Board of Governors of the Federal Reserve System

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 the capital adequacy of holding companies that uses standard assumptions across all covered firms. CCAR evaluates the capital planning practices and capital adequacy of holding companies using capital actions, such as dividend payments and share repurchases, planned by those firms.

This publication describes the two supervisory scenarios—baseline and severely adverse—that the Board will use in its supervisory stress tests this year; that a firm must use in conducting its 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 2020 capital plan submission.² This publication also details additional components—the global market shock component and the counterparty default component—that the largest and most complex firms must incorporate into the supervisory scenarios.

Supervisory Scenarios

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

The scenarios start in the first quarter of 2020 and extend through the first quarter of 2023. 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 and Severely Adverse Scenarios

The following sections describe the baseline 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 2020 consensus projections from Blue Chip Economic Indicators.⁴ This scenario does not represent a forecast of the Federal Reserve.

The baseline scenario for the United States is a moderate economic expansion over the 13-quarter stress-test period. Real GDP growth averages 1-3/4 percent (annual rate) in 2020, picks up to 2 percent by the end of 2021, and remains at that level in 2022. The unemployment rate ticks up to about 3-3/4 percent by the end of 2020, then increases to about 4 percent in early 2022, and remains at that level for the rest of the scenario period. Quarterly CPI inflation is relatively steady over the 13–quarter period, ranging from 2 to 2-1/4 percent at an annual rate.

Accompanying the moderate economic expansion, short-term Treasury rates are assumed to initially decline to slightly below 1-1/2 percent by the end of 2020, remain around that level through the end of 2021, and then rise to 1-3/4 percent by the end of the stress-test period. Longer-dated Treasury yields are assumed to rise modestly over time, consistent with some steepening of the yield curve. Yields on 10-year Treasury securities rise gradually from 1-3/4 percent in early 2020 to 2-3/4 percent at the end of the scenario period. The prime rate moves in line with short-term Treasury rates, while both corporate bond yields and mortgage rates rise in line with long-term Treasury yields. Equity prices rise 4-1/2 percent in 2020 and about 4-3/4 percent per year thereafter. Equity market volatility, as captured by the VIX, rises gradually from 22-3/4 in early 2020 to 26-1/2 by the end of the scenario period. Nominal house prices rise 2-1/4 percent in 2020 and 2021, and about 3-1/4 percent in 2022. The growth rate of commercial real estate prices averages about 5 percent in 2020 and 2021, and 2-3/4 percent in 2022.

The baseline paths for the international variables (see Table 2.B) are similar to the trajectories reported in the January 2020 Blue Chip Economic Indicatorsand the International Monetary Fund's October 2019 World Economic Outlook.⁵ The baseline scenario features a relatively steady expansion in international economic activity, albeit at a different pace across the four country blocs: Real GDP growth in developing Asia averages 5-3/4 percent per year through the scenario period, real GDP growth in the euro area averages about 1-1/4 percent, and real GDP growth in Japan averages about 3/4 percent. Finally, real GDP growth in the United Kingdom averages just over 1-1/4 percent over 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 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 2021 (see Table 3.A). This substantial increase 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 8-1/2 percent from its pre-recession peak, reaching a trough in the third quarter of 2021. The decline in activity is accompanied by a lower headline CPI inflation rate, which falls to an annual rate of about 1-1/4 percent after the first quarter of 2020, before gradually rising to average 1-3/4 percent in 2022.

In line with the severe decline in real activity, the interest rate for 3-month Treasury bills immediately falls near zero and remains at that level through the end of the scenario. The 10-year Treasury yield immediately falls to 3/4 percent during the first quarter of 2020 and rises gradually thereafter to 2-1/4 percent by the end of the stress-test period. The result is a gradual steepening of the yield curve over most of the stress-test 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 5-1/2 percentage points by the third quarter of 2020, an increase of 4 percentage points relative to the fourth quarter of 2019. The spread between mortgage rates and 10-year Treasury yields widens to 3-1/2 percentage points over the same period.

Asset prices drop sharply in this scenario. Equity prices fall 50 percent through the end of 2020, accompanied by a rise in the VIX, which reaches a peak of 70. House prices and commercial real estate prices also experience large overall declines of about 28 percent and 35 percent, respectively, during the first nine quarters of the scenario.

