Supervisory Scenarios
On February 5, 2019, the Federal Reserve released the three supervisory scenarios: baseline, adverse, and severely adverse.12 This section describes the adverse and severely adverse scenarios that were 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. The adverse and severely adverse scenarios are not forecasts but rather hypothetical scenarios designed to assess the strength of banking organizations and their resilience to an unfavorable economic environment.
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 three variables (real gross domestic product (GDP) growth, inflation, and the U.S./foreign currency exchange rate) in each of the four countries/country blocks.
Similar to DFAST 2018, the Federal Reserve applied a global market shock to the trading portfolio of 11 firms with large trading and private equity exposures and a counterparty default scenario component to 13 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 hypothetical trajectories for some of the key variables describing U.S. economic activity and asset prices under the severely adverse scenario.
Figure 5. Unemployment rate in the severely adverse and adverse scenarios, 2014:Q1–2022:Q1
Source: Bureau of Labor Statistics and Federal Reserve assumptions in the supervisory scenarios.
Figure 6. Real GDP growth rate in the severely adverse and adverse scenarios, 2014:Q1–2022:Q1
Source: Bureau of Economic Analysis and Federal Reserve assumptions in the supervisory scenarios.
Figure 7. Dow Jones Total Stock Market Index in the severely adverse and adverse scenarios, 2014:Q1–2022:Q1
Source: Dow Jones and Federal Reserve assumptions in the supervisory scenarios.
Figure 8. National House Price Index in the severely adverse and adverse scenarios, 2014:Q1–2022:Q1
Source: CoreLogic (seasonally adjusted by Federal Reserve) and Federal Reserve assumptions in the supervisory scenarios.
Figure 9. U.S. BBB corporate yield in the severely adverse and adverse scenarios, 2014:Q1–2022:Q1
Source: Merrill Lynch (adjusted by Federal Reserve using a Nelson-Siegel smoothed yield curve model) and Federal Reserve assumptions in the supervisory scenarios.
Figure 10. U.S. Market Volatility Index (VIX) in the severely adverse and adverse scenarios, 2014:Q1–2022:Q1
Source: Chicago Board Options Exchange (converted to quarterly by Federal Reserve using the maximum quarterly close-of-day value) and Federal Reserve assumptions in the supervisory scenarios.
The severely adverse scenario is characterized by a severe global recession accompanied by a period of heightened stress in CRE markets and corporate debt markets. This is a hypothetical scenario designed to assess the strength of banking organizations and their resilience to unfavorable economic conditions and does not represent a forecast of the Federal Reserve.
The U.S. unemployment rate climbs to a peak of 10 percent in the third quarter of 2020. This change in the unemployment rate is consistent with the Board's Policy Statement on the Scenario Design Framework for Stress Testing. In line with the increase in the unemployment rate, real GDP falls about 8 percent from its pre-recession peak, reaching a trough in the second quarter of 2019. The decline in activity is accompanied by a lower headline consumer price index (CPI) inflation, which falls to about 1-1/4 percent at an annual rate in the first quarter of 2019 and then rises gradually to about 2 percent at an annual rate by the second half of 2020.
As a result of the severe decline in real activity, the interest rate for 3-month Treasury bills falls 2-1/4 percentage points and remains near zero through the end of the scenario. The 10-year Treasury yield falls by a somewhat smaller amount, resulting in a mildly steeper yield curve. The 10-year Treasury yield reaches a trough of about 3/4 percent in the first quarter of 2019 and rises gradually thereafter to 1-1/2 percent by the first quarter of 2021 and 1-3/4 percent by the first quarter of 2022. Financial conditions in corporate and real estate lending markets are stressed severely. The spread between yields on investment-grade corporate bonds and yields on long-term Treasury securities widens to 5-1/2 percent by the third quarter of 2019, an increase of 3-1/2 percentage points relative to the fourth quarter of 2018. The spread between mortgage rates and 10-year Treasury yields widens to 3-1/2 percentage points over the same time period.
Asset prices drop sharply in this scenario. Equity prices fall 50 percent through the end of 2019, accompanied by a rise in the U.S. Market Volatility Index (VIX), which reaches a peak of 70 percent. House prices and CRE prices also experience large declines of about 25 percent and 35 percent, respectively.
