2015 Supervisory Scenarios for Annual Stress Tests Required under the
Dodd-Frank Act Stress Testing Rules and the Capital Plan Rule
The adverse and severely adverse scenarios describe hypothetical sets of conditions designed to assess the strength of banking organizations and their resilience to adverse economic environments. The scenarios are not forecasts. The baseline scenario follows a similar profile to the average projections from surveys of economic forecasters. It does not represent the forecast of the Federal Reserve.3
The scenarios start in the fourth quarter of 2014 (2014:Q4) and extend through the fourth quarter of 2017 (2017:Q4). Each scenario includes 28 variables; this set of variables is the same as the set provided in last year's supervisory scenarios. The variables describing economic developments within the United States include:
- Six measures of economic activity and prices: percentage changes (at an annual rate) in real and nominal Gross Domestic Product (GDP); the unemployment rate of the civilian non-institutional population aged 16 years and over; percentage changes (at an annual rate) in real and nominal disposable personal income; and the percentage change (at an annual rate) in the Consumer Price Index (CPI);
- Four aggregate measures of asset prices or financial conditions: indices of house prices, commercial property prices, equity prices, and U.S. stock market volatility; and,
- Six measures of interest rates: the rate on the 3-month Treasury bill; the yield on the 5-year Treasury bond; the yield on the 10-year Treasury bond; the yield on a 10-year BBB corporate security; the interest rate associated with a conforming, conventional, fixed-rate 30-year mortgage; and the prime rate.
The variables describing international economic conditions in each scenario include three variables in four countries or country blocks:
- The three variables for each country or country block: the percentage change (at an annual rate) in real GDP, the percentage change (at an annual rate) in the CPI or local equivalent, and the level of the U.S. dollar/foreign currency exchange rate.
- The four countries or country blocks included: the euro area (the 18 European Union member states that have adopted the euro as their common currency), the United Kingdom, developing Asia (the nominal GDP-weighted aggregate of China, India, South Korea, Hong Kong Special Administrative Region, and Taiwan), and Japan.
Baseline, Adverse and Severely Adverse Scenarios
The following sections describe the baseline scenario, the adverse scenario, and the severely adverse scenario.
The variables included in these scenarios are provided in tables at the end of this document. They can also be downloaded as an Excel spreadsheet (together with the historical time series of the variables) from the Board's website, at www.federalreserve.gov/bankinforeg/stress-tests-capital-planning.htm.
The baseline scenario is very similar to the average projections from surveys of economic forecasters. For example, the outlook for U.S. real activity and inflation in the baseline is in line with the October 2014 consensus projections from Blue Chip Economic Indicators.4
The baseline scenario for the United States (see Table 1A) is for a sustained, moderate expansion in economic activity. Real GDP grows at an average rate of just under 3 percent per year over the scenario; the unemployment rate declines modestly, reaching 5-1/4 percent by the end of the scenario in the fourth quarter of 2017; and CPI inflation averages just over 2 percent per year.
Accompanying this moderate economic expansion is a gradual normalization in Treasury yields across the maturity spectrum. Short-term Treasury rates begin to increase in the second quarter of 2015 and rise steadily thereafter, reaching just over 3 percent by the end of 2017. Five- and 10-year yields increase from the start of the scenario period and reach 4 percent and 4-1/4 percent, respectively, by the fourth quarter of 2017. Spreads on investment-grade corporate bonds change little over the scenario period, as do spreads on residential mortgages and other consumer loans. As a result, yields on BBB-rated corporate bonds and mortgage rates both increase roughly in line with long-term Treasury yields, and the prime rate increases roughly in line with short-term Treasury rates.
Consistent with these developments, asset prices are assumed to increase modestly in the baseline scenario. Equity prices, nominal house prices, and commercial property prices all rise steadily throughout the scenario; in addition, equity market volatility is assumed to remain at low levels.
The baseline outlook for the international variables (see Table 1B) is similar to that reported in the October 2014 Blue Chip Economic Indicators and the International Monetary Fund's October 2014 World Economic Outlook.5 The baseline scenario for economic activity and inflation outside the United States features an expansion in activity, albeit one that proceeds at different rates across the four countries or country blocks being considered. The outlook for real GDP growth in developing Asia is 6-1/4 percent per year; the expansion in real output in the United Kingdom proceeds at 2-1/2 percent per year; and real GDP growth in the euro area and Japan is assumed to average 1-1/2 percent per year and 1-1/4 percent per year, respectively.
This year's adverse scenario is characterized by a global weakening in economic activity and an increase in U.S. inflationary pressures that, overall, result in a rapid increase in both short- and long-term U.S. Treasury rates. In the scenario, bank funding costs react strongly to rising short-term rates, as described in greater detail in "Additional Key Features of the Adverse Scenario." This scenario is not a forecast; rather, it is a hypothetical scenario designed to assess the strength of banking organizations and their resilience to an unfavorable economic environment.
