Appendix B to Part 252 - Stress Testing Policy Statement
12:4.0.1.1.20.19.3.1.12 : Appendix B
Appendix B to Part 252 - Stress Testing Policy Statement Link to an
amendment published at 86 FR 7949, Feb. 3, 2021.
This Policy Statement describes the principles, policies, and
procedures that guide the development, implementation, and
validation of models used in the Federal Reserve's supervisory
stress test.
1. Principles of Supervisory Stress Testing
The system of models used in the supervisory stress test is
designed to result in projections that are (i) from an independent
supervisory perspective; (ii) forward-looking; (iii) consistent and
comparable across covered companies; (iv) generated from simpler
and more transparent approaches, where appropriate; (v) robust and
stable; (vi) conservative; and (vii) able to capture the impact of
economic stress. These principles are further explained below.
1.1. Independence
(a) In the supervisory stress test, the Federal Reserve uses
supervisory models that are developed internally and independently
(i.e., separate from models used by covered companies). The
supervisory models rely on detailed portfolio data provided by
covered companies but do not rely on models or estimates provided
by covered companies to the greatest extent possible.
(b) The Federal Reserve's stress testing framework is unique
among regulators in its use of independent estimates of losses and
revenues under stress. These estimates provide a perspective that
is not formed in consultation with covered companies or influenced
by firm-provided estimates and that is useful to the public in its
evaluation of covered companies' capital adequacy. This perspective
is also valuable to covered companies, who may benefit from
external assessments of their own losses and revenues under stress,
and from the degree of credibility that independence confers upon
supervisory stress test results.
(c) The independence of the supervisory stress test allows
stress test projections to adhere to the other key principles
described in the Policy Statement. The use of independent models
allows for consistent treatment across firms. Losses and revenues
under stress are estimated using the same modeling assumptions for
all covered companies, enabling comparisons across supervisory
stress test results. Differences in covered companies' results
reflect differences in firm-specific risks and input data instead
of differences in modeling assumptions. The use of independent
models also ensures that stress test results are produced by
stress-focused models, designed to project the performance of
covered companies in adverse economic conditions.
(d) In instances in which it is not possible or appropriate to
create a supervisory model for use in the stress test, including
when supervisory data are insufficient to support a modeled
estimate of losses or revenues, the Federal Reserve may use
firm-provided estimates or third-party models or data. For example,
in order to project trading and counterparty losses, sensitivities
to risk factors and other information generated by covered
companies' internal models are used. In the cases where
firm-provided or third-party model estimates are used, the Federal
Reserve monitors the quality and performance of the estimates
through targeted examination, additional data collection, or
benchmarking. The Board releases a list of the providers of
third-party models or data used in the stress test exercise in the
annual disclosure of quantitative results.
1.2. Forward-Looking
(a) The Federal Reserve has designed the supervisory stress test
to be forward-looking. Supervisory models are tools for producing
projections of potential losses and revenue effects based on each
covered company's portfolio and circumstances.
(b) While supervisory models are specified using historical
data, they should generally avoid relying solely on extrapolation
of past trends in order to make projections, and instead should be
able to incorporate events or outcomes that have not occurred. As
described in Section 2.4, the Federal Reserve implements several
supervisory modeling policies to limit reliance on past outcomes in
its projections of losses and revenues. The incorporation of the
macroeconomic scenario and global market shock component also
introduces elements outside of the realm of historical experience
into the supervisory stress test.
1.3. Consistency and Comparability
The Federal Reserve uses the same set of models and assumptions
to produce loss projections for all covered companies participating
in the supervisory stress test. A standard set of scenarios,
assumptions, and models promotes equitable treatment of firms
participating in the supervisory stress test and comparability of
results, supporting cross-firm analysis and providing valuable
information to supervisors and to the public. Adhering to a
consistent modeling approach across covered companies means that
differences in projected results are due to differences in input
data, such as instrument type or portfolio risk characteristics,
rather than differences in firm-specific assumptions made by the
Federal Reserve.
