Board of Governors of the Federal Reserve System

2021 Stress Test Scenarios

Introduction

The Federal Reserve Board's (Board) stress tests help ensure that large banks are able to lend to households and businesses even in a severe recession. The stress tests evaluate the resilience of large banks by estimating their losses, revenues, expenses and resulting capital levels—which provide a cushion against losses—under hypothetical recession scenarios into the future.¹

Last year, the Board ran two separate stress tests to assess the strength of large banks. The Board found that large banks were generally well capitalized under a range of hypothetical events. But due to continuing uncertainty from the COVID event, the Board placed restrictions on bank payouts to preserve the strength of the banking sector.

The hypothetical scenarios that banks are tested against are described in detail in this publication.² See the box "Recent Updates to Capital Planning Requirements" on the Board's recent regulatory actions on stress test requirements.

Supervisory Scenarios

The severely adverse scenario describes a hypothetical set of conditions designed to assess the strength and resilience of banking organizations to an adverse economic environment. The baseline scenario follows a profile similar to average projections from a survey of economic forecasters. These scenarios are not Federal Reserve forecasts.³

Scenario timing and variables: The scenarios start in the first quarter of 2021 and extend through the first quarter of 2024. 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: quarterly percent changes (at an annual rate) in real and nominal gross domestic product (GDP), real and nominal disposable personal income, the Consumer Price Index for all urban consumers (CPI), and the level of the unemployment rate of the civilian non-institutional population aged 16 years and over;
• Four aggregate measures of asset prices or financial conditions: indexes of house prices, commercial real estate prices, equity prices, and stock market volatility; and

• Six measures of interest rates: the rate on 3-month Treasury securities; the yield for 5-year Treasury securities; the yield for 10-year Treasury securities; the yield for 10-year BBB corporate securities; the interest rate associated with conforming, conventional, 30-year fixed-rate mortgages; and the prime rate.

  The variables describing international economic conditions in each scenario include three variables in four countries or country blocs:
• The three variables for each country or country bloc: quarterly percent changes (at an annual rate) in real GDP and in consumer price indexes or local equivalent, and the level of the U.S. dollar exchange rate.
• Four countries or country blocs: the euro area (the 19 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 and Severely Adverse Scenarios

The following sections describe the baseline and severely adverse scenarios. The variables included in these scenarios are provided in tables at the end of this document.⁴ Historical data for the domestic and the international variables are reported in table 1.A and table 1.B, respectively.

Baseline Scenario

The baseline outlook for U.S. real activity, inflation, and interest rates (see table 2.A) is similar to the October 2020 and January 2021 consensus projections from Blue Chip Economic Indicators and Blue Chip Financial Forecasts.⁵ This scenario does not represent a forecast of the Federal Reserve.

The baseline scenario for the United States is an economic expansion over the 13-quarter scenario period. Quarterly real GDP growth averages 4 percent (annual rate) in 2021, slows to 2-1/2 percent by the end of 2022, and slows further to about 2-1/4 percent at the end of the scenario period. The unemployment rate declines gradually from 6-3/4 percent at the end of 2020 to 4-1/2 percent at the end of the scenario period. Quarterly CPI inflation is relatively steady over the 13-quarter period, ranging from 1-3/4 to 2-1/4 percent at an annual rate.

Accompanying the economic expansion, short-term Treasury rates are assumed to gradually rise from 0 percent to 3/4 percent by the end of the scenario period. Longer-dated Treasury yields also are assumed to rise modestly over time, consistent with some steepening of the yield curve over most of the scenario period. Yields on 10-year Treasury securities rise from 1 percent in early 2021 to almost 1-1/2 percent in early 2022, and continue rising gradually to reach almost 2 percent by the end of the scenario period. The prime rate moves in line with short-term Treasury rates, while both corporate bond yields and mortgage rates rise in line with long-term Treasury yields. Equity prices rise 3-1/4 percent in 2021 and about 3-1/2 percent per year thereafter. Equity market volatility, as measured by the VIX, falls gradually from 32-3/4 in early 2021 to 26-1/2 by the end of the scenario period. Nominal house prices rise 3-1/2 percent in 2021, 3-3/4 percent in 2022, and 4 percent in 2023. Commercial real estate prices fall 4 percent from the fourth quarter of 2020 through the third quarter of 2021, and then rise 5 percent through the fourth quarter of 2022 and another 4 percent in 2023.

