On February 1, 2018, the Federal Reserve released the three supervisory scenarios: baseline, adverse, and severely adverse.13 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.14 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 2017, the Federal Reserve applied a global market shock to the trading portfolio of six firms with large trading and private equity exposures and a counterparty default scenario component to eight firms with substantial trading, processing, or custodial operations (see Global Market Shock and Counterparty Default Components). In addition, the Federal Reserve applied a supervisory market risk component, a simplified version of the global market shock and large counterparty default scenario component, to the six IHCs with trading activity that will be subject to the global market shock beginning in 2019.
Severely Adverse Scenario
The severely adverse scenario is characterized by a severe global recession that is accompanied by a global aversion to long-term fixed-income assets. As a result, long-term rates do not fall and yield curves steepen in the United States and the four countries/country blocks in the scenario. In turn, these developments lead to a broad-based and deep correction in asset prices--including in the corporate bond and real estate markets.
In this scenario, the level of U.S. real GDP begins to decline in the first quarter of 2018 and reaches a trough in the third quarter of 2019 that is 7½ percent below the pre-recession peak. The unemployment rate increases almost 6 percentage points, to 10 percent, by the third quarter of 2019. Headline consumer price inflation falls below 1 percent at an annual rate in the second quarter of 2018 and rises to about 1½ percent at an annual rate by the end of the scenario.
As a result of the severe decline in real activity, short-term Treasury rates fall and remain near zero through the end of the scenario period. However, investor aversion to long-term fixed-income assets keeps 10-year Treasury yields unchanged through the scenario 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 5¾ percentage points by the start of 2019, while the spread between mortgage rates and 10-year Treasury yields widens to about 3½ percentage points over the same time period.
Asset prices drop sharply in this scenario. Equity prices fall 65 percent by early 2019, accompanied by a surge in equity market volatility. The U.S. market volatility index (VIX) moves above 60 percent in the first half of 2018. Real estate prices also experience large declines, with house prices and commercial real estate prices falling 30 percent and 40 percent, respectively, by the third quarter of 2019.
The international component of this scenario features a sharp global downturn, with severe recessions in the euro area, the United Kingdom, and Japan, and a shallow and brief 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, with Japan experiencing a more significant deflation that persists through the end of the scenario period. As in this year's adverse scenario, 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.
The severely adverse scenario used in the 2018 stress test cycle features a more severe downturn in the U.S. economy as compared to the 2017 scenario. This increase in severity reflects the Federal Reserve's scenario design framework for stress testing, which includes elements that create a more severe test of the resilience of large firms when current economic conditions are especially strong. Under this framework, the unemployment rate in the severely adverse scenario will reach a peak of at least 10 percent, which leads to a progressively greater increase in the unemployment rate if the starting unemployment rate is below 6 percent. Furthermore, the 2018 scenario incorporates a steepening of the yield curve and a deeper correction in prices for a broad set of assets, including equities, housing, and commercial real estate. The international dimension of the scenario shows a recessionary episode that, relative to last year's scenario, is more severe in developing Asia and Japan but less severe in the euro area and the United Kingdom.
The adverse scenario is characterized by weakening economic activity across all of the economies included in the scenario. This economic downturn is accompanied by rapid declines in long-term rates and flattening yield curves in the United States and the four countries/country blocks in the scenario.
In the adverse scenario, the U.S. economy experiences a moderate recession that begins in the first quarter of 2018. Real GDP falls slightly more than 2¼ percent from the pre-recession peak in the fourth quarter of 2017 to the recession trough in the first quarter of 2019, while the unemployment rate rises steadily, peaking at 7 percent in the third quarter of 2019. The U.S. recession is accompanied by an initial fall in inflation in the first two quarters of 2018. The rate of increase in consumer prices then rises steadily before leveling off at around 2 percent by the second half of 2019.
Reflecting weak economic conditions, short-term interest rates in the United States decline to nearly zero, where they remain for the rest of the scenario period. Yields on 10-year Treasury securities drop to around ¾ of a percent in the first quarter of 2018 as the yield curve flattens, and then gradually rise to slightly less than 2 percent by the end of the scenario. Financial conditions tighten for corporations and households during the recession. Spreads between investment-grade corporate bond yields and 10-year Treasury yields gradually rise to about 3¾ percentage points by early 2019, while spreads between mortgage rates and 10-year Treasury yields widen to about 2¾ percentage points over the same period.
Asset prices decline in the adverse scenario. Equity prices fall approximately 30 percent by early 2019, accompanied by a rise in equity market volatility. Nominal house prices and commercial real estate prices experience sustained declines; house prices fall 12 percent and commercial real estate prices fall 15 percent by the first quarter of 2020.
