Board of Governors of the Federal Reserve System

Supervisory Stress Test Results

This section describes the Federal Reserve's projections of RWAs, losses, revenues, expenses, and capital positions for the 35 firms participating in DFAST 2018 under the severely adverse and adverse scenarios. Results are presented both in the aggregate for the 35 firms and for individual firms. The aggregate results provide a sense of the stringency of the adverse and severely adverse scenario projections and the sensitivities of losses, revenues, and capital at these firms as a group to the stressed economic and financial market conditions contained in those scenarios. The range of results across individual firms reflects differences in business focus, asset composition, revenue and expense sources, and portfolio risk characteristics. The comprehensive results for individual firms are reported in appendix C.

Year-over-year changes in supervisory stress test results reflect changes in

• firm starting capital positions;
• scenarios used for the supervisory stress test;
• portfolio composition and risk characteristics; and
• models used in the supervisory stress test.

Severely Adverse Scenario

In the aggregate, capital ratios at the beginning of the projection horizon were lower than starting capital ratios in the DFAST 2017 exercise, reflecting growth in firms' balance sheets as well as the effects of tax reform on firms' capital positions. The aggregate decline in pre-tax net income over the projection horizon was greater than the decline in pre-tax net income in the DFAST 2017 exercise. However, as a percent of aggregate total assets, the decline in pre-tax net income in DFAST 2018 is less than the decline in most of prior stress testing exercises since 2013 (see Figure 9). The decline in pre-tax net income as a percent of total assets is 0.8 percent in DFAST 2018, while the average decline in pre-tax net income in 2013-17 is 1.4 percent.

Under the severely adverse scenario, firms experienced a decline in OCI of $32 billion over the nine quarters of the planning horizon in DFAST 2018, compared to an increase of $2 billion in DFAST 2017. Relative to the DFAST 2017 exercise, the higher long-term Treasury yield in the severely adverse scenario reduced unrealized gains on U.S. Treasury and agency securities, which had previously offset unrealized losses on other securities, and the greater widening of the corporate bond spread resulted in higher losses for some portfolios. The steeper yield curve also resulted in higher net interest income and higher PPNR in the aggregate.

The effects of the severely adverse scenario varied across firms of different sizes and business mixes.

As noted in box 2, certain elements of TCJA--particularly those relating to taxes of foreign operations and earnings and deferred tax asset revaluation--had the immediate effect of reducing the amount of regulatory capital many firms held as of December 31, 2017. In addition, the reduction in the corporate tax rate and the elimination of NOL carrybacks affected supervisory projections of after-tax net income. In DFAST 2018, changes resulting from the TCJA had a negative effect on many firms' post-stress capital ratios, with the effects being material for some firms. On average, the impact of the changes was approximately −30 bps.

Stressed Regulatory Capital Ratios and Risk-Weighted Assets

Capital ratios are generally projected to decline under the severely adverse scenario. In the aggregate, each of the five capital and leverage ratios calculated in the fourth quarter of 2017 declines over the course of the planning horizon, with first-quarter 2020 levels ranging from 2.3 percentage points to 3.6 percentage points lower than at the start of the planning horizon (see table 2). Tables 4.A, 4.B, and 4.C present these ratios for each of the 35 firms.

The changes in post-stress capital ratios vary considerably across firms (see figure 11). The post-stress capital ratios incorporate Federal Reserve projections of the levels of total average assets and RWAs over the planning horizon. Declines in capital ratios in part reflect an increase in projected RWAs over the planning horizon. The increase in RWAs reflects projected asset and loan growth in the scenario.

Projected Losses

The Federal Reserve projects that the 35 firms as a group would experience significant losses on loans and other positions under the severely adverse scenario. In this scenario, losses are projected to be $578³⁶ billion for the 35 firms in the aggregate over the nine quarters of the planning horizon. These losses include

• $429 billion in accrual loan portfolio losses;
• $10 billion in OTTI and other realized securities losses;
• $113 billion in trading and/or counterparty losses at the 14 firms with substantial trading, processing, or custodial operations; and
• $26 billion in additional losses from items such as loans booked under the fair-value option (see table 2).

The largest losses derive from two sources: (1) accrual loan portfolios and (2) trading and counterparty positions subject to the global market shock and counterparty default component. Together, these account for 94 percent of the projected losses for the 35 firms in the severely adverse scenario (figure 10).

Loan Losses

Projected losses on domestic residential mortgages, credit cards, and other consumer loans represent 47 percent of projected loan losses and 35 percent of total projected losses for the 35 firms (see table 2). This is consistent with the severely adverse scenario, which features high unemployment rates and significant declines in housing prices. For the fourth year in a row, commercial and industrial loan losses and credit card losses are the two largest categories of loan losses at $111 billion and $113 billion, respectively. Combined, commercial and industrial and credit cards represent 39 percent of total projected losses. Trading and counterparty losses, which include losses from supervisory market risk component in DFAST 2018, represent 20 percent of total projected losses.

