Supervisory Stress Test Framework and Model Methodology
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 net income and other components of regulatory capital for each firm over a nine-quarter projection horizon. Projected net income, adjusted for the effect of taxes, is combined with non-common 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.20 Figure 11 illustrates the framework used to calculate changes in net income and regulatory capital.
Figure 11. Projecting net income and regulatory capital
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*For firms that have adopted ASU 2016-13, the Federal Reserve incorporated its projection of expected credit losses on securities in the allowance for credit losses, in accordance with FASB, Financial Instruments–Credit Losses (Topic 326), FASB ASU 2016-13 (Norwalk, Conn.: FASB, June 2016).
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, provisions for credit losses, and other losses, including
- PPNR;
- provisions for credit losses;
- losses on loans held for sale (HFS) or for investment and measured under the fair-value option (FVO);
- credit losses on investment securities in the available-for-sale (AFS) and held-to-maturity (HTM) portfolios;21
- losses on market risk exposures, credit valuation adjustment (CVA), and issuer default loss (IDL)22 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. The projections are based on the assumption that firms' balance sheets remain unchanged throughout the projection period. 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.23
The Federal Reserve models most components of PPNR using a suite of models that generally relate specific revenue and non-provision-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."24 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 projection 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
- CRE loans, including domestic and international non-owner-occupied multifamily or nonfarm, nonresidential property loans and construction and land development 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 projection 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. Generally, provisions for loan and lease losses for each quarter equal projected loan losses for the quarter plus the change in the allowance needed to cover the subsequent four quarters of expected loan losses, taking into account the allowance established by the firm as of the effective date of the stress test.25
The Federal Reserve assumes that the allowance at the end of each quarter covers projected loan losses for four quarters into the future. The supervisory estimate of the allowance at the start of the projection horizon, which is based on projected losses, may differ from a firm's established allowance at the beginning of the projection horizon, which is based on the firm's estimate of losses on the effective date of the stress test. Any difference between the supervisory calculation of the allowance and the firm's reported allowance at the beginning of the projection 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 HFS are accounted for at the lower of cost or market value.
The models for these asset classes project gains and losses on the firms' FVO/HFS loan portfolios over the nine-quarter projection horizon, net of any hedges, by applying the scenario-specific path of interest rates and credit spreads.
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 FVO/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.26 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).27 Second, credit losses 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.28 The models project security-level credit losses, using as an input the projected fair value for each security over the nine-quarter projection horizon under the macroeconomic scenarios.
Securities at risk of credit losses 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.29 Under the Board's regulatory capital rule, AOCI must be incorporated into CET1 capital for certain firms.30 The incorporation of AOCI in regulatory capital is described later in "Calculation of Regulatory Capital Ratios."
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.31
OCI losses from AFS securities are computed directly from the projected change in fair value, taking into account credit 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 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.32 In addition, the global market shock is applied to firm counterparty exposures to generate losses due to changes in CVA.
Issuer Default Loss
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 IDL account for concentration risk in agencies, trading book securitization positions, and corporate, sovereign, and municipal bonds. These losses are applied in each of the nine quarters of the projection horizon.
Largest Counterparty Default Losses
The LCPD scenario component is applied to firms with substantial trading or custodial operations. The LCPD captures the risk of losses due to an unexpected default of the counterparty whose default on all derivatives and securities financing transactions 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 in the first quarter of the projection horizon.
Balance Projections and the Calculation of Regulatory Capital Ratios
Balance Sheet Items and Risk-Weighted Assets
The Federal Reserve generally projects that a firm takes actions to maintain its current level of assets, including its securities, trading assets, and loans, over the projection horizon. The Federal Reserve assumes that a firm's risk-weighted assets (RWAs) and leverage ratio denominators remain unchanged over the projection horizon except for changes primarily related to items subject to deduction from regulatory capital or due to changes to the Board's regulations.33
Calculation of Regulatory Capital Ratios
The five regulatory capital measures that are included in the supervisory stress test are the (1) CET1 capital, (2) tier 1 risk-based capital, (3) total risk-based capital, (4) tier 1 leverage, and (5) supplementary leverage ratios (see table 2). 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.34
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.35
The Federal Reserve calculates the change in equity capital over the projection 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.36
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 projection horizon.
