Overview of Modeling Framework
The Federal Reserve estimates the effect of supervisory scenarios on the regulatory capital ratios of firms participating in the supervisory stress test by projecting the balance sheet, RWAs, net income, and resulting capital for each firm over a nine-quarter planning horizon. Projected net income, adjusted for the effect of taxes, is combined with capital action assumptions and other components of regulatory capital to produce post-stress capital ratios. The Federal Reserve's approach to modeling post-stress capital ratios generally follows U.S. generally accepted accounting principles (GAAP) and the regulatory capital framework.14 Figure 1 illustrates the framework used to calculate changes in net income and regulatory capital.
Figure 1. Projecting net income and regulatory capital
Projecting Pre-tax Net Income
The Federal Reserve calculates projected pre-tax net income for the firms subject to the supervisory stress test by combining projections of revenue, expenses, loan-loss provisions, and other losses, including
- PPNR;
- provisions for loan and lease losses;
- losses on loans held for sale (HFS) or for investment and measured under the fair-value option (FVO);
- other-than-temporary impairment (OTTI) losses on investment securities in the available-for-sale (AFS) and held-to-maturity (HTM) portfolios;
- losses on market risk exposures, credit valuation adjustment (CVA), and incremental default risk (IDR) for firms subject to the global market shock; and
- losses from a default of the largest counterparty for firms with substantial trading, processing, or custodial operations.
The Federal Reserve projects these components of pre-tax net income using supervisory models that take the Board's scenarios and firm-provided data as inputs. Macroeconomic variables used in select supervisory models vary across geographic locations (e.g., by state or by county). The Federal Reserve projects the paths of these variables as a function of aggregate macroeconomic variables included in the Board's scenarios.
Pre-provision Net Revenue
PPNR is defined as net interest income (interest income minus interest expense) plus noninterest income minus noninterest expense. Consistent with U.S. GAAP, the projection of PPNR includes projected losses due to operational-risk events and expenses related to the disposition of real-estate-owned properties.15
The Federal Reserve models most components of PPNR using a suite of models that generally relate specific revenue and non-credit-related expenses to the characteristics of firms and to macroeconomic variables. These include eight components of interest income, seven components of interest expense, six components of noninterest income, and three components of noninterest expense.
The Federal Reserve separately models losses from operational risk and other real-estate-owned (OREO) expenses. Operational risk is defined as "the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events."16 OREO expenses are those expenses related to the disposition of real-estate-owned properties and stem from losses on first-lien mortgages.
Loan Losses and Provisions on the Accrual Loan Portfolio
The Federal Reserve projects 13 quarters of losses on loans in the accrual loan portfolio using one of two modeling approaches: the expected-loss framework or the net charge-off approach.
For certain loans, expected losses under the macroeconomic scenario are estimated by projecting the probability of default (PD), loss given default (LGD), and exposure at default (EAD) for each quarter of the planning horizon. Expected losses in each quarter are the product of these three components.
Losses are modeled under the expected-loss framework for the following loan categories:
- corporate loans, including graded commercial and industrial (C&I) loans, agricultural loans, domestic farm loans, international farm loans, loans to foreign governments, loans for purchasing and carrying securities, other non-consumer loans, and other leases
- commercial real estate (CRE) loans, including domestic and international non-owner-occupied multifamily or nonfarm, nonresidential property loans and construction and land development (C&LD) loans
- domestic first-lien residential mortgages
- domestic home equity loans (HELs) and home equity lines of credit (HELOCs)
- domestic credit cards
- domestic auto loans
The net charge-off approach projects losses over the planning horizon using models that capture the historical behavior of net charge-offs as a function of macroeconomic and financial market conditions and loan portfolio characteristics. The Federal Reserve models losses under the net charge-off approach for other consumer loans, business and corporate credit card loans, small-business loans, student loans, and international retail loans.
Losses on the accrual loan portfolio flow into net income through provisions for loan and lease losses. Provisions for loan and lease losses for each quarter equal projected loan losses for the quarter plus the change in the allowance for loan and lease losses (ALLL) needed to cover the subsequent four quarters of expected loan losses, taking into account loan loss reserves established by the firm as of the effective date of the stress test exercise.