The baseline paths for the international variables (see table 2.B) are similar to the trajectories reported in the January 2021 Blue Chip Economic Indicatorsand the International Monetary Fund's October 2020 World Economic Outlook.⁶ The baseline scenario features a relatively steady expansion in international economic activity, albeit at different rates across the four country blocs: Annualized quarterly real GDP growth in developing Asia averages about 5 percent through the scenario period, 3-3/4 percent in the euro area, 2 percent in Japan, and 4-1/4 percent in the United Kingdom.

Severely Adverse Scenario

The severely adverse scenario follows the Board's Policy Statement on the Scenario Design Framework for Stress Testing ("Scenario Design Framework") and is characterized by a severe global recession accompanied by a period of heightened stress in commercial real estate and corporate debt markets.⁷ This is a hypothetical scenario designed to assess the strength and resilience of banking organizations and does not represent a forecast of the Federal Reserve.

Consistent with the Scenario Design Framework, under the severely adverse scenario, the U.S. unemployment rate climbs to a peak of 10-3/4 percent in the third quarter of 2022 (see table 3.A), a 4 percentage point increase relative to its fourth quarter 2020 level. Real GDP falls 4 percent from the fourth quarter of 2020 to its trough in the third quarter of 2022. The decline in activity is accompanied by lower CPI inflation, which quickly falls to an annual rate of about 1 percent in the second quarter of 2021 and stays at that level for another quarter before gradually rising to 2-1/4 percent by the end of the scenario period.

In line with the sharp decline in real activity, the 3-month Treasury rate remains near zero throughout the scenario. The 10-year Treasury yield immediately falls to 1/4 percent during the first quarter of 2021 and stays there through the first quarter of 2022, after which it gradually rises, reaching 1-1/2 percent by the end of the scenario period. The result is a gradual steepening of the yield curve over much of the scenario period.

Conditions in corporate and real estate lending markets deteriorate markedly. The spread between yields on investment-grade corporate bonds and yields on 10-year Treasury securities widens to almost 5-3/4 percentage points by the third quarter of 2021, an increase of 4-1/4 percentage points relative to the fourth quarter of 2020. 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 55 percent through the third quarter of 2021, accompanied by a rise in the VIX, which reaches a peak of 70. House prices and commercial real estate prices also experience large overall declines. House prices decline 23-1/2 percent through the end of 2022, while commercial real estate prices fall 40 percent through the first quarter of 2023.

The international component of this scenario features severe recessions in the euro area, the United Kingdom, and Japan, and a significant deceleration of activity (though still with positive growth for most of the scenario period) in developing Asia.The U.S. dollar appreciates against the euro, the pound sterling, and the currencies of developing Asia, but depreciates modestly against the yen, reflecting flight-to-safety capital flows.

Additional Key Features of the Severely Adverse Scenario

Stresses in the corporate loan market should be assumed to be more intense for lower-rated nonfinancial firms. Declines in aggregate U.S. house prices should be assumed to be concentrated in regions that have experienced rapid price gains over the past two years. Declines in commercial real estate prices should be assumed to be representative of risks to certain industries and property types that are being significantly affected by adjustments related to the COVID-19 event in the United States. Declines in U.S. house prices and U.S. commercial real estate prices should also be assumed to be representative of risks to house prices and commercial real estate prices in foreign regions and economies that experienced rapid price gains before the COVID-19 event and were significantly affected by the event. Moreover, although the weakness in euro area economic conditions reflects a broad-based contraction in euro area demand, this contraction should be assumed to be more protracted in countries with less ability to use fiscal policy to lean against the slowdown in economic activity. Conditions across Latin American economies should be assumed to be comparable to the sharp slowdown in the United States. The growth slowdown in developing Asia should be assumed to be representative of conditions across many emerging market economies.