The international component of this scenario features sharp slowdowns in all country blocs, leading to severe recessions in the euro area, the United Kingdom, and Japan and a pronounced deceleration of activity in developing Asia. As a result of the sharp contraction in economic activity, three of the foreign economies included in the scenario—the euro area, Japan, and developing Asia—experience sharp declines in inflation rates. 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 2020 Severely Adverse Scenario and the 2019 Severely Adverse Scenario

This year's severely adverse scenario features a slightly greater increase in the unemployment rate in the United States compared to last year's severely adverse scenario. This difference 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 stronger. 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 10 percent. In this year's scenario, interest rates do not fall as much as in last year's scenario, given their lower starting values. The declines in equity prices, house prices, and commercial real estate prices are similar to the declines in last year's 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 is assumed to be more protracted in countries with less room for fiscal policy stabilization. The sharp slowdown in developing Asia should be assumed to be representative of conditions across emerging market economies.

Stresses in the corporate loan market should be assumed to be more intense for lower-rated firms. Declines in aggregate U.S. residential and commercial real estate prices is 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 Severely Adverse Scenario

The global market shock is a set of hypothetical shocks to a large set of risk factors reflecting general market distress and heightened uncertainty. Firms with significant trading activity must consider the global market shock as part of their supervisory severely adverse scenario, and recognize associated losses in the first quarter of the planning period.⁷ In addition, certain large and highly interconnected firms must apply the same global market shock to project losses under the counterparty default scenario component. The global market shock is applied to asset positions held by the firms on a given as-of date. The as-of date for the global market shock is October 18, 2019.⁸ These shocks do not represent a forecast of the Federal Reserve.

The design and specification of the global market shock differ from that of the macroeconomic scenarios for several reasons. First, profits and losses from trading and counterparty credit are measured in mark-to-market terms, while revenues and losses from traditional banking are generally measured using the accrual method. Another key difference is the timing of loss recognition. The global market shock affects the mark-to-market value of trading positions and counterparty credit losses in the first quarter of the projection horizon. This timing is based on an observation that market dislocations can happen rapidly and unpredictably any time under stress conditions. Applying the global market shock in the first quarter of the projection horizon ensures that potential losses from trading and counterparty exposures are incorporated into trading companies' capital ratios at all points in the projection horizon.

The global market shock component is specified by a large set of risk factors that include, but are not limited to:

• Equity prices of key developed markets and developing and emerging market nations to which trading companies may have exposure, along with selected points along term structures of implied volatilities;

• Foreign exchange rates of most advanced economy and some emerging economy currencies, along with selected points along term structures of implied volatilities;

• Selected maturity government rates (e.g., U.S. Treasuries), swap rates, and other key rates for key developed markets and for developing and emerging market nations to which trading companies may have exposure;

• Selected maturities and expiries of implied volatilities that are key inputs to the pricing of interest rate derivatives;

• Selected expiries of futures prices for energy products including crude oil (differentiated by country of origin), natural gas, and power;

• Selected expiries of futures prices for metals and agricultural commodities; and

• Credit spreads or prices for selected credit-sensitive products including corporate bonds, credit default swaps, and loans by risk; non-agency residential mortgage-backed securities and commercial mortgage-backed securities by risk and vintage; sovereign debt; and municipal bonds.

The Board considers emerging and ongoing areas of financial market vulnerability in the development of the global market shock. This assessment of potential vulnerabilities is informed by financial stability reports, supervisory information, and internal and external assessments of potential sources of distress such as geopolitical, economic, and financial market events.

The global market shock includes a standardized set of risk factor shocks to financial market variables that apply to all firms with significant trading activity. Depending on the type of financial market vulnerabilities the global market shock assesses, the market shocks could be based on a single historical episode, multiple historical periods, hypothetical (but plausible) events that are based on salient risks, or a hybrid approach comprising some combination of historical episodes and hypothetical events. A market shock based on hypothetical events may result in changes in risk factors that were not previously observed.

Risk factor shocks are calibrated based on assumed time horizons. The calibration horizons reflect a number of considerations related to the scenario being modeled. One important consideration is the liquidity characteristics of different risk factors, which vary based on the specified market shock narrative. More specifically, calibration horizons reflect the variation in the speed at which trading companies could reasonably close out, or effectively hedge, risk exposures in the event of market stress. The calibration horizons are generally longer than the typical time needed to liquidate assets under normal conditions because they are designed to capture the unpredictable liquidity conditions that prevail in times of stress, among other factors.⁹ For example, changes within more liquid markets, such as interest rates, foreign exchange, or public equities, are calibrated to shorter horizons, such as three months, while changes within less liquid markets, such as non-agency securitized products or private equities, have longer calibration horizons, such as 12 months.

