Board of Governors of the Federal Reserve System

Supervisory Stress Test Results under the Severely Adverse Scenario

This section describes the Federal Reserve's projections of losses, revenues, expenses, and capital positions for the 33 large firms participating in DFAST 2020 under the severely adverse scenario. Results are presented both in the aggregate and for individual firms. The aggregate results provide a sense of the stringency of the severely adverse scenario projections and the sensitivities of losses, revenues, and capital at these firms as a group to the stressed economic and financial market conditions contained in those scenarios. The range of results across individual firms reflects differences in business focus, asset composition, revenue and expense sources, and portfolio risk characteristics. The comprehensive results for individual firms are reported in appendix B.

Year-over-year changes in supervisory stress test results reflect changes in

• firm starting capital positions;
• scenarios used for the supervisory stress test;
• portfolio composition and risk characteristics; and
• models used in the supervisory stress test.

Under the supervisory severely adverse scenario, the aggregate capital ratio is projected to decline to a minimum of 9.9 percent, before rising to 10.3 percent at the end of nine quarters (see table 2). In the aggregate, each of the five capital and leverage ratios decline over the course of the projection horizon from their fourth quarter of 2019 levels, with first-quarter 2022 levels ranging from 0.8 percentage points to 1.8 percentage points lower than at the start of the projection horizon (see table 2).

The changes in post-stress capital ratios vary considerably across firms (see figure 13), and table 4 presents these ratios for each of the 33 firms. Differences in the declines in ratios across firms are primarily related to differences in the Federal Reserve's projections of losses, revenues, and expenses but are also influenced by the regulatory capital treatment for different types of firms.

Projected Losses

The Federal Reserve projects that the 33 large firms as a group would experience significant losses on loans and other positions under the severely adverse scenario. In this scenario, losses are projected to be $550 billion³⁹ for the 33 firms in the aggregate over the nine quarters of the projection horizon.

These losses include

• $433 billion in accrual loan portfolio losses;
• $6 billion in securities losses;⁴⁰
• $83 billion in trading and/or counterparty losses at the 13 firms with substantial trading, processing, or custodial operations; and
• $29 billion in additional losses from items such as loans booked under the fair-value option (see table 2).

Losses on accrual loan portfolios account for 79 percent of the projected losses for the 33 firms, while trading and/or counterparty losses account for 15 percent (figure 12).

Loan Losses

Total loan losses are $433 billion for the 33 firms. For the 18 firms subject to an annual supervisory stress test, total loan losses this year are $316 billion, compared to $296 billion in projected loan losses for the same firms last year.

Loan losses for the full group of 33 firms are roughly equally split between consumer products (domestic residential mortgages, domestic junior liens and HELOCs, credit cards, and other consumer loans) and commercial products (domestic commercial real estate, commercial and industrial loans, and other loans) (see table 2). Consumer and commercial products represent 40 and 38 percent of total projected losses, respectively. Commercial and industrial loan losses and credit card losses are the two largest categories of loan losses at $114 billion and $144 billion, respectively.

For the full group of 33 firms, the nine-quarter cumulative loss rate for all accrual loan portfolios is 6.3 percent, where the loss rate is calculated as total projected loan losses over the nine quarters of the projection horizon divided by average loan balances over the horizon. However, total loan loss rates vary significantly across firms, ranging between 0.9 percent and 17.0 percent across these institutions (see table 7 and figure 14).

The differences in total loan loss rates across the firms reflect differences in the risk characteristics of the portfolios held by each firm owing to both the composition of lending across portfolios and the characteristics of the loans within each portfolio. Loan portfolio composition matters because projected loss rates vary significantly for different types of loans. In the aggregate, nine-quarter cumulative loss rates vary from 1.5 percent on domestic first-lien mortgages to 17.1 percent on credit cards, reflecting both differences in typical performance of these loans—some loan types tend to generate higher losses, though generally also higher revenue—and differences in the sensitivity of different types of loans to the severely adverse scenario. In particular, lending categories for which performance is sensitive to credit spreads or unemployment rates may experience high stressed loss rates due to the considerable stress on these factors in the severely adverse scenario.⁴¹

Projected loss rates on most loan categories show similar dispersion across firms (see table 7 and figures C.1 through C.7). There are significant differences across firms in the projected loan loss rates for similar types of loans. For example, while the median projected loss rate on commercial and industrial loans is 6.7 percent, the rates among firms with commercial and industrial loans vary from a low of 1.0 percent to a high of 20.9 percent. For credit card loans, the range of projected loss rates is from 10.4 percent to 26.4 percent, with a median of 18.7 percent. Differences in projected loss rates across firms primarily reflect differences in loan and borrower characteristics.