1.4. Simplicity
The Federal Reserve uses simple approaches in supervisory
modeling, where possible. Given a range of modeling approaches that
are equally conceptually sound, the Federal Reserve will select the
least complex modeling approach. In assessing simplicity, the
Federal Reserve favors those modeling approaches that allow for a
more straightforward interpretation of the drivers of model results
and that minimize operational challenges for model
implementation.
1.5. Robustness and Stability
The Federal Reserve maintains supervisory models that aim to be
robust and stable, such that changes in model projections over time
reflect underlying risk factors, scenarios, and model enhancements,
rather than transitory factors. The estimates of post-stress
capital produced by the supervisory stress test provide information
regarding a covered company's capital adequacy to market
participants, covered companies, and the public. Adherence to this
principle helps to ensure that changes in these model projections
over time are not driven by temporary variations in model
performance or inputs. Supervisory models are recalibrated with
newly available input data each year. These data affect supervisory
model projections, particularly in times of evolving risks.
However, these changes generally should not be the principal driver
of a change in results, year over year.
1.6. Conservatism
Given a reasonable set of assumptions or approaches, all else
equal, the Federal Reserve will opt to use those that result in
larger losses or lower revenue. For example, given a lack of
information about the true risk of a portfolio, the Federal Reserve
will compensate for the lack of data by using a high percentile
loss rate.
1.7. Focus on the Ability To Evaluate the Impact of Severe Economic
Stress
In evaluating whether supervisory models are appropriate for use
in a stress testing exercise, the Federal Reserve places particular
emphasis on supervisory models' abilities to project outcomes in
stressed economic environments. In the supervisory stress test, the
Federal Reserve also seeks to capture risks to capital that arise
specifically in times of economic stress, and that would not be
prevalent in more typical economic environments. For example, the
Federal Reserve includes losses stemming from the default of a
covered company's largest counterparty in its projections of
post-stress capital for firms with substantial trading or
processing and custodian operations. The default of a company's
largest counterparty is more likely to occur in times of severe
economic stress than in normal economic conditions.
2. Supervisory Stress Test Model Policies
To be consistent with the seven principles outlined in Section
1, the Federal Reserve has established policies and procedures to
guide the development, implementation, and use of all models used
in supervisory stress test projections, described in more detail
below. Each policy facilitates adherence to at least one of the
modeling principles that govern the supervisory stress test, and in
most cases facilitates adherence to several modeling
principles.
2.1. Soundness in Model Design
(a) During development, the Federal Reserve (i) subjects
supervisory models to extensive review of model theory and logic
and general conceptual soundness; (ii) examines and evaluates
justifications for modeling assumptions; and (iii) tests models to
establish the accuracy and stability of the estimates and forecasts
that they produce.
(b) After development, the Federal Reserve continues to subject
supervisory models to scrutiny during implementation to ensure that
the models remain appropriate for use in the stress test exercise.
The Federal Reserve monitors changes in the economic environment,
the structure of covered companies and their portfolios, and the
structure of the stress testing exercise, if applicable, to verify
that a model in use continues to serve the purposes for which it
was designed. Generally, the same principles, rigor, and standards
for evaluating the suitability of supervisory models that apply in
model development and design will apply in ongoing monitoring of
supervisory models.
2.2. Disclosure of Information Related to the Supervisory Stress
Test
(a) In general, the Board does not disclose information related
to the supervisory stress test or firm-specific results to covered
companies if that information is not also publicly disclosed.
(b) The Board has increased the breadth of its public disclosure
since the inception of the supervisory stress test to include more
information about model changes and key risk drivers, in addition
to more detail on different components of projected net revenues
and losses. Increasing public disclosure can help the public
understand and interpret the results of the supervisory stress
test, particularly with respect to the condition and capital
adequacy of participating firms. Providing additional information
about the supervisory stress test allows the public to make an
evaluation of the quality of the Board's assessment. This policy
also promotes consistent and equitable treatment of covered
companies by ensuring that institutions do not have access to
information about the supervisory stress test that is not also
accessible publicly, corresponding to the principle of consistency
and comparability.
2.3. Phasing in of Highly Material Model Changes
(a) The Federal Reserve may revise its supervisory stress test
models to include advances in modeling techniques, enhancements in
response to model validation findings, incorporation of richer and
more detailed data, public comment, and identification of models
with improved performance, particularly under adverse economic
conditions. Revisions to supervisory stress models may at times
have material impact on modeled outcomes.