In the adverse scenario, the United States experiences a mild recession that begins in the fourth quarter of 2014 and lasts through the second quarter of 2015 (see Table 2A). During this period, the level of real GDP falls approximately 1/2 percent relative to its level in the third quarter of 2014 and the unemployment rate increases to just over 7 percent. At the same time, the U.S. economy experiences a considerable rise in core inflation that results in a headline CPI inflation rate of 4 percent by the third quarter of 2015; headline inflation remains elevated thereafter. Short-term interest rates rise quickly as a result, reaching a little over 2-1/2 percent by the end of 2015 and 5-1/4 percent by the end of 2017. Longer-term Treasury yields increase by less, resulting in a yield curve throughout the scenario period that is both higher and flatter relative to the baseline. Corporate financial conditions tighten, reflecting both higher long-term Treasury yields and somewhat wider investment-grade corporate bond spreads. Household financial conditions are assumed to tighten broadly in line with movements in similar-maturity Treasury yields.
The recovery that begins in the second half of 2015 is quite sluggish and the unemployment rate continues to increase, reaching 8 percent in the fourth quarter of 2016, and flattens thereafter. Equity prices fall both during and after the recession and by the end of the scenario are about 25 percent lower than in the third quarter of 2014; equity market volatility also rises somewhat. House prices and commercial real estate prices decline by approximately 13 and 16 percent, respectively, relative to their level in the third quarter of 2014.
Outside the United States, the adverse scenario features recessions in the euro area, the United Kingdom, and Japan, and below-trend growth in developing Asia (see Table 2B). This weakness in economic activity results in a period of deflation for some countries or country blocks: The euro area experiences modest price declines for the first year of the scenario, and in Japan there is a sustained period of deflation with price declines that are steeper than those for the euro area. The exchange value of the dollar is little changed vis-à-vis the euro, the pound sterling, and the currencies of developing Asia relative to the baseline scenario; the dollar is assumed to depreciate against the yen, reflecting flight-to-safety capital flows.
This adverse scenario is qualitatively different from last year's adverse scenario released in November 2013.6 The main difference lies in the evolution of Treasury yields; in particular, the adverse scenario issued last year featured a general aversion of investors to long-term fixed-income assets worldwide that in turn resulted in a sharp rise in long-term interest rates and hence a steeper yield curve than in the corresponding baseline scenario. By contrast, in this year's adverse scenario, the hypothetical pick-up in U.S. inflation results in a yield curve that is higher and flatter than in the baseline. (This year's adverse scenario is broadly similar to the 2013 adverse scenario released in November 2012.7 )
Additional Key Features of the Adverse Scenario. The economic slowdown in the euro area should be interpreted as a broad-based contraction in euro-area demand, rather than as a development that is concentrated in a few euro-area countries. Similarly, the slowdown in developing Asia featured in this year's adverse scenario should be interpreted as a weakening in economic conditions across all emerging market economies and not simply as a phenomenon specific to the developing Asia region. Regarding property prices, the decline in aggregate U.S. house prices described earlier should be viewed as particularly relevant for states or metropolitan areas that have experienced brisk gains in house prices during the past couple of years. The decline in U.S. property prices should be interpreted as being representative of risks to property prices among those foreign economies where property prices are currently elevated.
As described earlier, firms should interpret the rise in short-term interest rates embodied in this year's adverse scenario as crystallizing certain risks to banks' funding costs. In particular, commercial deposits should be viewed as being unusually drawn to institutional money funds, which re-price promptly in response to changes in short-term Treasury rates. Consumer deposits should also be assumed to be drawn to higher-yielding alternatives.
Severely Adverse Scenario
The severely adverse scenario features a substantial weakening in global economic activity, accompanied by large reductions in asset prices. In the scenario, the U.S. corporate sector experiences increases in financial distress that are even larger than would be expected in a severe recession, together with a widening in corporate bond spreads and a decline in equity prices. The scenario also includes a rise in oil prices (Brent crude) to approximately $110 per barrel. These elements of the scenario are described in greater detail in "Additional Key Features of the Severely Adverse Scenario." As with the other scenarios described in this document, this scenario is not a forecast, but rather a hypothetical sequence of events designed to assess the strength of banking organizations and their resilience to a severely adverse economic environment.
The severely adverse scenario for the United States is characterized by a deep and prolonged recession in which the unemployment rate increases by 4 percentage points from its level in the third quarter of 2014, peaking at 10 percent in the middle of 2016 (see Table 3A). In terms of both the peak level reached by the unemployment rate and its total increase, this shock is of a similar magnitude to those experienced in severe U.S. contractions during the past half-century. By the end of 2015, the level of real GDP is approximately 4-1/2 percent lower than its level in the third quarter of 2014; it begins to recover thereafter. Despite this decline in real activity, higher oil prices cause the annualized rate of change in the CPI to reach 4-1/4 percent in the near term, before subsequently falling back.