The international component of this scenario features severe recessions in the euro area, United Kingdom, and Japan and a shallow recession in developing Asia. As a result of the sharp contraction in economic activity, all foreign economies included in the scenario experience a decline in consumer prices. The U.S. dollar appreciates against the euro, the pound sterling, and the currencies of developing Asia but depreciates modestly against the yen because of flight-to-safety capital flows.
This year's severely adverse scenario features a greater increase in the unemployment rate in the United States compared to last year's scenario. This increase in severity in that variable reflects the Board's Policy Statement on the Scenario Design Framework for Stress Testing, which calls for a more pronounced economic downturn when current conditions are especially strong. Given a lower unemployment rate at the beginning of this year's scenario compared to last year's, the framework calls for a correspondingly larger increase in the unemployment rate in order to reach a peak of at least 10 percent.
In addition, 10-year Treasury yields fall in this year's scenario. By contrast, last year's severely adverse scenario featured unchanged 10-year Treasury yields and a sharply steeper yield curve, reflecting a global aversion to long-term fixed income assets, a development not previously featured in a severely adverse scenario. As a result, the declines in some asset prices, such as stock prices, are more aligned with the declines featured in the 2017 severely adverse scenario.
Adverse Scenario
The adverse scenario is characterized by weakening economic activity across all of the economies included in the scenario, accompanied by a moderate correction in asset prices and rise in volatility. This is a hypothetical scenario designed to assess the strength of banking organizations and their resilience to adverse economic conditions, and does not represent a forecast of the Federal Reserve.
The macroeconomic and financial developments in this year's adverse scenario are similar to the developments in the severely adverse scenario but are more moderate in magnitude. As a result, the two scenarios together allow for an investigation of the relationship between firm-specific outcomes and the intensity of economic and financial dislocations.
As in the severely adverse scenario, the unemployment rate peaks in the third quarter of 2020 but reaches a lower level of 7 percent rather than 10 percent. The U.S. economy experiences a recession, with real GDP falling slightly more than 2-3/4 percent from peak to trough. Reflecting weak economic conditions, short-term interest rates and longer-term Treasury yields fall. In addition, financial conditions tighten and asset prices decline, but less intensely compared to the severely adverse scenario. For example, equity prices reach a trough at the end of 2019 in both scenarios, falling about 20 percent in the adverse scenario and 50 percent in the severely adverse scenario.
Following the recession, U.S. real activity picks up slowly at first and then gains momentum. The growth rate of U.S. real GDP increases from about 3/4 of a percent in 2020 to about 3-1/4 percent in 2021. The unemployment rate declines modestly, to about 6-1/4 percent by the end of the scenario period. Consumer price inflation remains close to 2 percent through the end of the scenario period. Yields on 10-year Treasury securities rise gradually to slightly less than 2 percent by the end of the scenario period.
Outside of the United States, the adverse scenario features moderate recessions in the euro area and the United Kingdom, a slightly more protracted recession in Japan than elsewhere, and below-trend growth in developing Asia. Weakness in global demand results in slowing inflation in all of the foreign economies under consideration, including a deflationary episode in Japan. Reflecting flight-to-safety capital flows, the U.S. dollar appreciates against the euro, the pound sterling, and the currencies of developing Asia and depreciates modestly against the yen.
Global Market Shock and Counterparty Default Components
The Federal Reserve applied a global market shock to the trading portfolios of 11 firms with large trading and private equity exposures.13 In addition, the Federal Reserve applied a largest counterparty default (LCPD) component, which assumes the default of a firm's largest counterparty under the global market shock, to the same 11 firms and two other firms with substantial trading, processing, or custodial operations.14 These components are each an add-on to the economic conditions and financial market environment specified in the adverse and severely adverse scenarios.
