Dodd-Frank Act Stress Test 2014: Supervisory Stress Test Methodology and Results
- Supervisory Stress Test Framework and Model Methodology
- Revised Capital Framework
- Supervisory Stress Test Results
- Appendix A: Supervisory Scenarios
The Federal Reserve expects large, complex bank holding companies (BHCs) to have sufficient capital to continue lending to support real economic activity while meeting their financial obligations, even under stressful economic conditions. Stress testing is one tool that helps bank supervisors measure whether a BHC has enough capital to support its operations throughout periods of stress. The Federal Reserve previously highlighted its use of stress testing as a means to assess a financial institution's capital sufficiency during periods of stress with its 2009 Supervisory Capital Assessment Program (SCAP) and since 2011 through the annual Comprehensive Capital Analysis and Review (CCAR) exercise.1
In the wake of the 2007-09 financial crisis, the Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).2 The Dodd-Frank Act requires the Federal Reserve to conduct an annual stress test of large BHCs and all nonbank financial companies designated by the Financial Stability Oversight Council (FSOC) for Federal Reserve supervision.The Federal Reserve in the annual stress test is to evaluate whether these companies have sufficient capital to absorb losses resulting from stressful economic and financial market conditions. The Dodd-Frank Act also requires BHCs and other financial companies supervised by the Federal Reserve to conduct their own stress tests. Together, the Dodd-Frank Act supervisory stress tests and the company-run stress tests are intended to provide company management and boards of directors, the public, and supervisors with forward-looking information to help gauge the potential effect of stressful conditions on capital adequacy of these large banking organizations.
The Federal Reserve adopted rules implementing these requirements in October 2012.3 Last year, to allow a phase-in of the provisions of the Federal Reserve's Dodd-Frank Act stress test (DFAST) rules, only the 18 BHCs that previously participated in the SCAP were required to conduct company-run stress tests and were subject to the Federal Reserve's supervisory stress test. During the current stress test cycle (DFAST 2014), which began on October 1, 2013, the Federal Reserve has conducted supervisory stress tests on all BHCs with $50 billion or more in total consolidated assets, a total of 30 BHCs, using scenarios that the Federal Reserve designed (supervisory scenarios).4 These BHCs were also required to conduct company-run stress tests under the supervisory scenarios. Both the supervisory and company-run stress tests are also integrated into the Federal Reserve's assessment of capital adequacy under CCAR.
This report describes hypothetical, stressful macroeconomic and financial market scenarios designed by the Federal Reserve; provides an overview of the analytical framework and methods used to generate the projections of balance sheets, net income, and the resulting post-stress capital ratios for each of the 30 BHCs; and discloses the results of the 2014 Dodd-Frank Act supervisory stress test. The Federal Reserve introduced several key changes and improvements to the DFAST in 2014. Specifically, this year, the Federal Reserve independently projected the balance sheet and risk-weighted assets (RWAs) of each BHC that participated in the stress test. By comparison, in past supervisory stress tests, the Federal Reserve used the balance sheet and RWA projections provided by each BHC in its company-run stress test. This improvement promotes greater comparability of the supervisory stress tests across BHCs. Also this year, the Federal Reserve incorporated into DFAST the revised regulatory capital framework that implements the Basel III regulatory capital reforms. The capital ratios calculated in the stress test reflect the phase-in of the revised capital framework. Finally, in this report, the Federal Reserve is disclosing the results of the supervisory stress test conducted under the adverse scenario for each company, in addition to the results under the severely adverse scenario that were disclosed in previous stress tests. The adverse scenario contains valuable information about a different set of conditions that can pose a risk to capital adequacy at the BHCs.
The disclosure of stress test results informs market participants and the public, enhances transparency, and promotes market discipline. The projections provide a horizontal perspective on the capital positions of these firms by incorporating detailed information about the risk characteristics associated with each BHC's business activities and by using a consistent approach across all the BHCs. This approach helps to facilitate a comparison of results across firms. The Federal Reserve also believes that providing information about the methodology used to produce the results offers useful context to interpret those results.
