Board of Governors of the Federal Reserve System

Errata

The Federal Reserve revised this publication on February 13, 2019, to reflect corrected data. The revision is listed below.

• On p. 10, under Table 1.A, the Q4 2018 Mortgage rate has been revised from 4.6 to 4.8 percent.

Introduction

The Federal Reserve Board conducts supervisory stress tests to help ensure that large bank holding companies operating in the United States will be able to lend to households and businesses even in a severe recession. The tests are known as the Dodd-Frank Act stress test (DFAST) and the Comprehensive Capital Analysis and Review (CCAR).¹

DFAST is a forward-looking assessment of capital adequacy that uses standard assumptions across all firms. CCAR evaluates the capital planning practices and capital adequacy using the capital actions, such as dividend payments and share repurchases, planned by the firms.

This publication describes the three supervisory scenarios--baseline, adverse, and severely adverse--that the Board will use in its supervisory stress tests this year; that a firm, savings and loan holding company, 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 2019 capital plan submission.² This 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.

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 2019 and extend through the first quarter of 2022. 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 3-month Treasury bills; the yield for 5-year Treasury notes; the yield for 10-year Treasury notes; the yield for 10-year BBB corporate securities; the interest rate associated with conforming, conventional, 30-year fixed-rate mortgages; and the prime rate.

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

The three variables for each country or country bloc: 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 blocs 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 http://www.federalreserve.gov/bankinforeg/dfa-stress-tests.htm. Historical data for the domestic and the international variables are reported in Table 1.A and Table 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 2019 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 scenario period. Real GDP growth averages 2-1/4 percent in 2019, drops slightly to 1-1/2 percent in 2020, and then rises to 2 percent in 2021. The unemployment rate falls to about 3-1/2 percent during 2019, and then increases to about 4 percent by the first half of 2021. CPI inflation averages about 2-1/4 percent each year.

Accompanying the moderate economic expansion, Treasury yields are assumed to rise modestly across the maturity spectrum. Short-term Treasury rates increase from about 2-1/2 percent in the first half 2019 to about 2-3/4 percent in the second half of 2019 and level off thereafter; yields on 10-year Treasury securities rise from 3 percent at the beginning of 2019 to about 3-1/4 percent at the beginning of 2020 and continue rising gradually to about 3-1/2 percent by the end of the scenario period. The prime rate increases in line with short-term Treasury rates, and both corporate bond yields and mortgage rates rise in line with long-term Treasury yields. Equity prices rise about 5 percent on average each year, and equity market volatility falls modestly. Nominal house prices rise about 2-1/2 percent per year through 2020, and about 3 percent per year thereafter. The growth rate of commercial real estate prices averages about 6 percent in 2019, and falls gradually to about 3 percent in 2020.

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

Severely Adverse Scenario

The severely adverse scenario is characterized by a severe global recession accompanied by a period of heightened stress in commercial real estate markets and corporate debt markets. This is a hypothetical scenario designed to assess the strength of banking organizations and their resilience to unfavorable economic conditions and does not represent a forecast of the Federal Reserve.

The U.S. unemployment rate climbs to a peak of 10 percent in the third quarter of 2020 (see Table 4.A). This change in the unemployment rate is consistent with the Board's Policy Statement on the Scenario Design Framework for Stress Testing.⁶ In line with the increase in the unemployment rate, real GDP falls about 8 percent from its pre-recession peak, reaching a trough in the third quarter of 2020. The decline in activity is accompanied by a lower headline CPI inflation, which falls to about 1-1/4 percent at an annual rate in the first quarter of 2019 and then rises gradually to about 2 percent at an annual rate by the second half of 2020.

As a result of the severe decline in real activity, the interest rate for 3-month Treasury bills falls 2-1/4 percentage points and remains near zero through the end of the scenario. The 10-year Treasury yield falls by a somewhat smaller amount, resulting in a mildly steeper yield curve. The 10-year Treasury yield reaches a trough of about 3/4 percent in the first quarter of 2019 and rises gradually thereafter to 1-1/2 percent by the first quarter of 2021 and 1-3/4 percent by the first quarter of 2022. 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 5-1/2 percent by the third quarter of 2019, an increase of 3-1/2 percentage points relative to the fourth quarter of 2018. The spread between mortgage rates and 10-year Treasury yields widens to 3-1/2 percentage points over the same time period.

Asset prices drop sharply in this scenario. Equity prices fall 50 percent through the end of 2019, accompanied by a rise in the VIX, which reaches a peak of 70 percent. House prices and commercial real estate prices also experience large declines of about 25 percent and 35 percent, respectively.

The international component of this scenario features severe recessions in the euro area, United Kingdom, and Japan, and a shallow recession 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. 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 2019 Severely Adverse Scenario and the 2018 Severely Adverse Scenario

This year's severely adverse scenario features a more severe recession and a greater increase in the unemployment rate in the United States compared to last year's scenario. This increase in severity in those variables reflects the Board's Policy Statement on the Scenario Design Framework for Stress Testing, which calls for a more pronounced economic downturn when current conditions are especially strong. Given a lower unemployment rate at the beginning of this year's scenario compared to last year's, the framework calls for a correspondingly larger increase in the unemployment rate in order to reach a peak of at least 10 percent.

In addition, 10-year Treasury yields fall in this year's scenario. By contrast, last year's severely adverse scenario featured unchanged 10-year Treasury yields, and a sharply steeper yield curve, reflecting a global aversion to long-term fixed income assets, a development not previously featured in a severely adverse scenario. As a result, the declines in some asset prices, such as stock prices, are more aligned with the declines featured in the 2017 severely adverse scenario.