(b) In order to mitigate sudden and unexpected changes to the
supervisory stress test results, the Federal Reserve follows a
general policy of phasing highly material model changes into the
supervisory stress test over two years. The Federal Reserve
assesses whether a model change would have a highly significant
impact on the projections of losses, components of revenue, or
post-stress capital ratios for covered companies. In these
instances, in the first year when the model change is first
implemented, estimates produced by the enhanced model are averaged
with estimates produced by the model used in the previous stress
test exercise. In the second and subsequent years, the supervisory
stress test exercise will reflect only estimates produced by the
enhanced model. This policy contributes to the stability of the
results of the supervisory stress test. By implementing highly
material model changes over the course of two stress test cycles,
the Federal Reserve seeks to ensure that changes in model
projections primarily reflect changes in underlying risk factors
and scenarios, year over year.
(c) In general, phase-in thresholds for highly material model
changes apply only to conceptual changes to models. Model changes
related to changes in accounting or regulatory capital rules and
model parameter re-estimation based on newly available data are
implemented with immediate effect.
(d) In assessing the materiality of a model change, the Federal
Reserve calculates the impact of using an enhanced model on
post-stress capital ratios using data and scenarios from prior
years' supervisory stress test exercises. The use of an enhanced
model is considered a highly material change if its use results in
a change in the CET1 ratio of 50 basis points or more for one or
more firms, relative to the model used in prior years' supervisory
exercises.
2.4. Limiting Reliance on Past Outcomes
(a) Models should not place undue emphasis on historical
outcomes in predicting future outcomes. The Federal Reserve aims to
produce supervisory stress test results that reflect likely
outcomes under the supervisory scenarios. The supervisory scenarios
may potentially incorporate events that have not occurred
historically. It is not necessarily consistent with the purpose of
a stress testing exercise to assume that the future will be like
the past.
(b) In order to model potential outcomes outside the realm of
historical experience, the Federal Reserve generally does not
include variables that would capture unobserved historical patterns
in supervisory models. The use of industry-level models, restricted
use of firm-specific fixed effects (described below), and minimized
use of dummy variables indicating a loan vintage or a specific
year, ensure that the outcomes of the supervisory models are
forward-looking, consistent and comparable across firms, and robust
and stable.
(c) Firm-specific fixed effects are variables that identify a
specific firm and capture unobserved differences in the revenues,
expenses or losses between firms. Firm-specific fixed effects are
generally not incorporated in supervisory models in order to avoid
the assumption that unobserved firm-specific historical patterns
will continue in the future. Exceptions to this policy are made
where appropriate. For example, if granular portfolio-level data on
key drivers of a covered company's performance are limited or
unavailable, and firm-specific fixed effects are more predictive of
a covered company's future performance than are industry-level
variables, then supervisory models may be specified with
firm-specific fixed effects.
(d) Models used in the supervisory stress test are developed
according to an industry-level approach, calibrated using data from
many institutions. In adhering to an industry-level approach, the
Federal Reserve models the response of specific portfolios and
instruments to variations in macroeconomic and financial scenario
variables. In this way, the Federal Reserve ensures that
differences across firms are driven by differences in firm-specific
input data, as opposed to differences in model parameters or
specifications. The industry approach to modeling is also
forward-looking, as the Federal Reserve does not assume that
historical patterns will necessarily continue into the future for
individual firms. By modeling a portfolio or instrument's response
to changes in economic or financial conditions at the industry
level, the Federal Reserve ensures that projected future losses are
a function of that portfolio or instrument's own characteristics,
rather than the historical experience of the covered company. This
policy helps to ensure that two firms with the same portfolio
receive the same results for that portfolio in the supervisory
stress test.