The projections in DFAST were calculated using input data provided by the 30 BHCs and a set of models developed or selected by the Federal Reserve 5 and are based on hypothetical, stressful macroeconomic and financial market scenarios developed by the Federal Reserve. The severely adverse scenario features a deep recession in the United States, Europe, and Japan, significant declines in asset prices and increases in risk premia, and a marked economic slowdown in developing Asia. The adverse scenario is characterized by a weakening in economic activity across all of the economies included in the scenario, combined with a global aversion to long-term fixed-income assets, that brings about rapid rises in long-term rates and steepening yield curves in the United States and globally. In addition to the two common sets of macroeconomic scenarios, a subset of BHCs was also subject to two additional components of the adverse and severely adverse scenarios--namely, the global market shock and counterparty default components. The global market shock was applied to six BHCs with large trading and private-equity exposures.6 The counterparty default component, under which the BHC's largest counterparty is assumed to default, was applied to eight BHCs with substantial trading or custodial operations.7
The models used in DFAST project the balance sheet, net income, and resulting post-stress capital ratios for each BHC over a nine-quarter planning horizon starting in the fourth quarter of 2013 and extending through the end of 2015. The Federal Reserve's projections should not be interpreted as expected or likely outcomes for these firms but rather as possible results under hypothetical, stressful conditions. These projections incorporate a number of conservative modeling assumptions but do not make explicit behavioral assumptions about the possible actions of a BHC's creditors and counterparties in the scenario, except through the scenario's characterizations of financial asset prices and economic activity.
The projections reflect assumptions about capital distributions prescribed in the Dodd-Frank Act stress test rule. For the first quarter of the planning horizon, capital actions for each BHC are assumed to be the actual actions taken by the BHC during that quarter. Over the remaining eight quarters of the planning horizon, each BHC is assumed to maintain its common stock dividend payments at the same level as the quarterly average in the previous year (that is, the first quarter of the planning horizon and the preceding three calendar quarters) and pay scheduled dividend, interest, or principal payments on any other capital instrument eligible for inclusion in the numerator of a regulatory capital ratio. However, repurchases of such capital instruments and issuance of stock is assumed to be zero except for common-stock issuance associated with expensed employee compensation.8
The results of these projections suggest that, in the aggregate, the 30 BHCs would experience substantial losses under both the adverse and the severely adverse scenarios. Over the nine quarters of the planning horizon, losses at the 30 BHCs under the severely adverse scenario are projected to be $501 billion, including losses across loan portfolios, losses from credit impairment on securities held in the BHCs' investment portfolios, trading and counterparty credit losses from the global market shock, and other losses. Projected net revenue before provisions for loan and lease losses (pre-provision net revenue, or PPNR) at the 30 BHCs over the nine quarters of the planning horizon under the severely adverse scenario is $316 billion, which is net of $151 billion of losses related to operational-risk events and mortgage repurchases, and expenses related to disposition of owned real estate. Losses from operational-risk events include potential costs from unfavorable litigation outcomes and reflect elevated litigation risk and the associated increase in legal reserves observed in recent years. Taken together, the high projected losses and low projected PPNR at the 30 BHCs results in projected net income before taxes of -$217 billion under the severely adverse scenario.
These net income projections result in substantial projected declines in regulatory capital ratios for nearly all of the BHCs under the severely adverse scenario. For BHCs with total consolidated assets greater than $250 billion and those with significant foreign exposures (advanced approaches BHCs 9 ), the decline in regulatory capital ratios, except for the tier 1 common ratio, in part reflects the gradual phasing-in of adjustments to Tier 1 capital for certain accumulated other comprehensive income (AOCI) items under the revised capital framework starting in 2014 (see box 1). Fair value losses on AFS securities lead to -$24 billion in other comprehensive income for advanced approaches BHCs. Other comprehensive income does not affect the tier 1 common ratio, as it is based on the capital framework in place as of October 1, 2013.
As illustrated in figure 1, the aggregate tier 1 common ratio would fall from an actual 11.5 percent in the third quarter of 2013 to a post-stress level of 7.8 percent in the fourth quarter of 2015. The decline in part reflects assumed capital actions prescribed in the Dodd-Frank Act stress test rule.
Note: Aggregate capital ratios for 29 of the participating BHCs.
Source: FR Y-9C and supervisory estimates under the severely adverse scenario. The aggregate tier 1 common ratio does not include Santander Holdings USA, which did not file the FR Y-9C until 2012. Santander's exclusion decreased the aggregate ratio about 1 to 2 basis points.
In the adverse scenario, losses at the 30 BHCs over the nine quarters of the planning horizon are projected to be $355 billion. As with the severely adverse scenario, these losses include losses across loan portfolios, losses from credit impairment on securities held in the BHCs' investment portfolios, trading and counterparty credit losses from the global market shock, and other losses. Projected PPNR at the 30 BHCs over the nine quarters of the planning horizon under the adverse scenario is $444 billion, which is net of $130 billion in losses related to operational-risk events and mortgage repurchases, and expenses related to disposition of owned real estate. Losses from operational-risk events under the adverse scenario also reflect elevated litigation risk. Projected PPNR under the adverse scenario is about 40 percent higher than under the severely adverse scenario, largely due to the much steeper yield curve assumed in the scenario. Projected net income before taxes totals $92 billion at the 30 BHCs, under the adverse scenario.