Following the recession, U.S. real activity picks up slowly at first and then gains momentum; growth in U.S. real GDP increases from ¾ of a percent in 2019 to about 3 percent in 2020. The unemployment rate declines modestly, to about 6¼ percent by the end of the scenario period. Consumer price inflation remains at roughly 2 percent through the end of the scenario period. Yields on 10-year Treasury securities continue to 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 pronounced and protracted recession in Japan, and below-trend growth in developing Asia. Weakness in global demand results in slowing inflation in all of the foreign economies under consideration and the onset of deflationary episodes in Japan and--more modestly--developing Asia. Reflecting flight-to-safety capital flows, the U.S. dollar appreciates against the euro, the pound sterling, and the currencies of developing Asia. The dollar depreciates modestly against the yen, also in line with flight-to-safety capital flows.
The main difference relative to the 2017 adverse scenario is that the 2018 adverse scenario features lower long-term interest rates and a flatter yield curve across all of the economies included in the scenario. This different profile of interest rates is associated with a less pronounced decline in the U.S. equity price index in the 2018 scenario.
Global Market Shock and Counterparty Default Components
The Federal Reserve applied a global market shock to the trading portfolios of six firms with large trading and private equity exposures.15 In addition, the Federal Reserve applied a counterparty default component, which assumes the default of a firm's largest counterparty under the global market shock, to the same six firms and two other firms with substantial trading, processing, or custodial operations.16 These components are 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 instantaneous, 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.17 The Federal Reserve published the global market shock for the adverse and severely adverse scenarios on February 1, 2018; the as-of date for the global market shock and the counterparty default is December 4, 2017.
The global market shock component for the severely adverse scenario is designed around three main elements: a sudden sharp increase in general risk premiums and credit risk, a rise and steepening of the U.S. yield curve, and a general selloff of U.S. assets relative to other developed countries. Markets that are more tightly linked to interest rates are more acutely affected. As an example, in general, corporate debt, residential mortgage-backed securities (RMBS), and commercial mortgage-backed securities (CMBS) markets are more severely affected than U.S. equities. Some markets less closely linked to interest rates experience conditions that are generally comparable to the second half of 2008.
Globally, yield curves for government bonds of most developed countries undergo moderate tightening due to outflows from U.S. asset markets. The U.S. yield curve rises across the term structure, particularly at the long end. Emerging market yield curves generally rise due to heightened risk premiums. The U.S. dollar depreciates relative to other developed market currencies due to investor outflows.
The major differences relative to the 2017 severely adverse scenario include a rise and steepening of the U.S. yield curve; greater depreciation of the U.S. dollar relative to other advanced currencies; and more muted shocks to some credit-sensitive assets, such as non-agency RMBS. These differences are intended to reflect a general sell-off in U.S. markets--combined with a less severe stress to illiquid assets.
The eight firms with substantial trading or custodial operations were required to incorporate a counterparty default scenario component into their supervisory adverse and severely adverse stress scenarios for CCAR 2018. 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 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. 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.
Each firm's largest counterparty is 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 December 4, 2017--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 major difference relative to the 2017 adverse scenario is a regional focus on developing Asian markets. In general, the 2018 adverse scenario includes larger changes in price, spread, and volatility levels across most markets.
In addition, the Federal Reserve applied a supervisory market risk component to the six IHCs with significant trading activity20 that will be subject to the full global market shock component starting in 2019. For this simplified version, the Federal Reserve applied exposure-level loss rates based on the losses used in the global market shock and large counterparty default components in 2014-17.
13. See Board of Governors of the Federal Reserve System (2018), "2018 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 2018), https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20180201a1.pdf for additional information and for the details of the supervisory scenarios. Return to text
14. 12 CFR part 252, appendix A. Return to text
15. The six firms 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 & Co. See 12 CFR 252.54(b)(2). Return to text
16. The eight LISCC firms 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 & Co. See 12 CFR 252.54(b)(2)(ii). Return to text
17. See CCAR 2018: Severely Adverse Global Market Shocks at https://www.federalreserve.gov/supervisionreg/files/ccar-2018-severely-adverse-market-shocks.xlsx, and CCAR 2018: Adverse Global Market Shocks at https://www.federalreserve.gov/supervisionreg/files/ccar-2018-adverse-market-shocks.xlsx. 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 designated central clearing counterparties. 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., December 4-8, 2017). Losses will be assumed to occur in the first quarter of the planning horizon. Return to text
20. The six firms subject to the supervisory market risk component are Barclays US LLC; Credit Suisse Holdings (USA), Inc.; DB USA Corporation; HSBC North America Holdings Inc.; RBC USA Holdco Corporation; and UBS Americas Holdings LLC. See 12 CFR 252.54(b)(2)(ii). Return to text