In response to this economic contraction--and despite the higher near-term path of CPI inflation--Treasury yields of all maturities are significantly lower throughout the scenario than in the baseline. Short-term interest rates remain near zero through 2017; long-term Treasury yields drop to 1 percent in the fourth quarter of 2014 and then edge up slowly over the remainder of the scenario period. Driven by the assumed decline in corporate credit quality, spreads on investment-grade corporate bonds jump from about 170 basis points to 500 basis points at their peak. As a result, despite lower long-term Treasury yields, corporate financial conditions tighten significantly in 2015 and the yield on investment-grade corporate bonds is higher than the baseline until the fourth quarter of 2016. Mortgage rates also increase over the course of 2015, driven by some widening in spreads.
Consistent with these developments, asset prices contract sharply in the scenario. Equity prices fall by approximately 60 percent from the third quarter of 2014 through the fourth quarter of 2015, and equity market volatility increases sharply. House prices decline by approximately 25 percent during the scenario period relative to their level in the third quarter of 2014, while commercial real estate prices are more than 30 percent lower at their trough.
The international component of the severely adverse scenario (see Table 3B) features severe recessions in the euro area, the United Kingdom, and Japan; and below-trend growth in developing Asia. For economies that are heavily dependent on imported oil--including developing Asia, Japan, and the euro area--this economic weakness is exacerbated by the rise in oil prices featured in this scenario. The euro-area recession begins in the fourth quarter of 2014, and the economy continues to contract through the fourth quarter of 2015; the level of euro-area real GDP contracts by 5 percent during the recession. The United Kingdom also experiences a recession in 2015 and its real GDP falls by almost 3-1/2 percent relative to the level in the third quarter of 2014. Economic activity is assumed to weaken materially for two quarters in developing Asia before rebounding strongly, while the adverse effects on Japanese real GDP are assumed to persist so that the level of Japan's real GDP is approximately 10-1/2 percent lower by the end of the second quarter of 2016 than in the third quarter of 2014.
Reflecting flight-to-safety capital flows associated with the scenario's global recession, the U.S. dollar is assumed to appreciate strongly against the euro and the currencies of developing Asia, and to appreciate more modestly against the pound sterling. The dollar is assumed to depreciate modestly against the yen, also reflecting flight-to-safety capital flows.
This year's severely adverse scenario is similar to last year's severely adverse scenario released in November 2013.8 The significant differences from last year include the somewhat larger widening in corporate bond spreads and the increase in the price of oil that are assumed in this year's scenario.
Additional Key Features of the Severely Adverse Scenario. As with the adverse scenario, the economic slowdown in the euro area should be interpreted as a broad-based contraction in euro-area demand, rather than as a development concentrated in a few euro-area countries. In this year's severely adverse scenario, part of the sharp slowdown in activity in developing Asia reflects the region's relatively high degree of oil dependence. As such, not all of the severe weakening in economic conditions in developing Asia is shared by other emerging market economies. As is the case for the adverse scenario, firms should view the large decline in aggregate U.S. house prices described in the severely adverse scenario as being particularly relevant for states or metropolitan areas that have experienced brisk gains in house prices during the past couple of years, and the large decline in U.S. property prices assumed in the scenario should be interpreted as being representative of risks to property prices in those foreign economies where property prices are elevated.
As mentioned earlier, in this year's severely adverse scenario, U.S. corporate credit quality deteriorates sharply. As in last year's scenario, this deterioration is particularly concentrated in riskier firms. Investors pull back from a variety of assets linked to risky corporate borrowers and, in particular, highly leveraged corporations. Spreads on assets linked to these corporations, particularly high-yield bonds, leveraged loans, and collateralized loan obligations (CLOs) backed by leveraged loans, widen to levels the same as the peaks reached in the 2007-2009 recession.
Global Market Shock Components for Supervisory Adverse and Severely Adverse Scenarios
The global market shock components are one-time, hypothetical shocks to a large set of risk factors. Generally, these shocks involve large and sudden changes in asset prices, interest rates, and spreads, reflecting general market dislocation and heightened uncertainty.9 BHCs with significant trading activity will be required to include the global market shock as part of their supervisory adverse and severely adverse scenarios.10 In addition, as discussed below, certain large and highly interconnected BHCs must apply the same global market shocks to their counterparty exposures to project losses under the counterparty default scenario component. The as-of date for the global market shock is October 6, 2014. A BHC 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 6, 2014 to October 10, 2014).
It is important to note that global market shocks included in the adverse and severely adverse scenarios are not forecasts, but rather are hypothetical scenarios designed to assess the strength and resilience of banking organizations in the event of sudden and significant deterioration in market environments.
