Board of Governors of the Federal Reserve System

Supervisory Stress Test Results under the Severely Adverse Scenario

This section describes the Federal Reserve's projections of losses, revenues, expenses, and capital positions for the 23 firms in DFAST 2021 under the severely adverse scenario. Results are presented both in the aggregate and for individual firms. The aggregate results reflect the combined sensitivities of losses, revenues, and capital at these firms to the stressed economic and financial market conditions contained in the severely adverse scenario. The range of results across individual firms reflects differences in business focus, asset composition, revenue and expense sources, and portfolio risk characteristics. The comprehensive results for individual firms are reported in appendix B.

Changes in supervisory stress test results across exercises reflect changes in

• firm starting capital positions;⁴¹
• the scenario used for the supervisory stress test;
• portfolio composition and risk characteristics; and
• models used in the supervisory stress test.

Under the supervisory severely adverse scenario, the aggregate CET1 ratio is projected to decline to a minimum of 10.6 percent before rising to 11.2 percent at the end of nine quarters (see table 3). In the aggregate, each of the five capital and leverage ratios declined over the course of the projection horizon from their levels in the fourth quarter of 2020, with levels in the first quarter of 2023 ranging from 1.0 percentage point to 1.8 percentage points lower than at the start of the projection horizon (see table 3).

The changes in post-stress capital ratios vary considerably across firms (see figure 13), and table 4 presents these ratios for each of the firms. Differences in the declines in ratios across firms are caused by variation in firms' business lines, their portfolios, and the characteristics of loans within these portfolios. This variation drives differences in magnitude and timing of loss, revenue, and expense projections in the Federal Reserve's stress test. The magnitude and timing of loss, revenue, and expense projections for a firm across stress tests may vary with the projected path of economic and financial components of the supervisory severely adverse scenario, in combination with a firm's business lines and portfolio characteristics.

Projected Losses

The Federal Reserve projects that the firms as a group would experience $474 billion in losses on loans and other positions in the aggregate over the nine quarters of the projection horizon.

These losses include

• $353 billion in accrual loan portfolio losses;
• $4 billion in securities losses;⁴²
• $86 billion in trading and counterparty losses at the 12 firms with substantial trading, processing, or custodial operations; and
• $31 billion in additional losses from items such as loans booked under the FVO (see table 3).

Losses on accrual loan portfolios account for 75 percent of the projected losses for the firms, while trading and counterparty losses account for 18 percent (see figure 12).

Loan Losses

Total loan losses are $353 billion in DFAST 2021. Although overall loan losses in DFAST 2021 are similar to that of DFAST 2020 for the firms participating this year, the composition of losses differs between the two stress tests.

Differences in projected losses over time primarily reflect changes in loan and borrower characteristics and changes in the scenarios. Over the course of 2020, there was a shift in the composition of firms' loan portfolios away from portfolios with higher loss rates. In particular, consumer credit card balances have declined significantly since the start of 2020 as a result of reduced consumer spending and higher loan repayment rates. This decline in credit card balances resulted in lower credit card losses. However, this effect was offset by higher losses on CRE loans, mainly driven by an increase in vacancy rates in the hospitality sector.

Consequently, loan losses on consumer products represent a smaller share of losses than losses on commercial products than in DFAST 2020 (see table 3). Consumer and commercial products represent 29 and 45 percent of total projected losses, respectively. C&I loan losses and credit card losses are the two largest categories of loan losses at $92 billion and $91 billion, respectively.

The aggregate nine-quarter cumulative loss rate for all accrual loan portfolios is 6.2 percent.⁴³ However, total loan loss rates vary significantly across the firms, ranging between 1.5 percent and 12.8 percent (see table 8 and figure 14).

Firms' loan loss rates reflect differences in the portfolios held by each firm and characteristics of the loans within each portfolio. Loan portfolio composition matters because projected loss rates vary significantly for different types of loans. In the aggregate, nine-quarter cumulative loss rates range from 1.5 percent on domestic first-lien mortgages to 16.2 percent on credit cards, reflecting both differences in the typical performance of these loans and differences in the sensitivity of different types of loans to the scenarios. Lending categories for which performance is sensitive to credit spreads or unemployment rates may experience high stressed loss rates due to the considerable stress on these factors in the severely adverse scenario.⁴⁴

Projected loss rates on most loan categories show variation across firms, which underscores the differences between each firm's loan portfolio (see table 8 and figures C.1 through C.7). There are significant differences across firms in the projected loan loss rates for similar types of loans. For example, while the median projected loss rate on C&I loans is 7.5 percent, the rates among firms with C&I loans vary from a low of 1.1 percent to a high of 18.9 percent. For credit card loans, the range of projected loss rates is 14.3 percent to 25.0 percent, with a median of 16 percent.