The Federal Reserve assumes that ALLL at the end of each quarter covers projected loan losses for four quarters into the future.17 The supervisory estimate of ALLL at the start of the planning horizon, which is based on projected losses under the adverse or severely adverse scenarios, may differ from a firm's established allowance at the beginning of the planning horizon, which is based on the firm's estimate of incurred losses on the effective date of the stress test.18 Any difference between the supervisory calculation of ALLL and the firm's reported allowance at the beginning of the planning horizon is linearly smoothed into the Federal Reserve's provisions projection over the nine quarters.
Losses on Loans Measured on a Fair-Value Basis
Certain loans are accounted for on a fair-value basis instead of on an accrual basis. For example, if a loan is accounted for using the FVO, it is marked to market and the accounting value of the loan changes as market risk factors and fundamentals change. Similarly, loans that are held for sale are accounted for at the lower of cost or market value.
The models for these asset classes project gains and losses on the banks' FVO/HFS loan portfolios over the nine-quarter planning horizon, net of any hedges, by applying the scenario-specific path of interest rates and credit spreads to loan yields.
Losses are modeled under this approach for the following loan categories:
- FVO/HFS C&I loans
- FVO/HFS CRE loans
- FVO/HFS residential mortgages, student loans, auto loans, and credit cards
Gains and losses on HFS C&I and CRE loans are estimated using a model specific to those asset classes. Gains and losses on FVO/HFS retail loans are modeled separately.
Losses on Securities in the Available-for-Sale and Held-to-Maturity Portfolios
The Federal Reserve estimates two types of losses on AFS or HTM securities related to investment activities.19 First, for securities classified as AFS, projected changes in the fair value of the securities due to changes in interest rates and other factors will result in unrealized gains or losses that are recognized in capital for some firms through other comprehensive income (OCI).20 Second, when the fair value of a security falls below its amortized cost, OTTI on the security may be recorded. With the exception of certain government-backed obligations, both AFS and HTM securities are at risk of incurring credit losses leading to OTTI.21 The models project security-level OTTI relating to credit losses, using as an input the projected fair value for each security over the nine-quarter planning horizon under the macroeconomic scenarios.
Securities at risk of credit-related OTTI include the following securitizations and direct debt obligations:
- corporate debt securities
- sovereign debt securities (other than U.S. government obligations)
- municipal debt securities
- mortgage-backed, asset-backed, collateralized loan obligation (CLO), and collateralized debt obligation (CDO) securities
Gains or Losses on the Fair Value of Available-for-Sale Securities
The fair value of securities in the AFS portfolio may change in response to the macroeconomic scenarios. Under U.S. GAAP, unrealized gains and losses on AFS securities are reflected in accumulated OCI (AOCI) but do not flow through net income.22 Under the regulatory capital rule, AOCI must be incorporated into common equity tier 1 capital (CET1) for certain firms.23 The incorporation of AOCI in regulatory capital is described in "Calculation of Regulatory Capital Ratios" below.
Unrealized gains and losses are calculated as the difference between each security's fair value and its amortized cost. The amortized cost of each AFS security is equivalent to the purchase price of a debt security, which is periodically adjusted if the debt security was purchased at a price other than par or face value, has a principal repayment, or has an impairment recognized in earnings.24
OCI losses from AFS securities are computed directly from the projected change in fair value, taking into account OTTI losses and applicable interest-rate hedges on securities. All debt securities held in the AFS portfolio are subject to OCI losses, including
- U.S. Treasuries;
- U.S. Agency securities;
- corporate debt securities;
- sovereign debt securities;
- municipal debt securities; and
- mortgage-backed, asset-backed, CLO, and CDO securities.
Losses on Trading and Private Equity Exposures and Credit Valuation Adjustment
The global market shock, which applies to a subset of firms, is a set of hypothetical shocks to market values and risk factors that affect the market value of firms' trading and private equity positions.25 The design of the global market shock component differs from the design of the nine-quarter macroeconomic scenario in that it assumes the losses are incurred instantaneously at the start of the planning horizon rather than gradually over nine quarters.
The trading and private equity model generates loss estimates related to trading and private equity positions under the global market shock. In addition, the global market shock is applied to firm counterparty exposures to generate losses due to changes in CVA.