The Federal Reserve will make the data for the global market shock components available no later than December 1, 2014.
Severely Adverse Scenario
The market shock component for the severely adverse scenario is built around a sudden sharp increase in general risk premiums and credit risk, combined with significant market illiquidity, associated, in part, with the distress of one or more large leveraged entities that rapidly sell a variety of assets into an already fragile market. Under the scenario, severe declines in the value of credit positions have immediate implications for less liquid products as investors attempt to rapidly exit these positions--specifically, private equity, securitizations, and exposures to emerging markets. While most declines are comparable to those experienced in 2008, products with favorable current market valuations are assumed to experience greater declines. Notably, mortgage-backed securities are among the assets being liquidated by distressed, leveraged entities, causing significant increases in the option-adjusted spreads on agency mortgage-backed securities.
Globally, government yield curves undergo marked shifts in level and shape due to market participants' risk aversion. The flight-to-quality pushes rates down across the term structure in the United States and certain European countries, while emerging markets and countries that are part of the so-called European periphery experience sharp increases in government yields. The magnitudes of the increases in rates vary, with jumps in European periphery spreads, and emerging markets rates approximating the moves experienced during periods of stress during 2011 and 2008, respectively. Countries that are affected by the flight-to-quality also experience currency appreciation. Fears of a prolonged and potentially more acute recession in Europe drive up sovereign CDS spreads in a manner generally consistent with the experience of 2011.
The core of the global market shock component for the adverse scenario consists of market shocks that are, by and large, similar in structure, but not as severe as those assumed in the severely adverse scenario. However, rates across the term structure in the United States and Europe increase, as the flight to quality mainly affects the short end of the yield curve while an aversion to long-term assets prevails. In addition, the increase in implied volatilities for equities is more subdued than what is typically associated with the level of the equity price declines in the adverse scenario.
Counterparty Default Component for Supervisory Adverse and Severely Adverse Scenarios
For CCAR 2015, certain large and highly interconnected firms must include a counterparty default scenario component in the adverse and severely adverse scenarios.11 In connection with the counterparty default scenario component, these BHCs 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 adverse and severely adverse stress scenarios.
The counterparty default scenario component involves the instantaneous and unexpected default of the BHC's largest counterparty.12 Each BHC's largest counterparty will be 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 for derivatives, to the value of the trade position and non-cash collateral exchanged. The as-of date for the counterparty default scenario component is October 6, 2014--the same date as the global market shock. As with the global market shock, a BHC 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 6, 2014, to October 10, 2014).
3. For more on the Federal Reserve's framework for designing scenarios for stress testing, see 12 CFR 252, appendix A. Return to text
4. See Aspen Publishers (2014), "Blue Chip Economic Indicators," vol. 39, no. 10 (October 10). Return to text
6. The 2014 Supervisory Scenarios for Annual Stress Tests Required under the Dodd-Frank Act Stress Testing Rules and the Capital Plan Rule are available at www.federalreserve.gov/bankinforeg/stress-tests/supervisory-baseline-adverse-and-severely-adverse-scenarios.htm. Return to text
7. The 2013 Supervisory Scenarios for Annual Stress Tests Required under the Dodd-Frank Act Stress Testing Rules and the Capital Plan Rule are available at www.federalreserve.gov/newsevents/press/bcreg/bcreg20121115a1.pdf. Return to text
8. The 2014 Supervisory Scenarios for Annual Stress Tests Required under the Dodd-Frank Act Stress Testing Rules and the Capital Plan Rule are available at www.federalreserve.gov/bankinforeg/stress-tests/supervisory-baseline-adverse-and-severely-adverse-scenarios.htm. Return to text
9. The global market shock components consist of shocks to a large number of risk factors that include a wide range of financial market variables that affect asset prices, such as a credit spread or the yield on a bond, and, also include, in some cases, shocks to the value of the position itself (for example, the market value of private-equity positions). Return to text
10. For this cycle, six BHCs are subject to the global market shock components: Bank of America Corporation; Citigroup Inc.; The Goldman Sachs Group, Inc.; JPMorgan Chase & Co.; Morgan Stanley; and Wells Fargo & Company. See 12 CFR 252.54(b)(2)(i). Return to text
11. Eight BHCs are subject to the counterparty default scenario component: Bank of America Corporation; The Bank of New York Mellon Corp.; Citigroup Inc.; The Goldman Sachs Group, Inc.; JPMorgan Chase & Co.; Morgan Stanley; State Street Corp.; and Wells Fargo & Company. See 12 CFR 252.54(b)(2)(ii). Return to text
12. In selecting its largest counterparty, a BHC will not consider certain sovereign entities (Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States) or designated central clearing counterparties. Return to text