For the 35 firms as a group, the nine-quarter cumulative loss rate for all accrual loan portfolios is 6.4 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. Total loan loss rates vary significantly across firms, ranging between 0.6 percent and 14.2 percent across these institutions (see table 7 and figure 12).

The differences in total loan loss rates across the firms reflect differences in the risk characteristics of the portfolios held by each firm with regard to both the type of lending of each portfolio and the loans within each portfolio. Loan portfolio composition matters because projected loss rates vary significantly by loan type. In the aggregate, nine-quarter cumulative loss rates vary between 2.7 percent on domestic first-lien mortgages and 14.4 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 different types of lending to the severely adverse scenario. In particular, lending categories for which performance is sensitive to credit spreads or housing prices may experience high stressed loss rates due to the considerable stress on these factors in the severely adverse scenario.

Projected loss rates on most loan categories show similar dispersion across firms (see table 7 and figures D.1 through D.7).³⁷ There are significant differences across firms in the projected loan loss rates for similar types of loans. For example, while the median projected loss rate on commercial and industrial loans is 7.3 percent, the rates among firms with commercial and industrial loans vary from a low of 2.4 percent to a high of 24.4 percent. For credit card loans, the range of projected loss rates is from 9.1 percent to 21.2 percent, with a median of 14.7 percent.

Differences in projected loss rates across firms primarily reflect differences in loan and borrower characteristics. The composition of firms' loan portfolios shifted since the DFAST 2017 exercise, with corporate lending experiencing the most rapid growth. In the aggregate, risk in bank holdings declined modestly relative to DFAST 2017, due in part to improved macroeconomic conditions. However, pockets of risk grew in certain loan portfolios, such as corporate loan portfolios, and certain individual firms have increased risk in their holdings.

In addition, some firms 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 in general reduced by the amount of such write-downs. For these firms, projected loss rates will be lower than for firms that hold similar loans that have not been subject to purchase-related write-downs.

Losses on Trading, Private Equity, SFT, and Derivatives Positions

The severely adverse scenario results include $113 billion in trading losses from the global market shock at the 12 firms with large trading and private-equity exposures and losses from the counterparty default component at the 14 firms with substantial trading, processing, or custodial operations. Trading and counterparty losses range between $0.6 billion and $29 billion across the 14 firms (see table 5) subject to the full global market shock and the supervisory market risk component.

The relative size of losses across firms depends not on nominal portfolio size but rather on the specific risk characteristics of each firm's trading positions, inclusive of hedges. Importantly, these projected losses are based on the trading positions and counterparty exposures held by these firms on a single date (December 4, 2017) and could have differed if they had been based on a different date.

Projected Pre-provision Net Revenue and Net Income

In the aggregate, the 35 firms are projected to generate $492 billion in PPNR cumulatively over the nine quarters of the planning horizon, equal to 3.0 percent of their combined average assets (see table 2). PPNR projections reflect low levels of noninterest income, consistent with the falling asset prices, rising equity market volatility, and sharply contracting economic activity in the severely adverse scenario. In addition, the PPNR projections incorporate expenses stemming from estimates of elevated levels of losses from operational-risk events such as fraud, employee lawsuits, litigation-related expenses, or computer system or other operating disruptions.³⁸ In aggregate for the 35 firms, those operational risk losses of almost $135 billion this year are $26 billion higher this year than last year, but remain within the range of what has been projected in previous DFAST exercises.

The ratio of projected cumulative PPNR to average assets varies across firms (see figure 13). 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 firms focusing on credit card lending, reflecting the higher net interest income that credit cards generally produce relative to other forms of lending.³⁹ Importantly, lower PPNR rates do not necessarily imply lower net income, because the same business focus and revenue risk characteristics determining differences in PPNR across firms could also result in offsetting differences in projected losses across firms.

Projected PPNR and losses are the primary determinants of projected pre-tax net income. Table 5 presents 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 for each of the 35 firms (see table 2 for aggregate). 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 $482 billion in total provisions includes $429 billion in net charge-offs, with the remainder being the reserve build. These amounts are cumulative over the planning horizon and mask 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 35 firms individually and for the firms as a group over the nine-quarter planning horizon. Projected net income before taxes (pre-tax net income) is an aggregate net loss of $139 billion over the planning horizon for the 35 firms.

