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From Banking and Finance Law Daily, November 8, 2013

Fed adopts policy statement on designing stress test scenarios

By Richard A. Roth, J.D.

The Federal Reserve Board has adopted a policy statement describing how it will design the baseline, adverse, and severely adverse scenarios that are to be used for Dodd-Frank Act stress tests. The policy statement, which is more detailed than a similar policy statement recently adopted by the Office of the Comptroller of the Currency, will be a new Appendix A to the Fed’s 12 C .F.R. Part 252—Enhanced Prudential Standards.

The Dodd-Frank Act requires the Fed to oversee stress tests for two categories of institutions:

  • Bank holding companies with $50 billion or more in total consolidated assets and nonbank companies designated by the Financial Stability Oversight Council for Fed supervision, which are to be subject to annual stress tests run by the Fed and are to conduct their own semi-annual stress tests.
  • Banks and holding companies for which the Fed is the primary supervisor and that have total consolidated assets of more than $10 billion, which are to conduct their own annual stress tests.

According to 12 C.F.R. §252.142(q), a stress test is “a process to assess the potential impact of scenarios on the consolidated earnings, losses, and capital of a covered company over the planning horizon, taking into account its current condition, risks, exposures, strategies, and activities.” Each stress test is to consider the effects of each of the three scenarios designed by the Fed (or more than three at the Fed’s discretion). In general, all companies will use the same scenarios, although the policy statement notes that some companies may be required to include additional components to reflect relevant factors.

Variables likely to be included. According to the policy statement, future scenarios are likely to incorporate the economic and financial variables that are part of the 2014 scenarios. These include six measures of economic activity and prices; four measures of developments in equity and property markets; six measures of interest rates; and three variables describing activities in the euro area, the United Kingdom, Japan, and developing parts of Asia. Changes over time are to be expected to account for changing circumstances, the Fed says, although it intends to minimize changes due to the effort financial institutions need to make to change their stress test models.

According to the policy statement, companies will be permitted to eliminate variables from their models that are irrelevant to their activities. They will be expected to add variables if doing so is necessary.

Standard scenarios. Each stress test will include at least three scenarios:

  • baseline, which will reflect a consensus view of the economic and financial outlook;
  • severely adverse, which will be based on conditions that characterize post-war recessions in the U.S. economy and will rely heavily on the effects of a severe post-war recession on the unemployment rate; and
  • adverse, which could be based on any of several approaches, including a recession less severe than presented in the severely adverse scenario; the inclusion of specific factors the Fed wants to consider that do not belong in the severely adverse scenario; or historical economic events such as a moderate recession, an oil price shock, or an inflation shock.

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