(e) The Federal Reserve minimizes the use of vintage or
year-specific fixed effects when estimating models and producing
supervisory projections. In general, these types of variables are
employed only when there are significant structural market shifts
or other unusual factors for which supervisory models cannot
otherwise account. Similar to the firm-specific fixed effects
policy, and consistent with the forward-looking principle, this
vintage indicator policy is in place so that projections of future
performance under stress do not incorporate assumptions that
patterns in unmeasured factors from brief historical time periods
persist. For example, the loans originated in a particular year
should not be assumed to continue to default at a higher rate in
the future because they did so in the past.
2.5. Treatment of Global Market Shock and Counterparty Default
Component
(a) Both the global market shock and counterparty default
components are exogenous components of the supervisory stress
scenarios that are independent of the macroeconomic and financial
market environment specified in those scenarios, and do not affect
projections of risk-weighted assets or balances. The global market
shock, which specifies movements in numerous market factors, 14
applies only to covered companies with significant trading
exposure. The counterparty default scenario component applies only
to covered companies with substantial trading or processing and
custodian operations. Though these stress factors may not be
directly correlated to macroeconomic or financial assumptions, they
can materially affect covered companies' risks. Losses from both
components are therefore considered in addition to the estimates of
losses under the macroeconomic scenario.
14 See 12 CFR part 252, appendix A, “Policy Statement on
the Scenario Design Framework for Stress Testing,” for a detailed
description of the global market shock.
(b) Counterparty credit risk on derivatives and repo-style
activities is incorporated in supervisory modeling in part by
assuming the default of the single counterparty to which the
covered firm would be most exposed in the global market shock
event. 15 Requiring covered companies subject to the large
counterparty default component to estimate and report the potential
losses and effects on capital associated with such an instantaneous
default is a simple method for capturing an important risk to
capital for firms with large trading and custodian or processing
activities. Engagement in substantial trading or custodial
operations makes the covered companies subject to the counterparty
default scenario component particularly vulnerable to the default
of their major counterparty or their clients' counterparty, in
transactions for which the covered companies act as agents. The
large counterparty default component is consistent with the purpose
of a stress testing exercise, as discussed in the principle about
the focus on the ability to evaluate the impact of severe economic
stress. The default of a covered company's largest counterparty is
a salient risk in a macroeconomic and financial crisis, and
generally less likely to occur in times of economic stability. This
approach seeks to ensure that covered companies can absorb losses
associated with the default of any counterparty, in addition to
losses associated with adverse economic conditions, in an
environment of economic uncertainty.
15 In addition to incorporating counterparty credit risk by
assuming the default of the covered company's largest counterparty,
the Federal Reserve incorporates counterparty credit risk in the
supervisory stress test by estimating mark-to-market losses, credit
valuation adjustment (CVA) losses, and incremental default risk
(IDR) losses associated with the global market shock.
(c) The full effect of the global market shock and counterparty
default components is realized in net income in the first quarter
of the projection horizon in the supervisory stress test. The Board
expects covered companies with material trading and counterparty
exposures to be sufficiently capitalized to absorb losses stemming
from these exposures that could occur during times of general
macroeconomic stress.
2.6. Incorporation of Business Plan Changes
(a) A firm's stress capital buffer requirement does not
incorporate changes to its business plan that are likely to have a
material impact on a covered company's capital adequacy and funding
profile (material business plan changes). For example, planned
issuances of common or preferred stock in connection with a planned
merger or acquisition will not be included in the stress capital
buffer requirement calculation. In addition, the common stock
dividends attributable to issuances in connection with a planned
merger or acquisition reflected in the covered company's pro-forma
balance sheet estimates will also not be included in the stress
capital buffer requirement calculation. Material business plan
changes, including those resulting from a merger or acquisition,
are incorporated into a covered company's capital and risk-weighted
assets upon consummation of the transaction or occurrence of the
change. As a result, the amount of capital required will adjust
based on changes to the covered company's risk-weighted assets.
(b) If the material business plan change resulted in or would
result in a material change in a covered company's risk profile,
the company is required to resubmit its capital plan and the Board
may determine to recalculate the stress capital buffer requirement
based on the resubmitted capital plan.
2.7. Credit Supply Maintenance
(a) The supervisory stress test incorporates the assumption that
aggregate credit supply does not contract during the stress period.