Like other components of the supervisory stress test, the Federal Reserve designed the global market shock component according to its model design principles. Given the unpredictable nature of the duration and timing of market shocks, the global market shock component assumes that the market dislocation affects the value of trading exposures instantaneously. The assumption is consistent with the Federal Reserve's model design principles that emphasize the use of conservative and forward-looking projections, particularly in the face of uncertainty.
The trading and private equity model covers a wide range of firms' exposures to asset classes such as public equity, foreign exchange, interest rates, commodities, securitized products, traded credit (e.g., municipals, auction rate securities, corporate credit, and sovereign credit), private equity, and other fair-value assets. Loss projections are constructed by applying movements specified in the global market shock to market values of firm-provided positions and risk factor sensitivities.26
Incremental Default Risk
The Federal Reserve separately estimates the risk of losses arising from a jump-to-default of issuers of debt securities in the trading book, in excess of mark-to-market losses calculated by the trading model. Trading losses associated with incremental default risk account for concentration risk in agencies, trading book securitization positions, and corporate, sovereign, and municipal bonds. The model measures the potential for jump-to-default losses as a function of the macroeconomic scenario. These losses are applied in each of the nine quarters of the planning horizon.
Largest Counterparty Default Losses
The largest counterparty default (LCPD) scenario component is applied to firms with substantial trading or custodial operations.27 The LCPD captures the risk of losses due to an unexpected default of the counterparty whose default on all derivatives and SFTs would generate the largest stressed losses for a firm.
Consistent with the Federal Reserve's modeling principles, losses associated with the LCPD component are recognized instantaneously in the first quarter of the planning horizon.
Balance Projections and the Calculation of Regulatory Capital Ratios
Balance Sheet Items and Risk-Weighted Assets
The Federal Reserve projects asset and liability balances using a common framework for determining the effect of its scenarios on balance sheet growth. This framework is consistent with the Federal Reserve's policy that aggregate credit supply does not contract during the stress period. The policy promotes the Federal Reserve's goal of helping to ensure that large financial firms remain sufficiently capitalized to accommodate credit demand in a severe downturn.
The balance sheet projections are based on historical data from the Federal Reserve's Financial Accounts of the United States (Z.1) statistical release.
The Federal Reserve projects credit RWA and market RWA (MRWA) separately. In the projection of credit RWA, the Federal Reserve assumes that features of the credit portfolio and non-trading book assets remain constant during the projection period, while the projection of MRWA takes into account changes in market conditions assumed in the supervisory scenarios.
Calculation of Regulatory Capital Ratios
The five regulatory capital measures that apply in the supervisory stress test are the (1) CET1, (2) tier 1 risk-based capital, (3) total risk-based capital, (4) tier 1 leverage, and (5) supplementary leverage ratios. A firm's regulatory capital ratios are calculated in accordance with the Board's regulatory capital rules using Federal Reserve projections of pre-tax net income and other scenario-dependent components of the regulatory capital ratios.
