Board of Governors of the Federal Reserve System

Supervisory Scenarios

On February 6, 2020, the Federal Reserve released the two supervisory scenarios: baseline and severely adverse.¹⁰ This section describes the severely adverse scenario that was used for the DFAST 2020 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 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 2020 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 12 variables made up of 3 variables (real gross domestic product (GDP) growth, inflation, and the U.S./foreign currency exchange rate) for each of 4 countries/country blocks.

Similar to DFAST 2019, 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.

The severely adverse scenario is characterized by a severe global recession accompanied by a period of heightened stress in commercial real estate and corporate debt markets.

The U.S. unemployment rate climbs to a peak of 10 percent in the third quarter of 2021 (see Table A.5). This substantial increase in the unemployment rate is consistent with the Board's Policy Statement on the Scenario Design Framework for Stress Testing.¹¹ In line with the increase in the unemployment rate, real GDP falls about 8-1/2 percent from its pre-recession peak, reaching a trough in the third quarter of 2021. The decline in activity is accompanied by a lower headline consumer price index (CPI) inflation rate, which falls to an annual rate of about 1-1/4 percent after the first quarter of 2020, before gradually rising to average 1-3/4 percent in 2022.

In line with the severe decline in real activity, the interest rate for 3-month Treasury bills immediately falls near zero and remains at that level through the end of the scenario. The 10-year Treasury yield immediately falls to 3/4 percent during the first quarter of 2020 and rises gradually thereafter to 2-1/4 percent by the end of the stress-test period. The result is a gradual steepening of the yield curve over most of the stress-test period. 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 percentage points by the third quarter of 2020, an increase of 4 percentage points relative to the fourth quarter of 2019. 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 50 percent through the end of 2020, accompanied by a rise in the U.S. Market Volatility Index (VIX), which reaches a peak of 70. House prices and commercial real estate prices also experience large overall declines of about 28 percent and 35 percent, respectively, during the first nine quarters of the scenario.

The international component of this scenario features sharp slowdowns in all country blocs, leading to severe recessions in the euro area, the United Kingdom, and Japan and a pronounced deceleration of activity in developing Asia. As a result of the sharp contraction in economic activity, three of the foreign economies included in the scenario—the euro area, Japan, and developing Asia—experience sharp declines in inflation rates. 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.

Comparison of the 2020 Severely Adverse Scenario and the 2019 Severely Adverse Scenario

This year's severely adverse scenario features a slightly greater increase in the unemployment rate in the United States compared to last year's severely adverse scenario. This difference 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 stronger. 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 10 percent. In this year's scenario, interest rates do not fall as much as in last year's scenario, given their lower starting values. The declines in equity prices, house prices, and commercial real estate prices are similar to the declines in last year's severely adverse scenario.

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.¹² 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 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 as part of their supervisory severely adverse scenario, 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 to project losses under the counterparty default 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 global market shock is October 18, 2019.¹⁵ These shocks do not represent a forecast of the Federal Reserve.

The design and specification of the global market shock differ from that of 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 any time 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 companies' capital ratios at all points in the projection horizon.

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 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, changes within more liquid markets, such as interest rates, foreign exchange, or public equities, are calibrated to shorter horizons, such as three months, while changes within less liquid markets, such as non-agency securitized products or private equities, have longer calibration horizons, such as 12 months.

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 advanced economy and some emerging economy currencies, along with selected points along term structures of implied volatilities;
• selected maturity government rates (e.g., U.S. Treasuries), swap rates, and other key rates for key developed markets and for developing and emerging market nations to which trading companies may have exposure;
• 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.

2020 Severely Adverse Scenario

The 2020 global market shock component for the severely adverse scenario is designed to be generally consistent with a macroeconomic background in which the U.S. economy has entered a sharp recession, characterized by widespread defaults on a range of debt instruments by business borrowers. Under the scenario, weaker obligors struggle to maintain their financial conditions due to material declines in earnings associated with the poor economic environment while rating agencies downgrade large portions of debt outstanding. The historically high levels of nonfinancial corporate debt to GDP amplify the losses resulting from the wave of corporate sector defaults. This dynamic creates feedback effects between the economy and the corporate sector.

Spreads widen sharply for non-investment grade and low investment grade bonds as ratings-sensitive investors anticipate further downgrades and sell assets. Similarly, the leveraged loan market comes under considerable pressure. Open-ended mutual funds and exchange-traded funds (ETFs) that hold leveraged loans and high yield bonds face heavy redemptions. Due to liquidity mismatches, mutual fund and ETF managers sell their most liquid holdings, leading to more extensive declines in the prices of fixed income securities and other related assets. Price declines on leveraged loans flow through to the prices for collateralized loan obligations (CLOs). CLO prices suffer severe corrections associated with the devaluation of the underlying collateral and selling by concentrated holders desiring to reduce risk.