Losses on Trading, Private Equity, Securities Financing Transactions, and Derivatives Positions

The severely adverse scenario results include $86 billion in trading and counterparty losses generated from the global market shock and LCPD components. For the 12 firms subject to one or both components, losses ranged from $0.5 billion to $21.1 billion (see table 6).

The relative size of losses across firms depends on the specific risk characteristics of each firm's trading positions, inclusive of hedges. Importantly, these projected losses are based on the trading positions and counterparty exposures held by these firms on the same as-of date (October 9, 2020) and could have differed if they had been based on a different date.

Projected PPNR

In the aggregate, the firms are projected to generate $298 billion in PPNR cumulatively over the nine quarters of the projection horizon, equal to 1.7 percent of their combined average assets (see table 3). PPNR projections are driven by the shape of the yield curve, the path of asset prices, equity market volatility, and measures of economic activity in the severely adverse scenario. In addition, PPNR projections incorporate expenses stemming from estimates of elevated levels of losses from operational-risk events such as fraud, employee lawsuits, litigation-related expenses, or computer system or other operating disruptions.⁴⁵ In the aggregate for the 23 firms, operational-risk losses are $151 billion for DFAST 2021. This amount is slightly higher than the $136 billion projected for the same set of firms in DFAST 2020.

Aggregate PPNR as a percent of combined average assets is lower under the severely adverse scenario in DFAST 2021 than in DFAST 2020. Lower PPNR is partly due to lower net interest income, reflecting a sharper decrease in the term spread under the severely adverse scenario and an increase in firm holdings of low-yielding assets. There were also other fairly sizable changes in firms' balance sheets in 2020. All else equal, larger balance sheets result in higher revenue that is roughly offset by higher expenses in the stress test projections. Noninterest income remained higher than in DFAST 2020, supported by stronger trading revenues and investment banking fees. Stronger noninterest income partly dampened the decrease in PPNR.

The ratio of projected cumulative PPNR to average assets varies across firms (see figure 15). A significant portion of this variation reflects differences in business focus across the institutions. For instance, the ratio of PPNR to assets tends to be higher at firms focusing on credit card lending, reflecting the higher net interest income that credit cards generally produce relative to other forms of lending.⁴⁶ Importantly, lower PPNR rates do not necessarily imply lower net income, because the same business focus and revenue risk characteristics determining differences in PPNR across firms could also result in offsetting differences in projected losses across firms.

Net Income and Regulatory Capital Treatment

Projected PPNR and provisions for loan losses are the primary determinants of projected pre-tax net income. The projected decline in pre-tax net income is 0.7 percent of average total assets, compared to a decline of 1.0 percent of average total assets in DFAST 2020 for the same firms. Table 6 presents projections of the components of pre-tax net income, including provisions into the allowance and one-time income and expense and extraordinary items, under the severely adverse scenario for each of the firms (see table 3 for aggregate). The projections are cumulative for the nine quarters of the projection horizon.

The Federal Reserve's projections of pre-tax net income under the severely adverse scenario imply negative net income at most firms individually and for the firms as a group over the nine-quarter projection horizon. Projected pre-tax net income shows an aggregate net loss of $117 billion over the projection horizon, compared to a $157 billion loss in DFAST 2020 for the same set of firms, even though CET1 declined less in DFAST 2020 than in DFAST 2021. Further reducing CET1 are higher projected loan charge-offs combined with lower projected revenue over the projection horizon, which results in larger deferred tax assets. Deferred tax assets are deducted from CET1 because they are not considered available to absorb losses.