Comparison of the Current Severely Adverse Scenario and the September 2020 Severely Adverse Scenario

In light of the heightened uncertainty associated with the COVID-19 event, the Board released the results of the updated stress test in December 2020, based on an updated severely adverse scenario and an alternative downside scenario released in September 2020.⁸ The current severely adverse scenario features a slightly greater increase in the unemployment rate in the United States compared with the September 2020 severely adverse scenario, but a lower peak unemployment rate. This difference reflects the Scenario Design Framework, which calls for a more pronounced economic downturn when current conditions are stronger. Given a lower unemployment rate at the beginning of the current scenario compared with the initial rate in the September 2020 scenario, the framework calls for a correspondingly larger increase in the unemployment rate. The path of interest rates in the current scenario is largely unchanged from the path in the September 2020 severely adverse scenario. The decline in house prices is somewhat smaller than the decline in the September 2020 severely adverse scenario, while the decline in equity prices is larger to account for the increases seen since September. The decline in commercial real estate prices is also larger, which is in line with the scenario's emphasis on heightened risks in this sector.

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 horizon.⁹ 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 positions held by the firms on a given as-of date, October 9, 2020.¹⁰ These shocks do not represent a forecast of the Federal Reserve.

The design and specification of the global market shock differs 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 at any time under stressed conditions. Applying the global market shock in the first quarter ensures that potential losses from trading and counterparty exposures are incorporated into trading companies' capital ratios at all points over the projection horizon.

The global market shock is specified by a large set of risk factors that include, but are not limited to:

• Equity prices of key developed economies and developing and emerging market economies along with selected points along term structures of implied volatilities;
• Foreign exchange rates of most major and some minor currencies, along with selected points along term structures of option-implied volatilities;
• Selected-maturity government yields (e.g., for 10-year U.S. Treasuries), swap rates, and other important interest rates for key developed economies and developing and emerging market economies;
• 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; non-agency residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBS); sovereign debt; and municipal bonds.

The Board considers emerging and ongoing areas of financial market vulnerability in the development of the global market shock. This assessment of potential vulnerabilities is informed by financial stability reports, supervisory information, and internal and external assessments of potential sources of distress such as geopolitical, economic, and financial market events.

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 vulnerability that the global market shock is intended to assess, the market shocks could be based on a single historical episode, multiple historical periods, hypothetical 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.¹¹

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. These characteristics will vary depending on the specified market shock narrative. More specifically, the 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 times needed to liquidate exposures under normal conditions because they are designed to capture the unpredictable liquidity conditions that prevail in times of stress.¹² In addition, shocks to risk factors in more-liquid markets, such as those for government securities, foreign exchange, or public equities, are calibrated to shorter horizons (such as three months), while shocks to risk factors in less-liquid markets, such as those for non-agency securitized products or private equities, have longer calibration horizons (such as 12 months).

2021 Severely Adverse Scenario

The 2021 global market shock component for the severely adverse scenario is characterized by a sharp curtailment in global economic activity as financial conditions tighten. In particular, with ratings agencies downgrading large swaths of outstanding debt, corporate bond spreads widen sharply as ratings-sensitive investors sell assets. The effect on investment-grade debt is somewhat mitigated by safe-haven flows, but non-investment-grade debt experiences high default rates and record low recovery rates. Price declines in the leveraged loan market are exacerbated by selling from open-end mutual funds and exchange-traded funds.

With fiscal conditions that are already stretched, U.S. state and local governments face additional stress. Revenue declines, combined with significant spending increases, lead to a widening in municipal bond spreads and increased risk of defaults. Mutual funds holding municipal debt face redemptions and outflows exceeding historical experience.

Commercial real estate prices—particularly for the retail and hospitality sectors—fall sharply in this scenario. Rapid selling of CMBS by nonbank commercial real estate lenders to meet margin calls puts considerable downward pressure on CMBS prices. Private-equity asset values experience sizable declines as leveraged firms face lower earnings and a weak economic outlook.