Capital Action Assumptions
To project post-stress capital ratios for DFAST 2021, the Federal Reserve uses the same set of standardized capital action assumptions that are specified in the Dodd-Frank Act stress test rules. As previously noted, in March 2020, the Board amended the capital action assumptions in its stress testing requirements.37 According to these amended requirements, common stock dividend payments are assumed to be zero over the projection horizon. Scheduled dividend, interest, or principal payments that qualify as additional tier 1 capital or tier 2 capital are assumed to be paid, and repurchases of such capital instruments are assumed to be zero. The capital action assumptions do not include issuances of new common stock or preferred stock. The projection of post-stress capital ratios does not include capital actions or other changes in the balance sheet associated with any business plan changes.
Data Inputs
Most of the data used in the Federal Reserve's stress test projections are gathered through the Capital Assessments and Stress Testing (FR Y-14) information collection, which includes a set of annual, quarterly, or monthly schedules.38 These reports collect detailed data on PPNR, loans, securities, trading and counterparty risk, and losses related to operational-risk events and business plan changes. Each of the firms participating in DFAST 2021 submitted FR Y-14A, FR Y-14Q, and FR Y-14M data as of December 31, 2020. The FR Y-14Q and FR Y-14M data were submitted according to the timeline indicated in the instructions.
Consistent with the Board's Stress Testing Policy Statement, the Federal Reserve makes certain assumptions about missing data or data with deficiencies significant enough to preclude the use of supervisory models.39 Given a reasonable set of assumptions or approaches, all else equal, the Federal Reserve will opt to use those that result in larger losses or lower revenue.
The conservative assumptions applied depend on the nature of the data deficiency.40 Where possible and appropriate, conservative values are assigned to specific deficient data items reported in the FR Y-14 information collection. For example, if certain observations in the first-lien mortgage portfolio were missing credit scores, the Federal Reserve would apply to those observations the 10th percentile credit score across all FR Y-14M submissions for that portfolio.
In other cases in which the data deficiency is severe enough that a modeled estimate cannot be produced for a portfolio segment or portfolio, the Federal Reserve may assign a conservative rate (e.g., the 10th percentile PPNR rate or the 90th percentile loss rate) to that segment or portfolio. In general, conservative portfolio loss rates are calculated at the most granular definition of a portfolio possible. For example, home equity losses are composed of losses on HELOCs and HELs. If a given firm reported deficient data for its HELOC portfolio only, then the overall home equity losses for that firm would be based on a conservative loss rate applied to the HELOC portfolio, but HEL projected losses would be modeled using the supervisory model.
Firms are required to submit detailed loan and securities information for all material portfolios, where portfolios categories are defined in the FR Y-14M and FR Y-14Q instructions. The definition of a portfolio's materiality varies and depends primarily on the firm's complexity. Each firm has the option to either submit or not submit the relevant data schedule for a given portfolio that does not meet the materiality threshold. If the firm does not submit data on its immaterial portfolio(s), the Federal Reserve will assign the median loss rate estimated across the set of firms with material portfolios.
Box 1. Model Changes for the 2021 Supervisory Stress Test
Model Refinements and Changes
Each year, the Federal Reserve refines 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. In addition, the Federal Reserve may make minor refinements to models. Examples include re-estimation with new data, re-specification based on performance testing, and other refinements to the code used to produce supervisory projections.
For DFAST 2021, the Federal Reserve completed the phase-in of the enhanced models that project certain components of PPNR. The Federal Reserve began a two-year transition to an updated PPNR model in DFAST 2020. The two-year phase-in policy was employed because the PPNR refinements materially affected projections for certain firms. Consistent with the Federal Reserve's stated policy for material model changes, the PPNR estimates for DFAST 2020 were the average of the results produced by model used in DFAST 2019 and the results produced under the updated model. PPNR estimates for DFAST 2021 fully reflect the updated model.