The broad selloff of corporate bonds and leveraged loans spills over to prices for other risky credit and private equity instruments. Credit spreads for emerging market corporate credit and sovereign bonds widen due to flight-to-safety considerations. Asset values for private equity experience sizable declines as leveraged firms face lower earnings and a weak economic outlook. Municipal bond spreads widen in line with lower municipal tax revenues associated with the severe weakening of the U.S. economy.

Short-term U.S. Treasury rates fall sharply reflecting an accommodative monetary policy response to the hypothetical economic downturn. Longer-term U.S. Treasury rates fall more modestly as the United States benefits from a flight-to-safety. Short-term U.S. interbank lending rates rise as firms face increased funding pressure from a pullback in overnight lending, while longer-term swap rates fall in sync with the decreases in long-term U.S. Treasury rates. This is not a forecast of how monetary policy would necessarily respond to these conditions.

Flight-to-safety considerations cause the U.S. dollar to appreciate somewhat against the currencies of most advanced economies, except the Swiss franc and the Japanese yen. The yen appreciates against the U.S. dollar as investors unwind positions and view the yen as a safe-haven currency. The Swiss franc appreciates against the U.S. dollar as investors seek an alternative safe-haven currency. Safe-haven considerations cause traditional precious metals to experience an increase in value while non-precious metals prices fall due to lower demand from the general economic weakness.

Comparison of the 2020 Severely Adverse Scenario and the 2019 Severely Adverse Scenario

This year's global market shock for the severely adverse scenario emphasizes a heightened stress to highly leveraged markets that causes CLOs and private equity investments to experience larger market value declines relative to 2019. There is a general spike in short-term interbank lending rates instead of a decline, as this year's scenario highlights a severe increase in funding pressures. European equity markets weaken at more modest levels relative to 2019, while U.S. equity markets fall more sharply. In addition, European currencies depreciate less severely against the U.S. dollar this year, reflecting the U.S.-focused nature of this year's scenario.

Counterparty Default Component for Supervisory Severely Adverse Scenario

Firms with substantial trading or custodial operations will be required to incorporate a counterparty default scenario component into the severely adverse scenario used in their company-run stress test.¹⁷ The counterparty default scenario component involves the instantaneous and unexpected default of the firm's largest counterparty.¹⁸

In connection with the counterparty default scenario component, these firms will be 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. The counterparty default scenario component is an add-on to the macroeconomic conditions and financial market environment specified in the Federal Reserve's severely adverse stress scenario.

The largest counterparty of each firm will be determined by net stressed losses. Net stressed losses are estimated by applying the global market shock to revalue non-cash securities financing transactions (SFT) (securities or collateral) posted or received and, for derivatives, the trade position and non-cash collateral exchanged. The as-of date for the counterparty default scenario component is October 18, 2019—the same date as the global market shock.¹⁹

References

 10. See Board of Governors of the Federal Reserve System (2020), 2020 Supervisory Scenarios for Annual Stress Tests Required under the Dodd-Frank Act Stress Testing Rules and the Capital Plan Rule (Washington: Board of Governors, February 2020), https://www.federalreserve.gov/newsevents/pressreleases/bcreg20200206a.htm for additional information and for the details of the supervisory scenarios. Return to text

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

 12. 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 C.F.R. § 252.54(b)(2). Return to text

 13. 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 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 large and noncomplex firm under the Board's capital plan rule (12 C.F.R. § 225.8). 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 it falls during the business week of the as-of date for the global market shock (i.e., October 14–18, 2019). Return to text

 16. Markets that are well-functioning and that appear to be very liquid can abruptly change in times of financial stress, and the timing and severity of such changes in market liquidity may diverge from historical experience. For example, prior to the 2007–2009 financial crisis, AAA-rated private-label residential mortgage-backed securities would likely have been considered highly liquid, but their liquidity changed drastically during the crisis period. Return to text

 17. The Board may require a covered company 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 risks 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 (QCCP). See definition of QCCP at 12 C.F.R. § 217.2.
U.S. intermediate holding companies (IHC) are not required to include any affiliate of the U.S. IHC as a counterparty. An affiliate of the company includes a parent company of the counterparty, as well as any other firm that is consolidated with the counterparty under applicable accounting standards, including U.S. generally accepted accounting principles (GAAP) or international financial reporting standards (IFRS). 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 it falls during the business week of the as-of date for the counterparty default scenario component (i.e., October 14–18, 2019). Losses will be assumed to occur in the first quarter of the projection horizon. Return to text