The aim of supervisory stress testing is to assess whether firms
are sufficiently capitalized to absorb losses during times of
economic stress, while also meeting obligations and continuing to
lend to households and businesses. The assumption that a balance
sheet of consistent magnitude is maintained allows supervisors to
evaluate the health of the banking sector assuming firms continue
to lend during times of stress.
(b) In order to implement this policy, the Federal Reserve must
make assumptions about new loan balances. To predict losses on new
originations over the planning horizon, newly originated loans are
assumed to have the same risk characteristics as the existing
portfolio, where applicable, with the exception of loan age and
delinquency status. These newly originated loans would be part of a
covered company's normal business, even in a stressed economic
environment. While an individual firm may assume that it reacts to
rising losses by sharply restricting its lending (e.g., by
exiting a particular business line), the banking industry as a
whole cannot do so without creating a “credit crunch” and
substantially increasing the severity and duration of an economic
downturn. The assumption that the magnitude of firm balance sheets
will be fixed in the supervisory stress test ensures that covered
companies cannot assume they will “shrink to health,” and serves
the Federal Reserve's goal of helping to ensure that major
financial firms remain sufficiently capitalized to accommodate
credit demand in a severe downturn. In addition, by precluding the
need to make assumptions about how underwriting standards might
tighten or loosen during times of economic stress, the Federal
Reserve follows the principle of consistency and comparability and
promotes consistency across covered companies.
(c) In projecting the denominator for the calculation of the
leverage ratio, the Federal Reserve will account for the effect of
changes associated with the calculation of regulatory capital or
changes to the Board's regulations.
2.8. Firm-Specific Overlays and Additional Firm-Provided Data
(a) The Federal Reserve does not make firm-specific overlays to
model results used in the supervisory stress test. This policy
ensures that the supervisory stress test results are determined
solely by the industry-level supervisory models and by
firm-specific input data. The Federal Reserve has instituted a
policy of not using additional input data submitted by one or some
of the covered companies unless comparable data can be collected
from all the firms that have material exposure in a given area.
Input data necessary to produce supervisory stress test estimates
is collected via the FR Y-14 information collection. The Federal
Reserve may request additional information from covered companies,
but otherwise will not incorporate additional information provided
as part of a firm's CCAR submission or obtained through other
channels into stress test projections.
(b) This policy curbs the use of data only from firms that have
incentives to provide it, as in cases in which additional data
would support the estimation of a lower loss rate or a higher
revenue rate, and promotes consistency across the stress test
results of covered companies.
2.9. Treatment of Missing or Erroneous Data
(a) Missing data, or data with deficiencies significant enough
to preclude the use of supervisory models, create uncertainty
around estimates of losses or components of revenue. If data that
are direct inputs to supervisory models are not provided as
required by the FR Y-14 information collection or are reported
erroneously, then a conservative value will be assigned to the
specific data based on all available data reported by covered
companies, depending on the extent of data deficiency. If the data
deficiency is severe enough that a modeled estimate cannot be
produced for a portfolio segment or portfolio, then the Federal
Reserve may assign a conservative rate (e.g., 10th or 90th
percentile PPNR or loss rate, respectively) to that segment or
portfolio.
(b) This policy promotes the principle of conservatism, given a
lack of information sufficient to produce a risk-sensitive estimate
of losses or revenue components using information on the true
characteristics of certain positions. This policy ensures
consistent treatment for all covered companies that report data
deemed insufficient to produce a modeled estimate. Finally, this
policy is simple and transparent.
2.10. Treatment of Immaterial Portfolio Data
(a) The Federal Reserve makes a distinction between insufficient
data reported by covered companies for material portfolios and
immaterial portfolios. To limit regulatory burden, the Federal
Reserve allows covered companies not to report detailed loan-level
or portfolio-level data for loan types that are not material as
defined in the FR Y-14 reporting instructions. In these cases, a
loss rate representing the median rates among covered companies for
whom the rate is calculated will be applied to the immaterial
portfolio. This approach is consistent across covered companies,
simple, and transparent, and promotes the principles of consistency
and comparability and simplicity.