2020 Severely Adverse Scenario

The 2020 global market shock component for the severely adverse scenario is designed to be generally consistent with a macroeconomic background in which the U.S. economy has entered a sharp recession, characterized by widespread defaults on a range of debt instruments by business borrowers. Under the scenario, weaker obligors struggle to maintain their financial conditions due to material declines in earnings associated with the poor economic environment while rating agencies downgrade large portions of debt outstanding. The historically high levels of nonfinancial corporate debt to GDP amplify the losses resulting from the wave of corporate sector defaults. This dynamic creates feedback effects between the economy and the corporate sector.

Spreads widen sharply for non-investment grade and low investment grade bonds as ratings-sensitive investors anticipate further downgrades and sell assets. Similarly, the leveraged loan market comes under considerable pressure. Open-ended mutual funds and exchange-traded funds (ETFs) that hold leveraged loans and high yield bonds face heavy redemptions. Due to liquidity mismatches, mutual fund and ETF managers sell their most liquid holdings, leading to more extensive declines in the prices of fixed income securities and other related assets. Price declines on leveraged loans flow through to the prices for collateralized loan obligations (CLOs). CLO prices suffer severe corrections associated with the devaluation of the underlying collateral and selling by concentrated holders desiring to reduce risk.

The broad selloff of corporate bonds and leveraged loans spills over to prices for other risky credit and private equity instruments. Credit spreads for emerging market corporate credit and sovereign bonds widen due to flight-to-safety considerations. Asset values for private equity experience sizable declines as leveraged firms face lower earnings and a weak economic outlook. Municipal bond spreads widen in line with lower municipal tax revenues associated with the severe weakening of the U.S. economy.

Short-term U.S. Treasury rates fall sharply reflecting an accommodative monetary policy response to the hypothetical economic downturn. Longer-term U.S. Treasury rates fall more modestly as the United States benefits from a flight-to-safety. Short-term U.S. interbank lending rates rise as firms face increased funding pressure from a pullback in overnight lending, while longer-term swap rates fall in sync with the decreases in long-term U.S. Treasury rates. This is not a forecast of how monetary policy would necessarily respond to these conditions.

Flight-to-safety considerations cause the U.S. dollar to appreciate somewhat against the currencies of most advanced economies, except the Swiss franc and the Japanese yen. The yen appreciates against the U.S. dollar as investors unwind positions and view the yen as a safe-haven currency. The Swiss franc appreciates against the U.S. dollar as investors seek an alternative safe-haven currency. Safe-haven considerations cause traditional precious metals to experience an increase in value while non-precious metals prices fall due to lower demand from the general economic weakness.

Comparison of the 2020 Severely Adverse Scenario and the 2019 Severely Adverse Scenario

This year's global market shock for the severely adverse scenario emphasizes a heightened stress to highly leveraged markets that causes CLOs and private equity investments to experience larger market value declines relative to 2019. There is a general spike in short-term interbank lending rates instead of a decline, as this year's scenario highlights a severe increase in funding pressures. European equity markets weaken at more modest levels relative to 2019, while U.S. equity markets fall more sharply. In addition, European currencies depreciate less severely against the U.S. dollar this year, reflecting the U.S.-focused nature of this year's scenario.

Counterparty Default Component for Supervisory Severely Adverse Scenario

Firms with substantial trading or custodial operations will be required to incorporate a counterparty default scenario component into the severely adverse scenario used in their company-run stress test.¹⁰ The counterparty default scenario component involves the instantaneous and unexpected default of the firm's largest counterparty.^{11 ,12}

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 severely adverse stress scenario.

The largest counterparty of each firm will be determined by net stressed losses. Net stressed losses are estimated by applying the global market shock to revalue non-cash securities financing transactions (securities or collateral) posted or received and, for derivatives, the trade position and non-cash collateral exchanged. The as-of date for the counterparty default scenario component is October 18, 2019—the same date as the global market shock.¹³

Variables for the Supervisory Scenarios

Table 1.A. Historical data: Domestic variables, Q1:2000–Q4:2019

Table 1.B. Historical data: International variables, Q1:2000–Q4:2019

Table 2.A. Supervisory baseline scenario: Domestic variables, Q1:2020–Q1:2023

Table 2.B. Supervisory baseline scenario: International variables, Q1:2020–Q1:2023

Table 3.A. Supervisory severely adverse scenario: Domestic variables, Q1:2020–Q1:2023

Table 3.B. Supervisory severely adverse scenario: International variables, Q1:2020–Q1:2023

Notes Regarding Scenario Variables

Sources for data through 2019:Q4 (as released through January 18, 2020). The 2019: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 CPI for all urban consumers (CPI-U), 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 notes, 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 notes, 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: Quarterly average of ICE BofAML US Corporate 7-10 Year Yield-to-Maturity Index, ICE Data Indices, LLC, used with permission. (C4A4 series).

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