Board of Governors of the Federal Reserve System

The Federal Reserve regularly monitors model performance and evaluates whether any adjustments to models are warranted. As the financial industry and economic environment are constantly changing, specific models may be adjusted to ensure that the models project results that are reasonable, consistent and comparable across banks, as well as appropriately sensitive to stress conditions. Following the Federal Reserve's policies related to model risk management, these adjustments are reviewed by an independent validation group.¹ Additionally, when producing stress test projections, the Federal Reserve considers issues specific to individual banks, such as the impact of recent mergers, acquisitions, or divestitures.

For the 2024 stress test, the Federal Reserve made several targeted model adjustments:

• Small Business Investment Companies (SBICs), entities that are licensed and regulated by the Small Business Administration, are a unique type of private equity fund that provide investment capital to eligible small businesses. Based on additional information about these investments and newly collected data, the Federal Reserve modified the estimate of losses on private equity investments in SBICs to better reflect the inherent risks of investments in SBICs. In particular, the Federal Reserve adjusted the loss rate from about 60 percent to about 25 percent. The Federal Reserve expects to continue making a similar loss rate adjustment for SBICs in future cycles, based on additional data.
• The Federal Reserve assumes that losses associated with certain loans backed by U.S. government agency guarantees will not be absorbed by banks in the stress test. Consistent with this practice, the Federal Reserve applied an adjustment to the applicable loan loss models to factor in shared-loss agreements with the Federal Deposit Insurance Corporation (FDIC). Additionally, funding provided by the FDIC in connection with a bank's acquisition of a failed institution could, due to the application of federal tax rules, have the effect of creating certain deferred tax assets; the Federal Reserve made an adjustment to the projection of the valuation allowance associated with this category of deferred tax assets in order to ameliorate an unintended impact in the stress test results.
• On November 16, 2023, the FDIC approved a final rule implementing a special assessment to recover the loss to the Deposit Insurance Fund associated with the closures of Silicon Valley Bank and Signature Bank. As these expenses are expected to be one-time events, the Federal Reserve excluded expenses related to this special assessment when producing stressed expense projections.
• The interest rate environment revealed differences in banks' reporting of some interest expenses. Some banks report these interest expenses in the "all other" category, while others report the same type of interest expense as "trading liabilities and other borrowed money." As a result, the Federal Reserve modeled the "all other" interest expense component of pre-provision net revenue with interest expenses reported as "trading liabilities and other borrowed money." In addition, reporting practices of interest income and expense related to "federal funds and repurchase agreements" differ across banks, especially in the recent rate environment. After additional analyses, the Federal Reserve adjusted the models for these two components to ensure consistent projections across banks.
• The Federal Reserve currently has model research efforts underway around an enhanced approach for modeling compensation expenses. Ongoing model monitoring combined with the recent material growth in compensation prompted the Federal Reserve to implement a model adjustment to explicitly condition the model projections on the share of variable compensation. Variable compensation is sensitive to rapid deteriorations in economic conditions. The adjustment results in a small reduction in compensation expenses for all banks. Because the adjustment results in a material change in post-stress capital ratios for some banks, it will be phased in over two cycles, consistent with the Federal Reserve's Stress Testing Policy Statement.
• The debt service coverage ratio is the ratio of commercial real estate (CRE) property's net operating income to its debt payments. It can serve as an indicator of a CRE borrower's ability to make interest payments. Informed by analysis of empirical default rates on CRE loans, the CRE probability of default model was adjusted for loans that approach maturity with a low debt service coverage ratio during the projection horizon. This adjustment accounts for the effect of interest rate risk on the refinancing of CRE loans.
• Synthetic securitizations are a form of loss mitigation in which a bank partially transfers credit risk on specific portfolios to outside investors through credit derivatives or guarantees. The Federal Reserve incorporated a richer dataset and considered this type of credit protection in modeling fair-value-option/held-for-sale loan losses.