Short-term Treasury rates decrease only slightly given the current low level of short-term interest rates. Longer-term Treasury yields fall modestly, consistent with lower expected short-term rates and flight-to-safety considerations. Short-term U.S. interbank lending rates rise sharply, reflecting a pullback in overnight lending. At the same time, longer-term swap rates fall in line with the decreases in long-term Treasury yields.

Flight-to-safety considerations result in U.S. public equity price declines that are relatively mild compared to other developed markets, and cause the U.S. dollar to appreciate somewhat against the currencies of most developed economies. The yen appreciates against the U.S. dollar as investors unwind positions. Safe-haven considerations cause precious metal prices to increase, while prices for non-precious metals and oil decline, as a result of the broader economic weakness.

Comparison of the Current Severely Adverse Scenario and the September 2020 Severely Adverse Scenario

In light of the heightened uncertainty associated with the COVID-19 event, the Board released the results of the updated stress test in December 2020, based on an updated severely adverse scenario and an alternative downside scenario released in September 2020. The global market shock for the current severely adverse scenario is generally similar to the global market shock for the September 2020 severely adverse scenario. Corporate credit still experiences a great deal of stress, but to a slightly lesser degree than in the earlier scenario. Stress in the municipal bond market is slightly greater, while U.S. public equity shocks are milder. In addition, the shocks to interest rates and sovereign credit spreads in the euro area periphery are larger, in general.

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 their supervisory severely adverse stress scenario for 2021 and recognize associated losses in the first quarter of the projection horizon.¹³ This component involves the unexpected default of the firm's largest counterparty.^{14 ,15}

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 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 Federal Reserve's severely adverse 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 securities financing transactions and derivatives, including collateral posted or received. The as-of date for the counterparty default scenario component is October 9, 2020—the same as-of date for the global market shock.¹⁶

Variables for the Supervisory Scenarios

Table 1.A. Historical data: Domestic variables, Q1:2000–Q4:2020

Table 1.B. Historical data: International variables, Q1:2000–Q4:2020

Table 2.A. Supervisory baseline scenario: Domestic variables, Q1:2021–Q1:2024

Table 2.B. Supervisory baseline scenario: International variables, Q1:2021–Q1:2024

Table 3.A. Supervisory severely adverse scenario: Domestic variables, Q1:2021–Q1:2024

Table 3.B. Supervisory severely adverse scenario: International variables, Q1:2021–Q1:2024

Notes Regarding Scenario Variables

The following are descriptions of data through 2020:Q4 (as released through January 15, 2021). The 2020:Q4 values of variables marked with an asterisk (*) are estimates.

*U.S. real GDP growth: Quarterly percent change in real gross domestic product (chained 2012 dollars), expressed at an annualized rate, Bureau of Economic Analysis (NIPA table 1.1.6, line 1).

*U.S. nominal GDP growth: Quarterly percent change in gross domestic product (current dollars), expressed at an annualized rate, Bureau of Economic Analysis (NIPA table 1.1.5, line 1).

*U.S. real disposable income growth: Quarterly percent change in real disposable personal income (current-dollar values divided by the price index for personal consumption expenditures), expressed at an annualized rate, Bureau of Economic Analysis (NIPA table 2.1, line 27, and NIPA table 1.1.4, line 2).

*U.S. nominal disposable income growth: Quarterly percent change in disposable personal income (current dollars), expressed at an annualized rate, Bureau of Economic Analysis (NIPA table 2.1, line 27).

U.S. unemployment rate: Quarterly average of seasonally adjusted monthly unemployment rates for the civilian, non-institutional population aged 16 years and older, Bureau of Labor Statistics (series LNS14000000).

U.S. CPI inflation: Percent change in the quarterly average of seasonally adjusted monthly levels of the all-items CPI for all urban consumers (CPI-U), expressed at an annualized rate, Bureau of Labor Statistics (series CUSR0000SA0).

U.S. 3-month Treasury rate: Quarterly average of 3-month Treasury bill secondary market rate on a discount basis, H.15 Release, Selected Interest Rates, Federal Reserve Board (series RIFSGFSM03_N.B).

