Board of Governors of the Federal Reserve System

Supervisory Scenarios

On February 12, 2021, the Federal Reserve published the two supervisory scenarios for DFAST 2021: baseline and severely adverse.⁹ This section describes the severely adverse scenario that was used for the projections contained in this report. These scenarios were developed using the approach described in the Board's Policy Statement on the Scenario Design Framework for Stress Testing.¹⁰ The severely adverse scenario is not a forecast but rather a hypothetical scenario designed to assess the strength of banking organizations and their resilience to an unfavorable economic environment.

The DFAST 2021 supervisory scenarios include trajectories for 28 variables. These include 16 variables that capture economic activity, asset prices, and interest rates in the U.S. economy and financial markets, and an additional three variables (real GDP growth, inflation, and the U.S./foreign currency exchange rate) for each of four foreign country blocs.

In 2021, the Federal Reserve applied a global market shock to the trading and private equity portfolios of 10 firms with large trading exposures and a largest counterparty default (LCPD) scenario component to 12 firms with substantial trading, processing, or custodial operations (see "Global Market Shock and Counterparty Default Components").

Severely Adverse Scenario

Figures 5 through 10 illustrate the trajectories for some of the key variables describing U.S. economic activity and asset prices under the severely adverse scenario.

The severely adverse scenario is characterized by a severe global recession accompanied by a period of heightened stress in CRE and corporate debt markets. Consistent with the Scenario Design Framework, under the severely adverse scenario, the U.S. unemployment rate climbs to a peak of 10-3/4 percent in the third quarter of 2022 (see table A.5), a 4 percentage point increase relative to its fourth quarter 2020 level.¹¹ Real GDP falls 4 percent from the end of the fourth quarter of 2020 to its trough in the third quarter of 2022. The decline in activity is accompanied by a lower headline consumer price index (CPI) inflation rate, which quickly falls to an annual rate of about 1 percent in the second quarter of 2021, and stays at that level for another quarter before gradually rising to 2-1/4 percent by the end of the scenario period.

In line with the sharp decline in real activity, the 3-month Treasury rate remains near zero throughout the scenario. The 10-year Treasury yield immediately falls to 1/4 percent during the first quarter of 2021 and stays there through the first quarter of 2022, after which it gradually rises, reaching 1-1/2 percent by the end of the scenario period. The result is a gradual steepening of the yield curve over much of the scenario period.

Conditions in corporate and real estate lending markets deteriorate markedly. The spread between yields on investment-grade corporate bonds and yields on 10-year Treasury securities widens to almost 5-3/4 percentage points by the third quarter of 2021, an increase of 4-1/4 percentage points relative to the fourth quarter of 2020. 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 55 percent through the third quarter of 2021, accompanied by a rise in the VIX, which reaches a peak of 70. House prices and CRE prices also experience large overall declines. House prices decline 23-1/2 percent through the end of 2022, while CRE prices fall 40 percent through the first quarter of 2023.

The international component of this scenario features severe recessions in the euro area, the United Kingdom, and Japan, and a significant deceleration of activity (though still with positive growth for most of the scenario period) in developing Asia. The U.S. dollar appreciates against the euro, the pound sterling, and the currencies of developing Asia, but depreciates modestly against the yen, reflecting flight-to-safety capital flows.

Additional Key Features of the Severely Adverse Scenario

Stresses in the corporate loan market should be assumed to be more intense for lower-rated nonfinancial firms. Declines in aggregate U.S. house prices should be assumed to be concentrated in regions that have experienced rapid price gains over the past two years. Declines in CRE prices should be assumed to be representative of risks to certain industries and property types that are being significantly affected by the COVID event in the United States. Declines in U.S. house prices and U.S. CRE prices should also be assumed to be representative of risks to house prices and CRE prices in foreign regions and economies that experienced rapid price gains before the COVID event and were significantly affected by the event. Moreover, 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 ability to use fiscal policy to lean against the slowdown in economic activity. Conditions across Latin American economies should be assumed to be comparable to the sharp slowdown in the United States. The growth slowdown in developing Asia should be assumed to be representative of conditions across many emerging market economies.

Global Market Shock and Counterparty Default Components

The Federal Reserve applied a global market shock to the trading and private equity portfolios of 10 firms with large trading exposures.¹² In addition, the Federal Reserve applied an LCPD component, which assumes the default of a firm's largest counterparty under the global market shock, to the same 10 firms and 2 other firms with substantial trading, processing, or custodial operations.¹³ These components are each an add-on to the economic conditions and financial market environment specified in the severely adverse scenarios.

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 and recognize associated losses in the first quarter of the projection period.¹⁴ In addition, certain large and highly interconnected firms must apply the same global market shock when projecting losses under the LCPD 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 DFAST 2021 global market shock is October 9, 2020.¹⁵ These shocks do not represent a forecast of the Federal Reserve.

The design and specification of the global market shock differ from those for 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 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 firms' capital ratios at all points over the projection period.

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 major and some minor currencies, along with selected points along term structures of implied volatilities;
• selected-maturity sovereign debt yields (e.g., U.S. Treasury yields), swap rates, and other major interest rates for key developed markets and developing economies;
• 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 that 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.¹⁶ For example, more-liquid asset classes, such as interest rates, foreign exchange, or public equities, are calibrated to shorter horizons, such as 3 months, while less-liquid assets, such as non-agency securitized products or private equities, have longer calibration horizons, such as 12 months.

