developing Asia markets. In general, the 2018 adverse scenario includes larger changes in price, spread, and volatility levels across most markets.

2018 Severely Adverse Scenario

The global market shock component for the severely adverse scenario is designed around three main elements: a sudden sharp increase in general risk premia and credit risk; a rise and steepening of the U.S. yield curve; and a general selloff of U.S. assets relative to other developed countries. Markets that are more tightly linked to interest rates are more acutely affected. As an example, in general, corporate debt, RMBS and CMBS markets are more severely affected than U.S. equities. Some markets less closely linked to interest rates experience conditions that are generally comparable to the second half of 2008.

Globally, yield curves for government bonds of most developed countries undergo moderate tightening due to outflows from U.S. asset markets. The U.S. yield curve rises across the term structure, particularly at the long end. Emerging market yield curves generally rise due to heightened risk premiums. The U.S. dollar depreciates relative to other developed market currencies due to investor outflows.

The major differences relative to the 2017 severely adverse scenario include a rise and steepening of the U.S. yield curve; greater depreciation of U.S. dollar relative to other advanced currencies; and more muted shocks to some credit-sensitive assets, such as non-agency RMBS. These differences are intended to reflect a general selloff in U.S. markets--combined with a less severe stress to illiquid assets.

Counterparty Default Component for Supervisory Adverse and Severely Adverse Scenarios

The eight BHCs with substantial trading or custodial operations will be required to incorporate a counterparty default scenario component into their supervisory adverse and severely adverse stress scenarios for CCAR 2018.¹⁰ The counterparty default scenario component involves the instantaneous and unexpected default of the BHC's largest counterparty.¹¹

In connection with the counterparty default scenario component, these BHCs will be 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. The counterparty default scenario component is an add-on to the macroeconomic conditions and financial market environment specified in the Federal Reserve's adverse and severely adverse stress scenarios.

Each BHC's largest counterparty will be determined by net stressed losses; estimated by applying the global market shock to revalue non-cash securities financing activity assets (securities or collateral) posted or received; and for derivatives, to the value of the trade position and non-cash collateral exchanged. The as-of date for the counterparty default scenario component is December 4, 2017--the same date as the global market shock.¹²

Market Risk Components for Supervisory Adverse and Severely Adverse Scenarios for IHCs

Beginning in CCAR 2019, an additional six firms with significant trading activity will be subject to the global market shock component in their adverse and severely adverse scenarios.¹³ For 2018, these firms will be subject to interim market risk components in the supervisory adverse and severely adverse scenarios used in the annual company-run stress test (company-run market risk component) and the supervisory stress test (supervisory market risk component) to assess the potential losses and capital impact in connection with each firm's trading and counterparty activity.¹⁴

For the company-run stress test, each firm must reflect trading and counterparty losses in the adverse and severely adverse scenarios using a company-run market risk component described in the individual notices to these firms that is tailored to the firms' risks.

For the supervisory stress test, the Federal Reserve will apply a supervisory market risk component, which is a simplified version of the global market shock and large counterparty default scenario component. As described in the letters to the IHCs, the Federal Reserve will apply specific loss rates to certain exposures, based on the losses used in the global market shock and large counterparty default components in 2014-2017. Specifically, the following loss rates will be applied to the applicable measure of exposures as of December 31, 2017:

• Securitized products losses: 22.1% loss rate in the adverse scenario and 46.4% loss rate in the severely adverse scenario to certain loans and credits held for trading.¹⁵
• Trading mark-to-market and trading incremental default risk losses: 1.4% loss rate in the adverse scenario and 1.8% loss rate in the severely adverse scenario to market risk-weighted assets.¹⁶
• Credit valuation adjustments: 1.3% loss rate in the adverse scenario and 2.8% loss rate in the severely adverse scenario to over-the-counter derivatives risk-weighted assets.¹⁷
• Large counterparty default losses: 1.0% loss rate in the adverse scenario and 1.5% loss rate in the severely adverse scenario to repo-style transactions and over-the-counter derivatives risk-weighted assets.¹⁸

Losses on the supervisory market risk component will be treated as an add-on to any losses associated with the macroeconomic scenarios and will be assumed to occur in the first quarter of the planning horizon. The Board will apply the same methodology to all U.S. IHCs subject to the supervisory market risk component in 2018.

Variables for the Supervisory Scenarios

Table 1.A. Historical data: Domestic variables, Q1:2000-Q4:2017

Table 1.B. Historical data: International variables, Q1:2000-Q4:2017

Table 2.A. Supervisory baseline scenario: Domestic variables, Q1:2018-Q1:2021

Table 2.B. Supervisory baseline scenario: International variables, Q1:2018-Q1:2021

Table 3.A. Supervisory adverse scenario: Domestic variables, Q1:2018-Q1:2021

Table 3.B. Supervisory adverse scenario: International variables, Q1:2018-Q1:2021

Table 4.A. Supervisory severely adverse scenario: Domestic variables, Q1:2018-Q1:2021

Table 4.B. Supervisory severely adverse scenario: International variables, Q1:2018-Q1:2021

Notes Regarding Scenario Variables

Sources for data through 2017:Q4 (as released through January 18, 2018). The 2017:Q4 values of variables marked with an asterisk (*) are projected.