Differences in projected loss rates over time primarily reflect changes in loan and borrower characteristics and changes in the scenarios. The composition of firms' loan portfolios shifted during 2019, with consumer lending experiencing the most rapid growth. However, in the aggregate, risk in overall bank loan holdings did not change materially during 2019. The severely adverse scenario features a larger increase in the unemployment rate and a larger increase in the corporate bond spread relative to last year, leading to a higher total loan loss rate in DFAST 2020.

Losses on Trading, Private Equity, SFT, and Derivatives Positions

The severely adverse scenario results include $83 billion in trading losses from the global market shock at the 11 firms with large trading and private-equity exposures and losses from the largest counterparty default component at the 13 firms with substantial trading, processing, or custodial operations. Trading and counterparty losses range between $0.6 billion and $22 billion across the 13 firms (see table 5) subject to the full global market shock.

The relative size of losses across firms depends not on nominal portfolio size but rather on the specific risk characteristics of each firm's trading positions, inclusive of hedges. Importantly, these projected losses are based on the trading positions and counterparty exposures held by these firms on a single date (October 18, 2019) and could have differed if they had been based on a different date.

Projected PPNR

In the aggregate, the 33 firms are projected to generate $429 billion in PPNR cumulatively over the nine quarters of the projection horizon, equal to 2.6 percent of their combined average assets (see table 2). The Federal Reserve's PPNR projections are driven by the shape of the yield curve, the path of asset prices, equity market volatility, and measures of economic activity in the severely adverse scenario. In addition, the PPNR projections incorporate expenses stemming from estimates of elevated levels of losses from operational-risk events such as fraud, employee lawsuits, litigation-related expenses, or computer system or other operating disruptions.⁴² In aggregate for the 33 firms, operational-risk losses are $144 billion this year. For the 18 firms disclosed in DFAST 2019, operational-risk losses were $123 billion, compared to $129 billion for the same 18 firms in DFAST 2020.

Aggregate PPNR as a percent of average assets is higher in DFAST 2020 relative to DFAST 2019. That difference is primarily attributable to the inclusion of the smaller firms. For the 18 firms for which stress test results were disclosed both last year and this year, PPNR as a percent of average assets remained nearly unchanged compared to DFAST 2019.

The ratio of projected cumulative PPNR to average assets varies across firms (see figure 15). A significant portion of this variation reflects differences in business focus across the institutions. For instance, the ratio of PPNR to assets tends to be higher at firms focusing on credit card lending, reflecting the higher net interest income that credit cards generally produce relative to other forms of lending.⁴³ Importantly, lower PPNR rates do not necessarily imply lower net income, because the same business focus and revenue risk characteristics determining differences in PPNR across firms could also result in offsetting differences in projected losses across firms.

Net Income and Regulatory Capital Treatment

Projected PPNR and losses are the primary determinants of projected pre-tax net income. The projected decline in pre-tax net income is 1.1 percent of average total assets, compared to a decline of 0.8 percent in the DFAST 2019 exercise (see figure 4). Table 5 presents projections of the components of pre-tax net income, including provisions into the allowance and one-time income and expense and extraordinary items, under the severely adverse scenario for each of the 33 firms (see table 2 for aggregate). The projections are cumulative for the nine quarters of the projection horizon.

The Federal Reserve's projections of pre-tax net income under the severely adverse scenario imply negative net income at most of the 33 firms individually and for the firms as a group over the nine-quarter projection horizon. Projected net income before taxes (pre-tax net income) is an aggregate net loss of $177 billion over the projection horizon for the 33 firms.

The net income projections incorporate loan losses indirectly through provisions, which equal projected loan losses plus the amount needed for the allowance to be at an appropriate level at the end of each quarter.⁵⁴ The $489 billion in total provisions includes $433 billion in net charge-offs, with the remainder being the reserve build. These amounts are cumulative over the projection horizon and do not fully reveal variation in the allowance during the course of the nine quarters. Specifically, the projected allowance increases during the early quarters of the projection horizon, given the increased economic stress in the severely adverse scenario, and then declines as the economic stress abates.