The global market shock is a set of hypothetical shocks to a large set of risk factors, such as asset prices, interest rates, and spreads, reflecting general market distress and heightened uncertainty. The risk factor shocks are calibrated to the period of time over which market events would unfold, which varies depending on the anticipated liquidity of different risk types, but are applied to firms' positions on a given as-of date. Firms with significant trading activity were required to include the global market shock in their estimates under the supervisory adverse and severely adverse scenarios and recognize trading and counterparty mark-to-market losses in the first quarter of the planning horizon.15 In addition, as discussed below, certain large and highly interconnected firms were required to apply the same global market shock to project losses under the LCPD component. The as-of date for the global market shock is November 5, 2018.16
The global market shock component for the severely adverse scenario features a significant weakening in European economic conditions and spillover effects that lead to sell-offs in financial assets more broadly. The European distress leads to global market dislocations, affecting U.S. and developing Asian and other emerging markets. There is a sudden increase in implied volatilities broadly, a large decline in industrial and energy commodity prices, and a significant widening in credit spreads, with an associated decline in market liquidity. Liquidity deterioration is most severe in those asset markets that are typically less liquid, such as corporate debt and private equity markets, and is less pronounced in those markets that are typically more liquid, such as publicly traded equity and currency markets. In addition, relationships between the prices of financial assets that would normally be expected to move together come under pressure and are weakened in some cases. As a result, certain hedging strategies are less effective than historical experience would suggest.
Flight-to-quality capital flows push interest rates down across the term structure in the U.S. and certain European countries, while emerging markets and countries that are part of the European periphery experience sharp increases in government yields. Countries that are affected by flight-to-quality experience currency appreciation, while European and emerging market currencies experience currency depreciation against the U.S. dollar.
The major differences relative to the 2018 severely adverse scenario include a heightened stress to European assets; a decline in the U.S. yield curve; an appreciation of the U.S. dollar relative to most other currencies; and more muted shocks to U.S. based assets, such as U.S. agency and municipal products. These differences are intended to reflect the more Europe-focused nature of the stress and a general flight-to-quality to U.S. markets.
As noted, firms with substantial trading or custodial operations were required to incorporate the LCPD component into their supervisory adverse and severely adverse scenarios for DFAST 2019.17 The LCPD component involves the instantaneous and unexpected default of the firm's largest counterparty.18
In connection with the LCPD component, these firms were required to estimate and report the potential losses and related effects on capital associated with the instantaneous and 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.
Each firm's largest counterparty was determined by net stressed losses, estimated by applying the global market shock to revalue non-cash securities financing activity assets (securities or collateral) posted or received, and by applying the global market shock to the value of the trade position and non-cash collateral exchanged for derivatives. The as-of date for the LCPD scenario component is November 5, 2018—the same date as the global market shock.19
The global market shock component for the adverse scenario simulates a marked decline in the economic outlook for developing Asian markets. As a result, sovereign credit spreads widen and currencies generally depreciate significantly in these markets. This shock spreads to other global markets, which results in increases in general risk premiums and credit risk. U.S. interest rates move lower across the term structure. Due to a sharp reduction in demand from developing Asia, most global commodity prices and currencies of commodity exporters decline significantly. Equity markets decline broadly.
The 2019 adverse scenario addresses themes similar to those of the 2018 adverse scenario.
References
12. See Board of Governors of the Federal Reserve System (2019), 2019 Supervisory Scenarios for Annual Stress Tests Required under the Dodd-Frank Act Stress Testing Rules and the Capital Plan Rule (Washington, DC: Board of Governors, February 2019), https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20190213a1.pdf for additional information and for the details of the supervisory scenarios. Return to text
13. The 11 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; UBS Americas Holding LLC; and Wells Fargo & Company. See 12 CFR 252.54(b)(2). Return to text
14. The 13 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; UBS Americas Holding LLC; and Wells Fargo & Company. See 12 CFR 252.54(b)(2)(ii). Return to text
15. 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 large and noncomplex firm under the Board's capital plan rule (12 CFR 225.8). Return to text
16. A firm may use data as of the date that corresponds to its weekly internal risk reporting cycle as long as it falls during the business week of the as-of date for the global market shock (i.e., November 5–9, 2018). Losses from the global market shock will be assumed to occur in the first quarter of the planning horizon. Return to text
17. The Board may require a firm to include one or more additional components in its adverse and severely adverse scenarios in the annual stress test based on the company's financial condition, size, complexity, risk profile, scope of operations, or activities, or risks to the U.S. economy. See 12 CFR 252.54(b)(2)(ii). Return to text
18. Certain entities are excluded from the selection of a firm's largest counterparty, including Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States. Return to text
19. As with the global market shock, a firm subject to the LCPD component may use data as of the date that corresponds to its weekly internal risk reporting cycle as long as it falls during the business week of the as-of date for the LCPD component (i.e., November 5–9, 2018). Losses will be assumed to occur in the first quarter of the planning horizon. Return to text