* U.S. real GDP growth: Percent change in real gross domestic product, chained (2009) dollars, expressed at an annualized rate, Bureau of Economic Analysis (NIPA table 1.1.6, line 1).

* U.S. nominal GDP growth: Percent change in gross domestic product (current dollars), expressed at an annualized rate, Bureau of Economic Analysis (NIPA table 1.1.5, line 1).

* U.S. real disposable income growth: Percent change in disposable personal income (current dollars) divided by the price index for personal consumption expenditures, expressed at an annualized rate, Bureau of Economic Analysis (NIPA table 2.1, line 27, and NIPA table 1.1.4, line 2).

* U.S. nominal disposable income growth: Percent change in disposable personal income (current dollars), expressed at an annualized rate, Bureau of Economic Analysis (NIPA table 2.1, line 27).

U.S. unemployment rate: Quarterly average of seasonally-adjusted monthly data for the unemployment rate of the civilian, noninstitutional population of age 16 years and older, Bureau of Labor Statistics (series LNS14000000).

U.S. CPI inflation: Percent change in the quarterly average of seasonally-adjusted monthly data for the consumer price index, expressed at an annualized rate, Bureau of Labor Statistics (series CUSR0000SA0).

U.S. 3-month Treasury rate: Quarterly average of 3-month Treasury bill secondary market rate on a discount basis, H.15 Release, Selected Interest Rates, Federal Reserve Board (series RIFSGFSM03_N.B).

U.S. 5-year Treasury yield: Quarterly average of the yield on 5-year U.S. Treasury bonds, constructed for the FRB/U.S. model by Federal Reserve staff based on the Svensson smoothed term structure model; see Lars E. O. Svensson (1995), "Estimating Forward Interest Rates with the Extended Nelson-Siegel Method," Quarterly Review, no. 3, Sveriges Riksbank, pp. 13-26.

U.S. 10-year Treasury yield: Quarterly average of the yield on 10-year U.S. Treasury bonds, constructed for the FRB/U.S. model by Federal Reserve staff based on the Svensson smoothed term structure model; see id.

U.S. BBB corporate yield: Merrill Lynch 10-year BBB corporate bond yield, Z.1 Release (Financial Accounts of the United States), Federal Reserve Board (series FL073163013.Q).

U.S. mortgage rate: Quarterly average of weekly series for the interest rate of a conventional, conforming, 30-year fixed-rate mortgage, obtained from the Primary Mortgage Market Survey of the Federal Home Loan Mortgage Corporation.

U.S. prime rate: Quarterly average of monthly series, H.15 Release (Selected Interest Rates), Federal Reserve Board (series RIFSPBLP_N.M).

U.S. Dow Jones Total Stock Market (Float Cap) Index: End of quarter value via Bloomberg Finance L.P.

* U.S. House Price Index: Price Index for Owner-Occupied Real Estate, CoreLogic National, Z.1 Release (Financial Accounts of the United States), Federal Reserve Board (series FL075035243.Q).

* U.S. Commercial Real Estate Price Index: Commercial Real Estate Price Index, Z.1 Release (Financial Accounts of the United States), Federal Reserve Board (series FL075035503.Q divided by 1000).

U.S. Market Volatility Index (VIX): VIX converted to quarterly frequency using the maximum close-of-day value in any quarter, Chicago Board Options Exchange via Bloomberg Finance LP.

* Euro area real GDP growth: Percent change in real gross domestic product at an annualized rate, staff calculations based on Statistical Office of the European Communities via Haver, extended back using ECB Area Wide Model dataset (ECB Working Paper series no. 42).

Euro area inflation: Percent change in the quarterly average of the harmonized index of consumer prices at an annualized rate, staff calculations based on Statistical Office of the European Communities via Haver.

* Developing Asia real GDP growth: Percent change in real gross domestic product at an annualized rate, staff calculations based on data from Bank of Korea via Haver; National Bureau of Statistics of China via Haver; Indian Central Statistics Office via Haver; Census and Statistics Department of Hong Kong via Haver; and Taiwan Directorate-General of Budget, Accounting and Statistics via Haver.

* Developing Asia inflation: Percent change in the quarterly average of the consumer price index, or local equivalent, at an annualized rate, staff calculations based on data from National Bureau of Statistics of China via Haver; Indian Ministry of Statistics and Programme Implementation via Haver; Labour Bureau of India via Haver; National Statistical Office of the Republic of Korea via Haver; Census and Statistics Department of Hong Kong via Haver; and Taiwan Directorate-General of Budget, Accounting and Statistics via Haver.

* Japan real GDP growth: Percent change in gross domestic product at an annualized rate from 1980 to present and percent change in gross domestic expenditure at an annualized rate prior to 1980, Cabinet Office of Japan via Haver.

*Japan inflation: Percent change in the quarterly average of the consumer price index at an annualized rate, based on data from the Ministry of Internal Affairs and Communications via Haver.

*U.K. real GDP growth: Percent change in gross domestic product at an annualized rate, U.K. Office for National Statistics via Haver.

U.K. inflation: Percent change in the quarterly average of the consumer price index at an annualized rate from 1988 to present and percent change in the quarterly average of the retail prices index prior to 1988, staff calculations based on data from the U.K. Office for National Statistics via Haver.

Exchange rates: End-of-quarter exchange rates, H.10 Release (Foreign Exchange Rates), Federal Reserve Board.

Footnotes