The pre-tax net income projections incorporate loan losses through provisions, which equal projected loan losses plus the amount needed for the allowance to be at an appropriate level at the end of each quarter. The $294 billion in total provisions for loan losses includes $353 billion in net charge-offs. Firms built large allowances in 2020 in response to the COVID event and changes to accounting rules.⁴⁷

The ratio of pre-tax net income to average assets for each of the firms ranges from negative 3.0 percent to 1.4 percent (see figure 16). Projected cumulative pre–tax net income for 17 of 23 firms is negative over the projection horizon. Differences across the firms reflect differences in the sensitivity of the various components of net income to the economic and financial market conditions in the severely adverse scenario. Additional variation in projected net income results from the effect of the global market shock and LCPD components that affect 12 of the 23 firms.

Firms that are required to include AOCI in regulatory capital and those that opt in to including it are also affected by OCI (see table 6). OCI is driven by unrealized gains and losses on AFS securities in the supervisory stress test. The severely adverse scenario in DFAST 2021 features a smaller decline in the 10-year Treasury yield relative to DFAST 2020 due to a lower initial level. The interest rate path and credit spreads assumed in the scenario result in negative $0.3 billion of OCI over the nine quarters of the projection horizon for firms required to include AOCI in regulatory capital and those that opt in to including it.

Table 2. Applicable capital ratios and calculations for firms in the 2021 Dodd-Frank Act stress tests

Table 3. 23 participating firms Projected stressed capital ratios, risk-weighted assets, losses, revenues, net income before taxes, and loan losses Federal Reserve estimates: Severely adverse scenario

Capital ratios, actual 2020:Q4 and projected 2021:Q1–2023:Q1

Projected loan losses, by type of loan, 2021:Q1–2023:Q1

Risk-weighted assets, actual 2020:Q4 and projected 2023:Q1

Projected losses, revenue, and net income before taxes through 2023:Q1

Table 4. Projected minimum common equity tier 1 ratio under the severely adverse scenario, 2021:Q1–2023:Q1 23 participating firms

Table 5. Capital ratios, actual 2020:Q4 and projected 2021:Q1–2023:Q1 under the severely adverse scenario:23 participating firms

Table 6. Projected losses, revenue, and net income before taxes through 2023:Q1 under the severely adverse scenario: 23 participating firms

Table 7. Projected loan losses by type of loan for 2021:Q1–2023:Q1 under the severely adverse scenario: 23 participating firms

Table 8. Projected loan losses by type of loan for 2021:Q1–2023:Q1 under the severely adverse scenario: 23 participating firms

Table 9. Mapping of loan categories to disclosure categories

 

References

 

 41. For firms participating in DFAST 2021 that adopted CECL and elected the CECL transition provision in 12 C.F.R. part 217, subpart G, the starting capital position used to project the path of regulatory capital includes eligible transitional amounts intended to mitigate the adverse effect of differences between allowances under CECL and the incurred loss methodology. Projected capital levels do not incorporate changes in the transitional amounts during the transition period, which has a duration of three or five years from the date of adoption, depending on the transition election. The aggregate CECL transition amount added to retained earnings for the purpose of calculating CET1 capital is $28 billion, or 0.3 percent of risk-weighted assets. For individual firms, the transition amount varies with the firm's portfolios, the characteristics of assets within these portfolios, and the transition provision option elected by the firm. Return to text

 42. 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 Financial Accounting Standards Board (2016), Financial Instruments–Credit Losses (Topic 326), FASB ASU 2016-13 (Norwalk, Conn.: FASB, June). Prior to the adoption of ASU 2016-13, securities credit losses were realized through other-than-temporary impairment. Return to text

 43. The loss rate is calculated as total projected loan losses over the nine quarters of the projection horizon divided by average loan balances over the horizon. Return to text

 44. Additionally, losses are calculated based on the EAD, which includes both outstanding balances and any additional drawdown of the credit line that occurs prior to default, while loss rates are calculated as a percentage of average outstanding balances over the projection horizon. Return to text

 45. These estimates are conditional on the severely adverse scenario and conservative assumptions. They are not a supervisory estimate of the firms' current or expected legal liability. Return to text

 46. As noted, credit card lending also tends to generate relatively high loss rates, suggesting that the higher PPNR rates at these firms do not necessarily indicate higher profitability. Return to text

 47. Firms generally adopted the CECL framework on January 1, 2020, and built up their allowances to reflect expected losses over the life of the assets in their portfolios. From December 2019 to December 2020, the firms that participated in DFAST 2021 more than doubled their allowances from $69 billion to $142 billion. Return to text