The ratio of pre-tax net income to average assets for each of the 35 firms ranges from −2.9 percent to 2.8 percent (see figure 14). Projected cumulative net income for most of the firms (26 of 35) 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 supervisory scenarios. Projected net income for the 14 firms subject to the global market shock, the supervisory market risk component, and/or the counterparty default component includes the effect of those additional scenario components in the adverse and severely adverse scenarios, introducing some additional variation in projected net income between these firms and the other firms participating in DFAST 2018.

Final capital ratios for advanced approaches firms and other firms that opt into advanced approaches treatment for AOCI are also impacted by other comprehensive income (OCI) (Table 5), which is driven by unrealized gains and losses on securities in the supervisory stress test.

The interest rate path and credit spreads assumed in the scenario result in −$32 billion of OCI over the nine quarters of the planning horizon for advanced approaches firms and other firms that opt into advanced approaches treatment for AOCI. Reflecting the complete phase-in of portions of AOCI in the revised regulatory capital framework, −$89 billion in AOCI is included in post-stress regulatory capital in the severely adverse scenario as of the first quarter of 2020.

Table 2. 35 participating firms Projected stressed capital ratios, risk-weighted assets, losses, revenues, net income before taxes, and loan losses Federal Reserve estimates: Severely adverse scenario

 

Capital ratios, actual 2017:Q4 and projected 2018:Q1-2020:Q1

Projected loan losses, by type of loan, 2018:Q1-2020:Q1

Risk-weighted assets, actual 2017:Q4 and projected 2020:Q1

Projected losses, revenue, and net income before taxes through 2020:Q1

Table 3. Projected minimum common equity tier 1 ratio under the severely adverse scenario, 2018:Q1-2020:Q1 35 participating firms

Table 4.A. Capital ratios, actual 2017:Q4 and projected 2018:Q1-2020:Q1 under the severely adverse scenario: Advanced approaches firms

Table 4.B. Capital ratios, actual 2017:Q4 and projected 2018:Q1-2020:Q1 under the severely adverse scenario: Non-advanced approaches firms

Table 4.C. Capital ratios, actual 2017:Q4 and projected 2018:Q1-2020:Q1 under the severely adverse scenario: 35 participating firms

Table 5. Projected losses, revenue, and net income before taxes through 2020:Q1 under the severely adverse scenario: 35 participating firms

Table 6. Projected loan losses by type of loan for 2018:Q1-2020:Q1 under the severely adverse scenario: 35 participating firms

Table 7. Projected loan losses by type of loan for 2018:Q1-2020:Q1 under the severely adverse scenario: 35 participating firms

Adverse Scenario

Stressed Capital Ratios and Risk-Weighted Assets

The adverse scenario projections suggest moderate declines in aggregate capital ratios for the 35 firms. The aggregate CET1 ratio is projected to fall 1.4 percentage points to its minimum over the planning horizon and to be 1.1 percentage points lower at the end of the planning horizon (see table 8). In addition, at the end of the planning horizon, the tier 1 risk-based capital ratio and the total risk-based capital ratio are 1.1 and 1.4 percentage points lower than at the start of the planning horizon, respectively. The tier 1 leverage ratio is projected to decline 0.8 percentage points over the planning horizon.

Generally, the projected declines in post-stress capital ratios are smaller than those under the severely adverse scenario, reflecting the generally less severe economic conditions assumed in the adverse scenario. As compared to the severely adverse scenario, the adverse scenario projections imply higher aggregate net income, driven in part by lower losses. Offsetting somewhat the effect of aggregate higher net income on capital, the adverse scenario also features more robust projected balance sheet and RWA growth than the severely adverse scenario, which on net tends to reduce post-stress capital ratios.

Projected Losses

The Federal Reserve's projections suggest that the 35 firms as a group would face elevated losses under the adverse scenario, though not as large as the losses under the severely adverse scenario. In this scenario, total losses are projected to equal $333 billion for the 35 firms over the nine-quarter planning horizon.

These losses include

• $263 billion in accrual loan losses;
• $3 billion in OTTI and other realized securities losses;
• $48 billion in losses from the global market shock and the largest counterparty default components; and
• $19 billion in additional losses from items such as loans booked under the fair-value option.

These results are presented in aggregate (table 8) and individually for each of the 35 firms (table 11 and appendix C). Aggregate loss amounts are lower than those projected under the severely adverse scenario, once again reflecting the relatively less stressful macroeconomic and financial market conditions assumed in the adverse scenario.