These positive net income projections are in part offset by negative AOCI for advanced approaches BHCs over the planning horizon, which combined result in moderate projected declines over the planning period in the aggregate regulatory capital ratios across the 30 BHCs. Fair value losses on AFS securities lead to -$103 billion in other comprehensive income for advanced approaches BHCs. Under the adverse scenario, the aggregate tier 1 common ratio would fall 180 basis points to its minimum over the planning horizon of 9.7 percent and be 70 basis points lower for a post-stress level of 10.8 percent in the fourth quarter of 2015.
1. The CCAR is an annual exercise by the Federal Reserve to ensure that institutions have robust, forward-looking capital planning processes that account for their unique risks and sufficient capital to continue operations throughout times of economic and financial stress. As part of the CCAR, the Federal Reserve evaluates institutions' capital adequacy, internal capital adequacy assessment processes, and their plans to make capital distributions, such as dividend payments or stock repurchases, and other actions that affect capital. Return to text
2. See 12 USC 5365(i)(1). Return to text
3. See 12 CFR Part 252. Return to text
4. The 30 BHCs that participated in the 2014 Dodd-Frank Act stress test are Ally Financial Inc.; American Express Company; Bank of America Corporation; The Bank of New York Mellon Corporation; BB&T Corporation; BBVA Compass Bancshares, Inc.; BMO Financial Corp.; Capital One Financial Corporation; Citigroup, Inc.; Comerica Incorporated; Discover Financial Services; Fifth Third Bancorp; The Goldman Sachs Group, Inc.; HSBC North America Holdings Inc.; Huntington Bancshares Inc.; JPMorgan Chase & Co.; Keycorp; M&T Bank Corporation; Morgan Stanley; Northern Trust Corp.; The PNC Financial Services Group, Inc.; RBS Citizens Financial Group, Inc.; Regions Financial Corporation; Santander Holdings USA, Inc.; State Street Corporation; SunTrust Banks, Inc.; U.S. Bancorp; UnionBanCal Corp.; Wells Fargo & Company; and Zions Bancorp. TD Bank US Holding Company and BancWest Corporation are not subject to Dodd-Frank Act stress testing until October 1, 2015, under the Board's stress test rule. See 12 CFR 252.43(a)(3). In addition, Deutsche Bank Trust Corporation has received an extension from compliance with the stress test rule until June 30, 2014. In 2013, the FSOC designated three nonbank financial companies for consolidated supervision by the Federal Reserve and enhanced prudential standards: American International Group, Inc., General Electric Capital Corporation, Inc., and Prudential Financial, Inc. All nonbank covered companies designated by the FSOC will be required to conduct their first stress test in the calendar year after the year in which the company becomes subject to the Board's minimum regulatory capital requirements, unless the Board accelerates or extends the compliance date. Return to text
6. The six BHCs subject to the global market shock are Bank of America Corporation; Citigroup, Inc.; The Goldman Sachs Group, Inc.; JPMorgan Chase & Co.; Morgan Stanley; and Wells Fargo & Company. See 12 CFR 252. 44(b); see also 12 CFR 252.54(b)(2)(i). Return to text
7. The eight BHCs subject to the counterparty default component are Bank of America Corporation; The Bank of New York Mellon Corporation; Citigroup, Inc.; The Goldman Sachs Group, Inc.; JPMorgan Chase & Co.; Morgan Stanley; State Street Corporation; and Wells Fargo & Company. See 12 CFR 252.44(b); see also 12 CFR 252.44(b)(2)(ii). Return to text
8. See 12 CFR 252.56(b)(2). Return to text
9. For purposes of DFAST 2014, an advanced approaches BHC includes any BHC that has consolidated assets greater than or equal to $250 billion or total consolidated on-balance-sheet foreign exposure of at least $10 billion as of December 31, 2013. The advanced approaches BHCs in DFAST 2014 are American Express Company, Bank of America Corporation, The Bank of New York Mellon Corporation, Capital One Financial Corporation, Citigroup, Inc., The Goldman Sachs Group, Inc., HSBC North America Holdings, Inc., JPMorgan Chase & Co., Morgan Stanley, Northern Trust Corporation, The PNC Financial Services Group, Inc., State Street Corporation, U.S. Bancorp, Wells Fargo & Company. Return to text