2021 Severely Adverse Scenario

The 2021 global market shock component for the severely adverse scenario is characterized by a sharp curtailment in global economic activity as financial conditions tighten. In particular, with ratings agencies downgrading large swaths of outstanding debt, corporate bond spreads widen sharply as ratings-sensitive investors sell assets. The effect on investment-grade debt is somewhat mitigated by flight-to-safety flows, but non-investment-grade debt experiences high default rates and record low recovery rates. Price declines in the leveraged loan market are exacerbated by selling from open-end mutual funds and exchange-traded funds.

With fiscal conditions that are already stretched, U.S. state and local governments face additional stress. Revenue declines, combined with significant spending increases, lead to a widening in municipal bond spreads and increased risk of defaults. Mutual funds holding municipal debt face redemptions and outflows exceeding historical experience.

CRE prices—particularly for the retail and hospitality sectors—fall sharply in this scenario. Rapid selling of commercial mortgage-backed securities (CMBS) by nonbank CRE lenders to meet margin calls puts considerable downward pressure on CMBS prices. Private-equity asset values experience sizable declines as leveraged firms face lower earnings and a weak economic outlook.

Short-term Treasury rates decrease only slightly given the current low level of short-term interest rates. Longer-term Treasury yields fall modestly, consistent with lower expected short-term rates and flight-to-safety considerations. Short-term U.S. interbank lending rates rise sharply, reflecting a pullback in overnight lending. At the same time, longer-term swap rates fall in line with the decreases in long-term Treasury yields.

Flight-to-safety considerations result in U.S. public equity price declines that are relatively mild compared to other developed markets, and cause the U.S. dollar to appreciate somewhat against the currencies of most developed economies. The yen appreciates against the U.S. dollar as investors unwind positions. Safe-haven considerations cause precious metal prices to increase, while prices for non-precious metals and oil decline, as a result of the broader economic weakness.

Largest Counterparty Default Component of the Supervisory Severely Adverse Scenario

Firms with substantial trading or custodial operations are required to incorporate a largest counterparty default scenario component into their supervisory severely adverse stress scenario for DFAST 2021 and recognize associated losses in the first quarter of the projection horizon.¹⁷ This component involves the unexpected default of the firm's largest counterparty.¹⁸

In connection with the largest counterparty default scenario component, these firms are required to estimate and report the potential losses and related effects on capital associated with the 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 largest counterparty default scenario component is an add-on to the Federal Reserve's severely adverse scenario.

The largest counterparty of each firm is determined by net stressed losses. Net stressed losses are estimated by applying the global market shock to revalue securities financing transactions and derivatives, including collateral posted or received. The as-of date for the DFAST 2021 counterparty default scenario component is October 9, 2020—the same date as for the global market shock.¹⁹

 

References

 

 9. For additional information and for the details of the supervisory scenarios, see Board of Governors of the Federal Reserve System (2021), 2021 Stress Test Scenarios (Washington: Board of Governors, February), https://www.federalreserve.gov/publications/stress-test-scenarios-february-2021.htm. Return to text

 10. See 12 C.F.R. pt. 252, appendix A. Return to text

 11. The Scenario Design Framework suggests an increase in the unemployment rate in the range between 3 and 5 percentage points from its initial level, with the expectation that the Federal Reserve will select an increase from the lower end of the range when the unemployment rate is already elevated. Return to text

 12. The 10 firms subject to the global market shock are 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; and Wells Fargo & Company. See 12 C.F.R. § 252.54(b)(2)(i). Return to text

 13. The 12 firms subject to the LCPD component 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; and Wells Fargo & Company. See 12 C.F.R. § 252.54(b)(2)(ii). Return to text

 14. The global market shock component applies to a firm that is subject to the supervisory stress test and that has aggregate trading assets and liabilities of $50 billion or more, or aggregate trading assets and liabilities equal to 10 percent or more of total consolidated assets, and is not a Category IV firm. See 12 C.F.R. § 252.54(b)(2)(i). Return to text

 15. A firm may use data as of the date that corresponds to its weekly internal risk reporting cycle as long as the date falls during the business week of the as-of date for the global market shock (i.e., October 5–9, 2020). Return to text

 16. Markets that are well-functioning and that appear to be very liquid can undergo abrupt changes in times of financial stress, and the timing and severity of changes in market liquidity may diverge from historical experience. For example, before the 2007–09 financial crisis, AAA-rated private-label residential mortgage-backed securities would likely have been considered highly liquid, but their liquidity deteriorated drastically during the crisis period. Return to text

 17. The Board may require a firm to include one or more additional components in its severely adverse scenario in the annual stress test based on the company's financial condition, size, complexity, risk profile, scope of operations, or activities, or based on risk to the U.S. economy. See 12 C.F.R. § 252.54(b)(2)(ii). Return to text

 18. In selecting its largest counterparty, a firm subject to the counterparty default component will not consider certain sovereign entities (Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States) or qualifying central counterparties (QCCPs). See definition of a QCCP at 12 C.F.R. § 217.2. Return to text

 19. As with the global market shock, a firm subject to the counterparty default component may use data as of the date that corresponds to its weekly internal risk reporting cycle as long as the date falls during the business week of the as-of date for the counterparty default scenario component (i.e., October 5–9, 2020). Return to text