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5000 - Statements of Policy



PRINCIPLES FOR DEVELOPMENT AND DISTRIBUTION OF
STRESS TEST SCENARIOS

I. Introduction

Section 165(i)(2) of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 requires certain financial companies, including FDIC-insured state nonmember banks and FDIC-insured state-chartered savings associations with total consolidated assets of more than $10 billion ("covered banks"), to conduct annual stress tests. The Federal Deposit Insurance Corporation ("FDIC" or "Corporation") published in the Federal Register on October 15, 2012, a final rule ("Stress Test Rule") implementing the requirements and setting out definitions and rules for scope of application, scenarios, reporting, and disclosure.1 Under the Stress Test Rule, each year the FDIC will distribute stress test scenarios to covered banks. This document articulates the principles that the FDIC will apply to develop and distribute those scenarios for covered banks.

II. Stress Tests

As defined by the Stress Test Rule, a stress test means "the process to assess the potential impact of scenarios on the consolidated earnings, losses, and capital of a covered bank over the planning horizon, taking into account the current condition of the covered bank and the covered bank's risks, exposures, strategies, and activities."2 Stress tests help covered banks and the FDIC determine whether those banks have capital sufficient to absorb losses that could result from adverse economic conditions. The FDIC views stress test results as one source of forward-looking information that can help identify downside risks and assess the potential impact of adverse outcomes on capital adequacy. Stress tests are not the only tool the FDIC uses for these purposes; a complete assessment of a covered bank's capital position typically includes review of its capital planning processes, the governance concerning those processes, and the adequacy of capital under established regulatory capital measures. The FDIC expects the board of directors and senior management of each covered bank to consider the results of the annual stress test when conducting capital planning, assessing capital adequacy, and evaluating risk management practices.3 The FDIC also may use stress test results to determine whether additional analytical techniques and exercises are appropriate for a covered bank to employ in identifying, measuring, and monitoring risks to the financial soundness of the covered bank.

Under the Stress Test Rule, each covered bank is required to conduct an annual stress test using its financial data as of September 30th of each year, unless the FDIC requires a different "as of" date for any or all categories of financial data.4 The stress test must assess the potential impact of specific scenarios on the regulatory capital of the covered bank and on certain related items over

a forward-looking planning horizon, taking into account all relevant exposures and activities.5 Under the Stress Test Rule, the planning horizon is at least nine quarters, consisting of the fourth quarter of the current calendar year plus all four quarters of each of the two subsequent calendar years.

III. Scenarios

Scenarios are those sets of conditions that affect the U.S. economy or the financial condition of a covered bank that the Corporation annually determines are appropriate for use in the stress tests, including, but not limited to, baseline, adverse, and severely adverse scenarios.6 The FDIC annually will determine scenarios that are appropriate for use under the Stress Test Rule. In conducting the stress test under the Stress Test Rule, each covered bank must use the scenarios provided by the FDIC.

Each scenario includes the values of the variables specified for each quarter over the stress test horizon. The FDIC expects that covered banks may not need to use all of the variables provided and may need to estimate relationships to identify other variables, such as those reflecting local economic conditions, from the values the FDIC provides. The FDIC will review the appropriateness of estimation processes and resulting estimates, or other modifications of variables, through its ongoing supervisory processes.

The variables specified for each scenario generally address economic activity, asset prices, and other measures of financial market conditions for the United States and key foreign countries. Variables that describe economic activity likely include, but are not be limited to, the growth rate of gross domestic product, the unemployment rate, and the inflation rate. The FDIC anticipates that the path of the unemployment rate in particular will be a key variable indicating the severity of economic stress, as this variable provides a simple and widely noted gauge of the state of the U.S. economy. This point is discussed further in this statement in connection with severely adverse scenarios.

Other variables may represent asset prices and financial market conditions, including interest rates. The FDIC expects to specify scenarios using a standard core set of variables, although variables may be added or deleted as the U.S. and global economic environment evolves. The FDIC will attempt to minimize additions, redefinitions, or re-specifications of the stress test variables from year to year, as the use of such new or different variables may potentially require covered banks to modify their testing systems.

The scenarios provided by the FDIC reflect at least three sets of economic and financial conditions, described in the rule as baseline, adverse, and severely adverse. The baseline broadly corresponds to the set of conditions expected to prevail over the term of the stress tests. The adverse and severely adverse scenarios introduce hypothetical stress conditions intended to test the safety and soundness of covered banks as well as their capital planning processes. The aim is to assess the covered banks' ability to identify and measure the risks they face under adverse conditions, and to ensure that appropriate amounts of capital exist to support those risks. The FDIC will evaluate both the adequacy of the projections and the processes used in the stress test. The FDIC expects covered banks to be able to maintain ready access to funding, continue operations, meet obligations to creditors and counterparties, and continue to serve as credit intermediaries under conditions that are significantly more adverse than expected.

The baseline scenario means a set of conditions that affect the U.S. economy or the financial condition of a covered bank, and that reflect the consensus views of the economic and financial outlook.7 These views are based on information obtained from government agencies, other public sector organizations, and private sector forecasters as close to the date of the annual stress test as possible. The baseline may be based on one or more of the "consensus" forecasts produced by various organizations, although the FDIC may choose to depart from the consensus if necessary to provide a more appropriate baseline for the stress tests.

The adverse scenario means a set of conditions that affect the U.S. economy or the financial condition of a covered bank that are more adverse than those associated with the baseline scenario and may include trading or other additional components.8 The adverse scenario may also be used to investigate other risks, such as including operational risks that the FDIC believes should be better understood or more closely monitored.

