The Board of Governors of the Federal Reserve System (“FRB”) reviewed the results of their 2016 supervisory stress tests and determined that “the nation’s largest bank holding companies continue to build their capital levels and improve their credit quality, strengthening their ability to lend to households and businesses during a severe recession.” The supervisory stress tests are one component of the Comprehensive Capital Analysis and Review (“CCAR”), an annual exercise to evaluate the capital planning processes and capital adequacy of large bank holding companies (“BHCs”).
The 2016 Dodd-Frank Act stress test cycle (“DFAST 2016”) began January 1, 2016, and projected the performance of 33 BHCs in three scenarios over nine quarters (baseline, adverse, and severely adverse). The FRB stated that the results of the DFAST 2016 projections “suggest that, in the aggregate, the 33 BHCs would experience substantial losses under both the adverse and the severely adverse scenarios.” Through nine quarters of the planning horizon, the aggregate losses under the “severely adverse scenario are projected to be $526 billion.” These projected losses include:
- $385 billion in accrual loan portfolio losses;
- $11 billion in OTTI and other realized securities losses;
- $113 billion in trading and/or counterparty losses at the eight BHCs with substantial trading, processing, or custodial operations; and
- $17 billion in additional losses from items such as loans booked under the fair-value option.
Compared to last year’s severely adverse test scenario, firms that are active in trading and market activities saw smaller losses in net income as a result of less severe stress in the equity markets, but firms more focused on traditional lending activities were more affected by negative short-term interest rates and greater stress in the real economy. The FRB explained that the year-over-year changes in supervisory stress test results reflect several factors: (i) changes in BHCs’ starting capital positions; (ii) portfolio composition and risk characteristics; (iii) changing hypothetical scenarios; and (iv) model changes.
The FRB noted that the 2015 severely adverse scenario “assumed that corporate credit quality worsened even more than what would be expected in a severe recession,” which “amplified the widening of corporate bond spreads, decline in equity prices, and increase in equity price volatility.” By comparison, the 2016 severely adverse scenario “includes a more severe recession than last year’s scenario and also features negative short-term interest rates, which moderates the decline in equity prices and increases in market volatility relative to last year.”
The FRB highlighted that the Federal Reserve made “notable changes” in three models used for this year’s supervisory stress tests, namely: (i) the operational risk model; (ii) the market risk-weighted assets model; and (iii) the capital calculation model. The FRB observed that these changes had “moderate effects on the aggregate results but had varied effects on individual firms.”