U.S. 5-year Treasury yield: Quarterly average of the yield on 5-year U.S. Treasury notes, constructed for the FRB/US model by Federal Reserve staff based on the Svensson smoothed term structure model (see Lars E. O. Svensson, 1995, "Estimating Forward Interest Rates with the Extended Nelson–Siegel Method," Quarterly Review, no. 3, Sveriges Riksbank, pp. 13–26).

U.S. 10-year Treasury yield: Quarterly average of the yield on 10-year U.S. Treasury notes, constructed for the FRB/U.S. model by Federal Reserve staff based on the Svensson smoothed term structure model; (see Svensson, "Estimating Forward Interest Rates").

U.S. BBB corporate yield: Quarterly average of ICE BofAML U.S. Corporate 7-10 Year Yield-to-Maturity Index, ICE Data Indices, LLC, used with permission. (C4A4 series.)

U.S. mortgage rate: Quarterly average of weekly series for the interest rate of a conventional, conforming, 30-year fixed-rate mortgage, obtained from the Primary Mortgage Market Survey of the Federal Home Loan Mortgage Corporation.

U.S. prime rate: Quarterly average of monthly series, H.15 Release (Selected Interest Rates), Federal Reserve Board (series RIFSPBLP_N.M).

U.S. Dow Jones Total Stock Market (Float Cap) Index: End-of-quarter value via Bloomberg Finance L.P.

*U.S. House Price Index: Price Index for Owner-Occupied Real Estate, Z.1 Release (Financial Accounts of the United States), Federal Reserve Board (series FL075035243.Q divided by 1000).

*U.S. Commercial Real Estate Price Index: Commercial Real Estate Price Index, Z.1 Release (Financial Accounts of the United States), Federal Reserve Board (series FL075035503.Q divided by 1000).

U.S. Market Volatility Index (VIX): VIX converted to quarterly frequency using the maximum close-of-day value in any quarter, Chicago Board Options Exchange via Bloomberg Finance LP.

*Euro area real GDP growth: Quarterly percent change in real gross domestic product at an annualized rate, staff calculations based on Statistical Office of the European Communities via Haver, extended back using ECB Area Wide Model dataset (ECB Working Paper series no. 42).

Euro area inflation: Percent change in the quarterly average of the harmonized index of consumer prices at an annualized rate, staff calculations based on Statistical Office of the European Communities via Haver.

*Developing Asia real GDP growth: Quarterly percent change in real gross domestic product at an annualized rate, staff calculations based on data from Bank of Korea via Haver; National Bureau of Statistics of China via Haver; Indian Central Statistics Office via Haver; Census and Statistics Department of Hong Kong via Haver; and Taiwan Directorate-General of Budget, Accounting and Statistics via Haver.

*Developing Asia inflation: Percent change in the quarterly average of the consumer price index, or local equivalent, at an annualized rate, staff calculations based on data from National Bureau of Statistics of China via Haver; Indian Ministry of Statistics and Programme Implementation via Haver; Labour Bureau of India via Haver; Statistics Korea (KOSTAT) via Haver; Census and Statistics Department of Hong Kong via Haver; and Taiwan Directorate-General of Budget, Accounting and Statistics via Haver.

*Japan real GDP growth: Quarterly percent change in gross domestic product at an annualized rate from 1980 to present and percent change in gross domestic expenditure at an annualized rate prior to 1980, Cabinet Office of Japan via Haver.

*Japan inflation: Percent change in the quarterly average of the consumer price index at an annualized rate, based on data from the Ministry of Internal Affairs and Communications via Haver.

*U.K. real GDP growth: Quarterly percent change in gross domestic product at an annualized rate, U.K. Office for National Statistics via Haver.

*U.K. inflation: Percent change in the quarterly average of the consumer price index at an annualized rate from 1988 to present and percent change in the quarterly average of the retail prices index prior to 1988, staff calculations based on data from the U.K. Office for National Statistics via Haver.

Exchange rates: End-of-quarter exchange rates, H.10 Release (Foreign Exchange Rates), Federal Reserve Board.

Footnotes