Model Adjustments due to the COVID Event
The uncertainty associated with the COVID event, the path of the economy, and the government responses present challenges for risk measurement and projections, including for the types of models used in the stress tests by both firms and the Federal Reserve. To address these challenges, the Federal Reserve made three targeted adjustments for DFAST 2021. These adjustments are intended to maintain appropriate sensitivity to stress conditions and to ensure data consistency across firms. They affect the probability of default (PD) for auto loans and credit card accounts, loss given default (LGD) for commercial real estate loans backed by hotel properties, and the calculation of the payment status for first-lien mortgages in forbearance. Following the Federal Reserve's policies related to model risk management, these adjustments were reviewed by an independent validation group.1
Auto and Credit Cards
The COVID event caused unprecedented changes in macroeconomic and financial variables. At the same time, credit risk measures have not risen appreciably from pre–COVID event levels, due to government responses to support households and businesses, as well as loss mitigation programs initiated by firms. As a result, relationships between macroeconomic variables and credit risk measures are outside their range of historical experience.
Due to these unusual circumstances, loss projections without a model adjustment would not capture the elevated risk associated with the COVID event. The Federal Reserve adjusted the 2020 values of the unemployment rate that enter the auto loan and credit card models by averaging the unemployment rate over previous quarters. This adjustment better aligns the macroeconomic variables with credit risk measures and results in higher loss projections than if the models were run without the adjustment. This adjustment is similar to the ones temporarily imposed on corporate and certain consumer loan models in the December 2020 Stress Test. Note that those particular adjustments are no longer necessary in DFAST 2021 due to the nature of the specific model structures.
Commercial Real Estate
In 2020, demand for hotels declined substantially because of travel restrictions, lockdowns, and other COVID event-related factors, leading to an unprecedented increase in hotel vacancy rates and a steep drop in hotel property values. The Federal Reserve's stress test framework projects that loans collateralized by hotel properties in markets with extraordinarily high vacancy rates would experience losses that reflect significantly lower collateral recovery rates than have been historically observed. In the December 2020 Stress Test, the Federal Reserve set a lower bound on the recovery rate for such loans that reflects this value.2 The Federal Reserve raised the lower bound in DFAST 2021, reflecting a stabilization in hotel property values in the second half of 2020. Raising the lower bound on recovery rates results in lower projected losses.
First-Lien Mortgages
The COVID event has severely affected the ability of some borrowers to repay their loans.3 Loan loss mitigation and forbearance programs implemented widely by the federal government assisted borrowers struggling to make payments. While these programs affect nearly all consumer loans to varying degrees, the percentage of loan balances in forbearance is material for first-lien mortgages. At the same time, there are important differences in how individual firms reported loss mitigation data on regulatory reports. For DFAST 2021, the Federal Reserve adjusted the calculation of payment status for first-lien mortgages in forbearance to standardize reporting practices across firms. This is the same adjustment that was made in the December 2020 Stress Test. This adjustment results in higher projected losses than if the model were run without the adjustment.
Government Support Programs
Consistent with previous stress tests, the model adjustments in DFAST 2021 do not directly account for an increase in government support programs. These programs—including expanded eligibility for unemployment insurance, larger unemployment insurance payments, and federal loan guarantee programs, such as the Paycheck Protection Program (PPP)—support credit access and improve credit quality for households and businesses.4 Many COVID event-related support programs for households and businesses have already expired or will expire in the coming months. Note that the Federal Reserve's stress test framework does not directly incorporate potential future policy actions, although some aspects may be indirectly considered during the design of the supervisory scenarios.
