Appendix A: Model Changes for the 2020 Supervisory Stress Test
Each year, the Federal Reserve has refined both the substance and process of the supervisory stress test, including its development and enhancement of independent supervisory models. The supervisory stress test models may be enhanced to reflect advances in modeling techniques; enhancements in response to model validation findings; incorporation of richer and more detailed data; and identification of more stable models or models with improved performance, particularly under stressful economic conditions.
For the 2020 supervisory stress test, the Federal Reserve aligned the calculation of regulatory capital ratios and balances with recent changes in regulations; enhanced the models that project certain components of pre-provision net revenue (PPNR), credit card losses, and corporate loan losses; completed a phase-in for the auto loan model; and modified the trading and private equity model. In addition to these model changes, the Federal Reserve made less material enhancements to simplify models and account for changes in the historical data used to estimate the models.104
Alignments to Changes in Regulatory Capital Rules
The Federal Reserve modified the capital calculation to align the computations with the capital simplification, tailoring, and stress capital buffer rules.105 To conform the calculations to the simplifications rule, the Federal Reserve increased in its capital calculation the threshold for deducting mortgage servicing assets, certain deferred tax assets (DTAs) arising from temporary differences, and investments in the capital of unconsolidated financial institutions from regulatory capital. Similarly, to align with the tailoring rule, the Federal Reserve will no longer include accumulated other comprehensive income in the calculation of certain firms' regulatory capital. Consistent with the stress capital buffer rule, the Federal Reserve will no longer include certain capital actions or the impacts of material business plan changes in its regulatory capital calculation and will assume that a firm's balances, RWAs, and leverage ratio denominators generally remain unchanged over the projection horizon.106 In addition, to maintain a consistent capital calculation methodology across all firms, the Federal Reserve will limit the use of firms' projections in the capital calculation.
The Federal Reserve will continue to monitor changes to laws and regulations related to the pandemic response and could make additional changes to its calculations if appropriate.
Refinements to Supervisory Models
PPNR Models
The Federal Reserve made two enhancements to the PPNR autoregressive models, which are the models used to project most PPNR components. In prior versions of the models, the Federal Reserve estimated firm fixed effects using the full set of data available since the financial crisis and included in each model one or more lags of the quarterly observations of the respective PPNR component. The enhanced versions estimate firm fixed effects using data from the more recent past (a trailing multiyear fixed effect) and include the lag of the respective PPNR component measured as the average of that component over the prior year. These enhancements increase the importance of firm performance in more recent years and diminish the degree to which quarterly volatility in historical PPNR affects projections over the horizon.
In addition, the Federal Reserve re-estimated its full suite of PPNR models on an expanded sample, re-specifying models based on performance testing. While those re-specifications have a small effect on overall PPNR, they result in larger offsetting effects on the projections of individual components. For example, the effect of model enhancements on projections of noninterest income is offset, in part, by the effect on the projections of noninterest expenses. Overall, the changes improve model performance for total PPNR.
These refinements have material effects on projections for certain firms.107 Consistent with the Federal Reserve's stated policy for material model changes, the PPNR estimates for the 2020 supervisory stress test will be the average of the model used in 2019 and the updated model.108 PPNR estimates for the 2021 supervisory stress test will only reflect the updated model.
Credit Card Model
The Federal Reserve refined the credit card model by applying an adjustment to card losses for firms with credit card revenue and loss sharing agreements (RLSAs). In these agreements, a portion of the revenues and losses generated by a specified credit card portfolio may be shared with a private entity. The previous version of the credit card model did not fully account for RLSAs. These agreements were reflected only in supervisory projections of the firm's PPNR to the extent that firms reported historical PPNR net of these agreements. In cases for which revenues but not losses on RLSAs are reported in historical PPNR, the updated credit card model adjusts losses to reflect the portion shared with the private entity. This update increases consistency in the treatment across firms with RLSAs. The Federal Reserve also re-estimated the credit card model using additional data to better capture recent trends. The collective impact is expected to result in a slight increase in overall losses projected by the domestic credit card model, with larger increases for firms with material bank card exposures.109
Corporate Loan Model
The Federal Reserve modified the corporate model to separately calibrate financial and non-financial obligors. This modification reflects updated expected default frequency (EDF) data that has broader coverage and an extended sample period. The Federal Reserve also re-estimated the corporate model using this extended sample to better capture the effects of the financial crisis. The collective impact is expected to result in a slight decrease in overall losses projected by the corporate model, mainly due to lower loss rates on financial obligors, with no material impacts on any firm.110
Other Model Changes
Phase-in of the Auto Loan Model
The Federal Reserve began a two-year transition to an updated auto loan model in the 2019 supervisory stress test, with the updated model fully in effect for 2020. The two-year phase-in policy was employed because the auto model refinements materially affected the forecast auto loan losses for a number of firms.111 The 2019 changes to the auto loan model are described in the 2019 document on the supervisory stress test methodology.112 Collectively, the enhancements are expected to result in a small increase in overall projected auto loan losses; however, for firms with large domestic auto loan portfolios, the changes may result in materially higher projected losses.113
Trading and Private Equity Model
The Federal Reserve will modify the estimate of losses on private equity investments in affordable housing that qualify as Public Welfare Investments (PWI) under Regulation Y. These investments will be separately identified and losses will be calculated using the market shock that is applied to Section 42 Housing Credits. The Federal Reserve intends to collect additional information to refine its approach to identifying these investments and estimating their losses.
Minor Refinements and Re-estimation
Each year, the Federal Reserve makes a number of relatively minor refinements to models that may include re-estimation with new data, re-specification based on performance testing, and other refinements to the code used to produce supervisory projections. In 2019, the Federal Reserve made such refinements to the models for commercial real estate, counterparty, fair value for debt and equity securities, first- and second-lien mortgages, and operational risk. The refinements collectively resulted in a minimal change in post-stress capital ratios with no material impacts on any disclosed firm.114
References
104. Portfolios with material model changes are defined as those in which the change in revenue or losses exceeds 50 basis points for any firm individually under the severely adverse scenario, expressed as a percentage of risk-weighted assets (RWAs), based on data and scenarios from the 2019 supervisory stress test. In cases in which a portfolio contains more than one change, materiality is defined by the net change. Return to text
105. See note 90. Return to text
106. In projecting a firm's RWAs and leverage ratio denominators, the Federal Reserve will account for the effect of changes associated with the calculation of regulatory capital or changes to the Board's regulations. Return to text
107. Analysis was conducted using data and scenarios from the 2019 supervisory stress test. The effect on projections for the 2020 supervisory stress test and future tests is uncertain and will depend on changes in firm portfolios, data, and scenarios. Return to text
108. Starting in DFAST 2017, the Federal Reserve began to adhere to a policy of phasing in the most material model enhancements over two stress test cycles to smooth the effect on post-stress capital ratios. See Stress Testing Policy Statement, 82 Fed. Reg. 59528 (Dec. 15, 2017). Return to text
109. See note 107. Return to text
110. See note 107. Return to text
111. See note 108. Return to text
112. See Board of Governors of the Federal Reserve System, Dodd-Frank Act Stress Test 2019: Supervisory Stress Test Methodology (Washington: Board of Governors, March 2019), https://www.federalreserve.gov/publications/files/2019-march-supervisory-stress-test-methodology.pdf. Return to text
113. See note 107. Return to text
114. See note 107. Return to text