Loan Losses

As in the severely adverse scenario, the accrual loan portfolio is the largest source of losses in the adverse scenario, accounting for $263 billion of projected losses for the 35 firms. The lower peak unemployment rate and more moderate residential and commercial real estate price declines in the adverse scenario result in lower projected accrual loan losses on consumer and real estate-related loans relative to the severely adverse scenario. In aggregate, the nine-quarter loan loss rate of the 35 firms is 3.9 percent. As in the severely adverse scenario results, there is considerable diversity across firms in projected loan loss rates, both in the aggregate and by loan type (see figures 17 and D.8 to D.14).

Losses on Trading, Private Equity, and Derivatives Positions

Projected losses resulting from the impact of the global market shock and the supervisory market risk component at the 12 firms with large trading and private-equity exposures and losses from the counterparty default component at the 14 firms with substantial trading, processing, or custodial operations equal $48 billion under the adverse scenario. These losses are less than half of those projected under the severely adverse scenario, reflecting the less severe market shocks assumed in the adverse scenario. Trading and counterparty losses range between $0.4 billion and $13 billion across the 14 firms (see table 11) subject to the full global market shock and the supervisory market risk component.

Projected PPNR and Net Income

Aggregate PPNR is projected to equal $467 billion for the 35 firms under the adverse scenario, equal to 2.8 percent of average projected assets for these firms. Projected PPNR is lower than under the severely adverse scenario due to a steeper yield curve in the severely adverse scenario. As a result, net interest income in the adverse scenario is lower than in the severely adverse scenario. However, projected operational-risk losses are lower compared to the severely adverse scenario, the latter being consistent with the adverse scenario's more moderate housing price decline. Projected ratios of PPNR to assets vary significantly across the 35 firms (see figure 18).

In the aggregate, the 35 firms are projected to have cumulative pre-tax net income of $125 billion over the nine-quarter planning horizon under the adverse scenario. Twenty-three of the firms are projected to have positive cumulative pre-tax net income, though 24 firms experience at least one quarter of negative pre-tax net income during the planning horizon. The $272 billion in total provisions reported in table 8 includes $263 billion in net charge-offs, with the remainder being the reserve build, or the increase in loan loss reserves.

Aggregate pre-tax net income under the adverse scenario is positive, with a ratio of income to average assets of 0.7 percent. Projected nine-quarter return on assets under the adverse scenario ranges between −1.3 and 4.6 percent for the 35 firms (see figure 19).

Results reflect $19 billion of OCI over the nine quarters of the planning horizon for advanced approaches firms and other firms that opt into advanced approaches treatment for AOCI in the adverse scenario. In the aggregate, −$38 billion in AOCI is included in post-stress regulatory capital as of the first quarter of 2020.

Table 8. 35 participating firms Projected stressed capital ratios, risk-weighted assets, losses, revenues, net income before taxes, and loan losses Federal Reserve estimates: Adverse scenario

 

Capital ratios, actual 2017:Q4 and projected 2018:Q1-2020:Q1

Projected loan losses, by type of loan, 2018:Q1-2020:Q1

Risk-weighted assets, actual 2017:Q4 and projected 2020:Q1

Projected losses, revenue, and net income before taxes through 2020:Q1

Table 9. Projected minimum common equity tier 1 ratio under the adverse scenario, 2018:Q1-2020:Q1 35 participating firms

Table 10.A. Capital ratios, actual 2017:Q4 and projected 2018:Q1-2020:Q1 under the adverse scenario: Advanced approaches firms

Table 10.B. Capital ratios, actual 2017:Q4 and projected 2018:Q1-2020:Q1 under the adverse scenario: Non-advanced approaches firms

Table 10.C. Capital ratios, actual 2017:Q4 and projected 2018:Q1-2020:Q1 under the adverse scenario: 35 participating firms

Table 11. Projected losses, revenue, and net income before taxes through 2020:Q1 under the adverse scenario: 35 participating firms

Table 12. Projected loan losses by type of loan for 2018:Q1-2020:Q1 under the adverse scenario: 35 participating firms

Table 13. Projected loan losses by type of loan for 2018:Q1-2020:Q1 under the adverse scenario: 35 participating firms

copied from 2017 file

Table 14. Mapping of loan categories to disclosure categories

 

References

 

 36. Projected losses in figure 10 sum to $577 billion. Difference due to rounding. Return to text

 37. Losses are calculated based on the exposure at default, which includes both outstanding balances and any additional drawdown of the credit line that occurs prior to default, while loss rates are calculated as a percent of average outstanding balances over the planning horizon. See appendix B for more detail on the models used to project net income and stressed capital. Return to text

 38. These estimates are conditional on the hypothetical adverse and severely adverse scenario and on conservative assumptions. They are not a supervisory estimate of the firms' current or expected legal liability. Return to text

 39. As noted, credit card lending also tends to generate relatively high loss rates, so the higher PPNR rates at these firms do not necessarily indicate higher profitability. Return to text