Pre-tax net income and the other scenario-dependent components of the regulatory capital ratios are combined with additional information, including assumptions about taxes and capital distributions, to calculate post-stress regulatory capital. In that calculation, the Federal Reserve first adjusts pre-tax net income to account for taxes and other components of net income, such as income attributable to minority interests, to arrive at after-tax net income.28
The Federal Reserve calculates the change in equity capital over the planning horizon by combining projected after-tax net income with changes in OCI, assumed capital distributions, and other components of equity capital. The path of regulatory capital over the projection horizon is calculated by combining the projected change in equity capital with the firm's starting capital position and accounting for other adjustments to regulatory capital specified in the Board's regulatory capital framework.29
The denominator of each firm's regulatory capital ratios, other than the leverage ratios, is calculated using the standardized approach for calculating RWAs for each quarter of the planning horizon, in accordance with the transition arrangements in the Board's capital rules.30
References
14. 12 CFR part 217. Return to text
15. PPNR projections do not include debt valuation adjustment, which is not included in regulatory capital. Return to text
16. See "Basel II: International Convergence of Capital Measurement and Capital Standards," https://www.bis.org/publ/bcbs107.htm. Return to text
17. See SR letter 06-17, "Interagency Policy Statement on the Allowance for Loan and Lease Losses (ALLL)," December 13, 2006, https://www.federalreserve.gov/boarddocs/srletters/2006/SR0617.htm. Return to text
18. With regard to Accounting Standards Update No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (CECL), the Federal Reserve amended its stress testing rules in December 2018 to require a banking organization that has adopted CECL to incorporate CECL in its own stress testing methodologies, data, and disclosure for the company-run stress test beginning in the stress test cycle coinciding with its first full year of CECL adoption. For example, firms that adopt CECL in 2020 are required to reflect the CECL provision for credit losses beginning in the 2020 stress test cycle. See https://www.federalreserve.gov/newsevents/pressreleases/bcreg20181221a.htm. In addition, the Board stated in December 2018 that the supervisory stress test modeling framework as it relates to CECL would not be altered for the 2019, 2020, or 2021 cycles. See "Statement on the current expected credit loss methodology (CECL) and stress testing," https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20181221b1.pdf. Return to text
19. This portfolio does not include securities held for trading. Losses on these securities are projected by the model that projects gains and losses on trading exposures. Return to text
20. Other comprehensive income is accounted for outside of net income. Under regulatory capital rules, accumulated OCI (AOCI) that arises from unrealized changes in the value of AFS securities must be incorporated into CET1 for firms subject to the advanced approaches and other firms that do not opt out of including AOCI in regulatory capital. Return to text
21. Certain government-backed securities, such as U.S. Treasuries, U.S. government agency obligations, U.S. government agency or government-sponsored enterprise (GSE) mortgage-backed securities, Federal Family Education Loan Program (FFELP) student loan asset-backed securities, and pre-refunded municipal bonds, are assumed not to be subject to credit-related OTTI charges. Return to text
22. Unrealized gains and losses on equity securities are recognized in net income and affect regulatory capital for all firms. Financial Accounting Standards Board Accounting Standards Update No. 2016-01. Return to text
23. The Board has proposed to amend its prudential standards to allow firms with total consolidated assets of less than $700 billion and cross-jurisdictional activity of less than $75 billion to opt out of including AOCI in regulatory capital (83 Fed. Reg. 61408 (November 29, 2018)). Return to text
24. The fair value of each AFS security is projected over the nine-quarter planning horizon using either a present-value calculation, a full revaluation using a security-specific discounted cash flow model, or a duration-based approach, depending on the asset class. Return to text
25. The global market shock in the 2019 supervisory stress test applies to firms that have aggregate trading assets and liabilities of $50 billion or more or trading assets and liabilities equal to or greater than 10 percent of total consolidated assets. See 82 FR 59608 (December 15, 2017). The firms subject to the global market shock include Bank of America Corporation; Barclays US LLC; Citigroup Inc.; Credit Suisse Holdings (USA), Inc.; DB USA Corporation; The Goldman Sachs Group, Inc.; HSBC North America Holdings Inc.; JPMorgan Chase & Co.; Morgan Stanley; UBS Americas Holding LLC; and Wells Fargo & Company. Return to text
26. The trading model is also used to calculate gains or losses on firms' portfolios of hedges on credit valuation adjustment exposures (CVA hedges). Return to text
27. The firms that will be subject to the LCPD component in the 2019 stress test exercise are Bank of America Corporation; The Bank of New York Mellon Corporation; Barclays US LLC; Citigroup Inc.; Credit Suisse Holdings (USA), Inc.; DB USA Corporation; The Goldman Sachs Group, Inc.; HSBC North America Holdings Inc.; JPMorgan Chase & Co.; Morgan Stanley; State Street Corporation; UBS Americas Holding LLC; and Wells Fargo & Company. Return to text
28. The Federal Reserve applies a consistent tax rate of 21 percent to pre-tax net income and accounts for deferred tax assets. Return to text
29. The regulatory capital framework specifies that regulatory capital ratios account for items subject to adjustment or deduction in regulatory capital, limits the recognition of certain assets that are less loss-absorbing, and imposes other restrictions. Return to text
30. See 12 CFR 252.42(m); 80 Fed. Reg. 75,419; 12 CFR part 217, subpart G. Return to text