Additional Key Features of the Severely Adverse Scenario

Although the weakness in euro area economic conditions reflects a broad-based contraction in euro area demand, 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.

Declines in aggregate U.S. residential 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.

Adverse Scenario

The adverse scenario is characterized by weakening economic activity across all of the economies included in the scenario, accompanied by a moderate correction in asset prices and rise in volatility. This is a hypothetical scenario designed to assess the strength of banking organizations and their resilience to adverse economic conditions, and does not represent a forecast of the Federal Reserve.

The macroeconomic and financial developments in this year's adverse scenario are similar to the developments in the severely adverse scenario but are more moderate in magnitude. As a result, the two scenarios together allow for an investigation of the relationship between firm-specific outcomes and the intensity of economic and financial dislocations.

As in the severely adverse scenario, the unemployment rate peaks in the third quarter of 2020 but reaches a lower level of 7 percent rather than 10 percent (Table 3.A). The U.S. economy experiences a recession, with real GDP falling slightly more than 2-3/4 percent from peak to trough. Reflecting weak economic conditions, short-term interest rates and longer-term Treasury yields fall. In addition, financial conditions tighten and asset prices decline, but less intensely compared to the severely adverse scenario. For example, equity prices reach a trough at the end of 2019 in both scenarios, falling about 20 percent in the adverse scenario and 50 percent in the severely adverse scenario.

Following the recession, U.S. real activity picks up slowly at first and then gains momentum. The growth rate of U.S. real GDP increases from about 3/4 of a percent in 2020 to about 3-1/4 percent in 2021. The unemployment rate declines modestly, to about 6-1/4 percent by the end of the scenario period. Consumer price inflation remains close to 2 percent through the end of the scenario period. Yields on 10-year Treasury securities 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 slightly more protracted recession in Japan than elsewhere, and 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, including a deflationary episode in Japan. Reflecting flight-to-safety capital flows, the U.S. dollar appreciates against the euro, the pound sterling, and the currencies of developing Asia, and depreciates modestly against the yen.

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 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 hypothetical shocks to a large set of risk factors, such as asset prices, interest rates, and spreads, reflecting general market distress and heightened uncertainty. The risk factor shocks are calibrated to the period of time over which market events would unfold, which varies depending on the anticipated liquidity of different risk types, but are applied to firms' positions on a given as-of date. Firms with significant trading activity will be required to include the global market shock as part of their supervisory adverse and severely adverse scenarios, and recognize trading and counterparty mark-to-market losses in the first quarter of the planning horizon.⁷ In addition, as discussed below, certain large and highly interconnected firms must apply the same global market shock to project losses under the counterparty default scenario component. The as-of date for the global market shock is November 5, 2018.⁸

2019 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 2019 adverse scenario addresses themes similar to those of the 2018 adverse scenario.

2019 Severely Adverse Scenario

The global market shock component for the severely adverse scenario features a significant weakening in European economic conditions and spillover effects that lead to sell-offs in financial assets more broadly. The European distress leads to global market dislocations, affecting U.S. and developing Asian and other emerging markets. There is a sudden increase in implied volatilities broadly, a large decline in industrial and energy commodity prices, and a significant widening in credit spreads, with an associated decline in market liquidity. Liquidity deterioration is most severe in those asset markets that are typically less liquid, such as corporate debt and private equity markets, and is less pronounced in those markets that are typically more liquid such as publicly traded equity and currency markets. In addition, relationships between the prices of financial assets that would normally be expected to move together come under pressure and are weakened in some cases. As a result, certain hedging strategies are less effective than historical experience would suggest.

Flight-to-quality capital flows push interest rates down across the term structure in the U.S. and certain European countries, while emerging markets and countries that are part of the European periphery experience sharp increases in government yields. Countries that are affected by the flight-to-quality experience currency appreciation, while European and emerging market currencies experience currency depreciation against the U.S. dollar.

The major differences relative to the 2018 severely adverse scenario include a heightened stress to European assets; a decline in the U.S. yield curve; an appreciation of the U.S. dollar relative to most other currencies; and more muted shocks to U.S. based assets, such as U.S. agency and municipal products. These differences are intended to reflect the more Europe-focused nature of the stress and a general flight-to-quality to U.S. markets.

Counterparty Default Component for Supervisory Adverse and Severely Adverse Scenarios

Firms 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 2019.⁹ The counterparty default scenario component involves the instantaneous and unexpected default of the firm's largest counterparty.¹⁰

In connection with the counterparty default scenario component, these firms 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 firm'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 November 5, 2018--the same date as the global market shock.¹¹

Variables for the Supervisory Scenarios

Table 1.A. Historical data: Domestic variables, Q1:2000–Q4:2018

Table 1.B. Historical data: International variables, Q1:2000–Q4:2018

Table 2.A. Supervisory baseline scenario: Domestic variables, Q1:2019–Q1:2022

Table 2.B. Supervisory baseline scenario: International variables, Q1:2019–Q1:2022

Table 3.A. Supervisory adverse scenario: Domestic variables, Q1:2019–Q1:2022

Table 3.B. Supervisory adverse scenario: International variables, Q1:2019–Q1:2022

Table 4.A. Supervisory severely adverse scenario: Domestic variables, Q1:2019–Q1:2022

Table 4.B. Supervisory severely adverse scenario: International variables, Q1:2019–Q1:2022

Notes Regarding Scenario Variables

Sources for data through 2018:Q4 (as released through January 18, 2019). The 2018: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