3. Principles and Policies of Supervisory Model Validation
(a) Independent and comprehensive model validation is key to the
credibility of supervisory stress tests. An independent unit of
validation staff within the Federal Reserve, with input from an
advisory council of academic experts not affiliated with the
Federal Reserve, ensures that stress test models are subject to
effective challenge, defined as critical analysis by objective,
informed parties that can identify model limitations and recommend
appropriate changes.
(b) The Federal Reserve's supervisory model validation program,
built upon the principles of independence, technical competence,
and stature, is able to subject models to effective challenge,
expanding upon efforts made by supervisory modeling teams to manage
model risk and confirming that supervisory models are appropriate
for their intended uses. The supervisory model validation program
produces reviews that are consistent, thorough, and comprehensive.
Its structure ensures independence from the Federal Reserve's model
development function, and its prominent role in communicating the
state of model risk to the Board of Governors assures its stature
within the Federal Reserve.
3.1. Structural Independence
(a) The management and staff of the internal model validation
program are structurally independent from the model development
teams. Validators do not report to model developers, and vice
versa. This ensures that model validation is conducted and overseen
by objective parties. Validation staff's performance criteria
include an ability to review all aspects of the models rigorously,
thoroughly, and objectively, and to provide meaningful and clear
feedback to model developers and users.
(b) In addition, the Model Validation Council, a council of
external academic experts, provides independent advice on the
Federal Reserve's process to assess models used in the supervisory
stress test. In biannual meetings with Federal Reserve officials,
members of the council discuss selective supervisory models, after
being provided with detailed model documentation for and non-public
information about those models. The documentation and discussions
enable the council to assess the effectiveness of the models used
in the supervisory stress tests and of the overarching model
validation program.
3.2. Technical Competence of Validation Staff
(a) The model validation program is designed to provide
thorough, high-quality reviews that are consistent across
supervisory models.
(b) First, the model validation program employs technically
expert staff with knowledge across model types. Second, reviews for
every supervisory model follow the same set of review guidelines,
and take place on an ongoing basis. The model validation program is
comprehensive, in the sense that validators assess all models
currently in use, expand the scope of validation beyond basic model
use, and cover both model soundness and performance.
(c) The model validation program covers three main areas of
validation: (1) Conceptual soundness; (2) ongoing monitoring; and
(3) outcomes analysis. Validation staff evaluates all aspects of
model development, implementation, and use, including but not
limited to theory, design, methodology, input data, testing,
performance, documentation standards, implementation controls
(including access and change controls), and code verification.
3.3. Stature of Validation Function
(a) The validation program informs the Board of Governors about
the state of model risk in the overall stress testing program,
along with ongoing practices to control and mitigate model
risk.
(b) The model validation program communicates its findings and
recommendations regarding model risk to relevant parties within the
Federal Reserve System. Validators provide detailed feedback to
model developers and provide thematic feedback or observations on
the overall system of models to the management of the modeling
teams. Model validation feedback is also communicated to the users
of supervisory model output for use in their deliberations and
decisions about supervisory stress testing. In addition, the
Director of the Division of Supervision and Regulation approves all
models used in the supervisory stress test in advance of each
exercise, based on validators' recommendations, development
responses, and suggestions for risk mitigants. In several cases,
models have been modified or implemented differently based on
validators' feedback. The Model Validation Council also contributes
to the stature of the Federal Reserve's validation program, by
providing an external point of view on modifications to supervisory
models and on validation program governance.
3.4. Simple approach for projecting risk-weighted assets
(a) In projecting risk-weighted assets, the Federal Reserve will
generally assume that a covered company's risk-weighted assets
remain unchanged over the planning horizon. This assumption allows
the Federal Reserve to independently project the risk-weighted
assets of covered companies in line with the goal of simplicity
(Principle 1.4). In addition, this approach is forward-looking
(Principle 1.2), as this assumption removes reliance on historical
data and past outcomes from the projection of risk-weighted
assets.
(b) In projecting a firm's risk-weighted assets, the Federal
Reserve will account for the effect of changes associated with the
calculation of regulatory capital or changes to the Board's
regulations in the calculation of risk-weighted assets.
[84 FR 6668, Feb. 28, 2019, as amended at 85 FR 15605, Mar. 18,
2020]