The severely adverse scenario means a set of conditions that affect the U.S. economy or the financial condition of a covered bank and that overall are more severe than those associated with the adverse scenario and may include trading or other additional components.9 Three examples of severe recessions from recent U.S. experience may illustrate the anticipated depth of the severely adverse scenario as it relates to the unemployment rate:

• The 1973--75 recession, during which the unemployment rate increased 4.1 percentage points, from 4.9 percent in third quarter 1973 to 9.0 percent in second quarter 1975 (one quarter after the recession ended).

• The back-to-back recessions in 1980 and 1981--82, during which the unemployment rate increased 4.7 percentage points, from 6.1 percent in fourth quarter 1979 to 10.8 percent in fourth quarter 1982 (the last quarter of the recession).

• The 2007--09 recession, during which the unemployment rate increased 5.3 percentage points, from 4.7 percent in third quarter 2007 to 10.0 percent in fourth quarter 2009 (two quarters after the recession ended).

Other variables under the adverse and severely adverse scenarios would be expected to follow paths consistent with the depth and duration of previous recessions and with models of macroeconomic activity. The severely adverse scenario also may reflect other risks that are especially salient and that might not be captured by past recessions, including elevated levels of systemic risk.

The scenarios distributed by the FDIC for the stress tests cover at least nine quarters. In addition, the FDIC will generally publish scenarios that cover one year beyond the planning horizon of the stress test, to allow for the estimation of loan losses for the year following the stress planning horizon; this additional specification allows covered banks to determine adequate levels of loan loss reserves.

The FDIC believes that as a general matter all covered banks should use the same set of scenarios and planning horizon so that the FDIC can better compare results across institutions. To that end, the FDIC intends to provide one set of scenarios for use by all covered banks. However, the FDIC believes there may be circumstances that would warrant the use of different or additional scenarios or a planning horizon of more than nine quarters. Thus, under the Stress Test Rule, the FDIC reserves the authority to require a covered bank to use different or additional scenarios and/or planning horizons the Corporation may deem appropriate.10

For example, a covered bank may conduct business activities or have risk exposures that would encounter stress under conditions that differ materially from those that would generate stress for other banks. The FDIC expects such situations to be rare and anticipates making every effort to distribute the same scenarios to all covered banks.

In addition to the minimum three scenarios, the FDIC may require a covered bank with significant trading activities to include factors related to trading and counterparty risk in its stress test. Typically, these factors might include additional shocks to specific market prices, interest rates, rate spreads, or other key market variables consistent with historical or hypothetical adverse market events.

IV. Development and Distribution

As one part of the process of developing scenarios, the FDIC will gather information from outside entities and develop themes for the stress test scenarios, including the identification of potentially material vulnerabilities or salient risks to the financial system, and consider potential paths for individual variables. The outside entities may include academic experts, staffs of international organizations, foreign supervisors, financial institutions that regularly provide forecasts, and other private sector risk analysts that regularly conduct stress tests based on U.S. and global economic and financial scenarios. The FDIC will use the information gathered in this manner to inform its consideration of potential risks and scenarios.

The Office of the Comptroller of the Currency ("OCC"), the Board of Governors of the Federal Reserve System ("Board"), and the FDIC (collectively, the "Agencies") expect to consult closely to develop scenarios for stress testing. Absent specific supervisory concerns, the FDIC anticipates that the annual stress test scenarios distributed by the FDIC will be the same as or nearly identical to the scenarios developed by the Board for the supervisory stress tests conducted by the Board under Section 165(i)(1). This would mean the same economic and financial variables following the same paths as used in the scenarios for the Board's supervisory stress tests.

Although the Agencies generally expect to consult closely on scenario development, they may have different views of risks that should be reflected in the stress test scenarios used by covered banks for the annual stress test. The FDIC may distribute scenarios to covered banks that differ in certain respects from those distributed by the OCC and the Board if necessary to better reflect specific FDIC concerns. The FDIC expects such situations to be extremely rare, however, and anticipates making every effort to avoid differences in the scenarios required by each agency.

The FDIC anticipates that the stress test scenarios will be revised annually as appropriate to ensure that each scenario remains relevant under prevailing economic and industry conditions. These yearly revisions will enable the scenarios to capture evolving risks and vulnerabilities. The need to ensure that scenarios do not become outdated because of economic and financial developments makes a lengthy process of review and comment concerning scenarios prior to distribution each year impractical. However, the process of consultation with the Board and the OCC, as well as the ongoing interaction of FDIC staff with public and private sector experts to obtain views on salient risks and to obtain suggestions for the behavior of key economic variables, should ensure that the stress conditions reflected in the scenarios are well suited to their purpose.

The scenario development process culminates with the distribution of the scenarios to all covered banks no later than November 15th of each year. The scenario descriptions provided to covered banks will include values for economic and financial variables depicting the paths those variables follow under the scenarios. The FDIC believes that distribution of the scenarios no later than November 15th aligns with similar processes at the OCC and the Board.

[Source: 77 Fed. 69554, November 20, 2012, effective November 20, 2012]

177 FR 62417 (Oct. 15, 2012). Go back to Text

212 CFR 325.202(l) Go back to Text

3Id. at 325.205(b)(3). Go back to Text

4Id. at 325.201(c)(2) and 325.203(a). Go back to Text

5Id. at 325.205(a). Go back to Text

6Id. at 325.202(i). Go back to Text

7Id. at 325.202(c). Go back to Text

8Id. at 325.202(a). Go back to Text

9Id. at 325.202(j). Go back to Text

10Id. at 325.201(c). Go back to Text


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Last updated September 16, 2013 regs@fdic.gov