The ratio of pre-tax net income to average assets for each of the 33 firms ranges from −4.3 percent to 2.2 percent (see figure 16). Projected cumulative net income for most of the firms (26 of 33) is negative over the projection horizon. Differences across the firms reflect differences in the sensitivity of the various components of net income to the economic and financial market conditions in the supervisory scenarios. Projected net income for the 13 firms subject to the global market shock, the supervisory market risk component, and/or the counterparty default component includes the effect of those additional scenario components in the severely adverse scenario, introducing some additional variation in projected net income between these firms and the other firms participating in DFAST 2020.

Firms that are required to include AOCI in regulatory capital and those that opt in to including it are also impacted by OCI (table 5), which is driven by unrealized gains and losses on AFS securities in the supervisory stress test. The severely adverse scenario features a smaller decline in the 10-year Treasury yield in the first quarter, leading to lower projected unrealized gains for AFS securities in DFAST 2020 for the 18 firms that were also in the DFAST 2019 exercise. The interest rate path and credit spreads assumed in the scenario result in $8.5 billion of OCI over the nine quarters of the projection horizon for firms required to include AOCI in regulatory capital and those that opt in to including it.

Since DFAST 2019, the Federal Reserve modified the capital calculation to align with the capital simplification, tailoring, and stress capital buffer rules, which affected the DFAST 2020 results. As a result of the tailoring rules, AOCI is excluded from regulatory capital for certain firms, which increases these firms' projected capital ratios due to AOCI generally being negative at the beginning of the projection horizon. The model changes related to the simplifications rule reduce capital deductions, which increases projected capital ratios in the stress test. Finally, the changes related to the stress capital buffer rule increase projected capital ratios due to no longer including certain capital actions in the projection horizon, as well as assuming no balance sheet growth.

Table 1. Applicable capital ratios and calculations for firms in the 2020 Dodd-Frank Act stress tests

Table 2. 33 participating firms Projected stressed capital ratios, risk-weighted assets, losses, revenues, net income before taxes, and loan losses Federal Reserve estimates: Severely adverse scenario

 

Capital ratios, actual 2019:Q4 and projected 2020:Q1–2022:Q1

Projected loan losses, by type of loan, 2020:Q1–2022:Q1

Risk-weighted assets, actual 2019:Q4 and projected 2022:Q1

Projected losses, revenue, and net income before taxes through 2022:Q1

Table 3. Projected minimum common equity tier 1 ratio under the severely adverse scenario, 2020:Q1–2022:Q1 33 participating firms

Table 4.A. Capital ratios, actual 2019:Q4 and projected 2020:Q1–2022:Q1 under the severely adverse scenario:Risk-based Category I, II, and III firms

Table 4.B. Capital ratios, actual 2019:Q4 and projected 2020:Q1–2022:Q1 under the severely adverse scenario:Risk-based Category IV firms

Table 4.C. Capital ratios, actual 2019:Q4 and projected 2020:Q1–2022:Q1 under the severely adverse scenario: 33 participating firms

Table 5. Projected losses, revenue, and net income before taxes through 2022:Q1 under the severely adverse scenario: 33 participating firms

Table 6. Projected loan losses by type of loan for 2020:Q1–2022:Q1 under the severely adverse scenario: 33 participating firms

Table 7. Projected loan losses by type of loan for 2020:Q1–2022:Q1 under the severely adverse scenario: 33 participating firms

 

References

 39. Projected losses in the subsequent list sum to $551 billion due to rounding. Return to text

 40. For firms that have adopted ASU 2016-13, the Federal Reserve incorporated its projection of expected credit losses on securities in the allowance for credit losses, in accordance with Financial Accounting Standards Board (FASB), Financial Instruments–Credit Losses (Topic 326), FASB Accounting Standards Update (ASU) 2016-13 (Norwalk, Conn.: FASB, June 2016). Prior to the adoption of ASU 2016-13, securities credit losses were realized through other-than-temporary impairment (OTTI). Return to text

 41. Additionally, losses are calculated based on the exposure at default (EAD), which includes both outstanding balances and any additional drawdown of the credit line that occurs prior to default, while loss rates are calculated as a percent of average outstanding balances over the projection horizon. Return to text

 42. These estimates are conditional on the severely adverse scenario and on conservative assumptions. They are not a supervisory estimate of the firms' current or expected legal liability. Return to text

 43. As noted, credit card lending also tends to generate relatively high loss rates, so the higher PPNR rates at these firms do not necessarily indicate higher profitability. Return to text

 44. See note 24. Return to text