1. Each year, an independent System Model Validation group validates the supervisory stress test models. This group's model validation process includes reviews of model performance, conceptual soundness, and the processes, procedures, and controls used in model development, implementation, and the production of results. See Board of Governors of the Federal Reserve System (2021), Dodd-Frank Act Stress Test 2021: Supervisory Stress Test Methodology (Washington: Board of Governors, April), https://www.federalreserve.gov/publications/files/2021-april-supervisory-stress-test-methodology.pdf. Return to text
2. See Board of Governors of the Federal Reserve System, December 2020 Stress Test Results (Washington: Board of Governors, December 2020), https://www.federalreserve.gov/publications/files/2020-dec-stress-test-results-20201218.pdf. Return to text
3. A survey by the U.S. Census Bureau in late May and early June 2021 estimated that 9.7 percent of mortgage borrowers had little to no confidence that they could complete their mortgage payment. See Household Pulse Survey, https://www.census.gov/data/tables/2021/demo/hhp/hhp31.html. Return to text
4. The Federal Reserve reflects the federal loan guarantee for PPP loans in its stress test. The Federal Reserve's stress test assumes that PPP loans earn interest income but incur no credit losses. In addition, PPP loans are assigned a risk weight of zero, consistent with the regulatory capital rule. Return to text
References
20. See 12 C.F.R. pt. 217. Return to text
21. For firms that have adopted Accounting Standards Update (ASU) 2016-13, the Federal Reserve incorporated its projection of expected credit losses on securities in the allowance for credit losses, in accordance with Financial Accounting Standards Board (FASB), Financial Instruments–Credit Losses (Topic 326), FASB ASU 2016-13 (Norwalk, Conn.: FASB, June 2016). Return to text
22. This was formerly known as the "Incremental Default Risk" model. The name change does not reflect a change in the model, but rather was made to enhance consistency with industry terminology and to better distinguish between modeling of issuer defaults and counterparty defaults. Return to text
23. PPNR projections do not include debt valuation adjustments, which are not included in regulatory capital. Return to text
24. See Basel Committee on Banking Supervision, International Convergence of Capital Measurement and Capital Standards (Basel, Switzerland: BCBS, June 2004), 149, https://www.bis.org/publ/bcbs107.pdf. Return to text
25. To reduce uncertainty, allow for better capital planning at affected firms, and gather additional information on the effect of Current Expected Credit Losses (CECL), the Federal Reserve maintained the framework used prior to the adoption of CECL for calculating allowances on loans in DFAST 2021. See Board of Governors of the Federal Reserve System, "Statement on the Current Expected Credit Loss Methodology (CECL) and Stress Testing," press release, December 21, 2018, https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20181221b1.pdf. Return to text
26. 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
27. OCI 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 capital for firms subject to the advanced approaches and other firms that do not opt out of including AOCI in regulatory capital. Return to text
28. Certain government-backed securities, such as U.S. Treasuries, U.S. government agency obligations, U.S. government agency or government-sponsored enterprise mortgage-backed securities, Federal Family Education Loan Program student loan asset-backed securities, and pre-refunded municipal bonds, are assumed not to be subject to credit losses. Return to text
29. Unrealized gains and losses on equity securities are recognized in net income and affect regulatory capital for all firms. See FASB, Financial Instruments—Overall(Subtopic 825-10), FASB ASU 2016-01 (Norwalk, Conn.: FASB, January 2016). Return to text
30. The Board's capital rule allows firms that are not subject to Category I or II standards to opt out of including AOCI in regulatory capital. See 12 C.F.R. § 217.22(b)(2). Return to text
31. The fair value of each AFS security is projected over the nine-quarter projection 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
32. The trading model is also used to calculate gains or losses on firms' portfolios of hedges on CVA exposures (CVA hedges). Return to text
33. See 12 C.F.R. pt. 252, appendix B. Return to text
34. In April 2020, the Board temporarily excluded deposits at Federal Reserve Banks and holdings of U.S. Treasuries from the denominator of the supplementary leverage ratio (SLR). This temporary relief expired after the first quarter of 2021, and the Federal Reserve has adjusted its supervisory capital calculation to reflect this change in the firms' projected SLR. See 85 Fed. Reg. 20578 (Apr. 14, 2020). Return to text
35. The Federal Reserve applies a consistent tax rate of 21 percent to pre-tax net income and accounts for deferred tax assets. The tax calculations do not include the effect of the temporary provision in the Coronavirus Aid, Relief, and Economic Security (CARES) Act to allow for tax carrybacks, which expired at the end of the 2020 tax year. Return to text
36. 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
37. See 85 Fed. Reg. 15576 (Mar. 18, 2020). Return to text
38. The FR Y-14 report forms are available on the Federal Reserve website at https://www.federalreserve.gov/apps/reportforms/default.aspx. Return to text
39. See 12 C.F.R. pt. 252, appendix B. Return to text
40. The Federal Reserve has established conservative approaches for missing or insufficient data for its core PPNR, operational-risk loss, retail loan loss, wholesale loan loss, securities loss, fair-value loan loss, and CVA models. The methodology that the Federal Reserve uses to implement these assumptions may vary somewhat across supervisory models. Return to text