[Federal Register Volume 84, Number 40 (Thursday, February 28, 2019)]
[Notices]
[Pages 6784-6787]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2019-03505]


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FEDERAL RESERVE SYSTEM

[Docket No. OP-1651]


Enhanced Disclosure of the Models Used in the Federal Reserve's 
Supervisory Stress Test

AGENCY: Board of Governors of the Federal Reserve System (Board).

ACTION: Final notification.

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SUMMARY: The Board is finalizing an enhanced disclosure of the models 
used in the Federal Reserve's supervisory stress test conducted under 
the Board's Regulation YY pursuant to the Dodd-Frank Wall Street Reform 
and Consumer Protection Act and the Board's capital plan rule.

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DATES: April 1, 2019.

FOR FURTHER INFORMATION CONTACT: Lisa Ryu, Associate Director, (202) 
263-4833, Kathleen Johnson, Assistant Director, (202) 452-3644, Robert 
Sarama, Assistant Director (202) 973-7436, or Aurite Werman, Senior 
Financial Analyst, (202) 263-4802, Division of Supervision and 
Regulation; Benjamin W. McDonough, Assistant General Counsel, (202) 
452-2036, Julie Anthony, Senior Counsel, (202) 475-6682, or Asad 
Kudiya, Counsel, (202) 475-6358, Legal Division, Board of Governors of 
the Federal Reserve System, 20th Street and Constitution Avenue NW, 
Washington, DC 20551. Users of Telecommunication Device for Deaf (TDD) 
only, call (202) 263-4869.

SUPPLEMENTARY INFORMATION:

Background

    Each year the Federal Reserve publicly discloses the results of the 
supervisory stress test.\1\ The disclosures include revenues, expenses, 
losses, pre-tax net income, and capital ratios that would result under 
two sets of adverse economic and financial conditions. As part of the 
disclosures, the Federal Reserve also describes the broad framework and 
methodology used in the supervisory stress test, including information 
about the models used to estimate components of pre-tax net income and 
post-stress capital ratios in the stress test. The annual disclosures 
of both the stress test results and supervisory model framework and 
methodology represent a significant increase in the public transparency 
of large bank supervision in the U.S. since the 2007-2009 financial 
crisis.\2\ Indeed, prior to the first supervisory stress test in 2009, 
many analysts and institutions cautioned against these disclosures, 
arguing that releasing bank-specific loss estimates to the public would 
be destabilizing. However, experience to date has shown the opposite to 
be true--disclosing these details to the public has garnered public and 
market confidence in the process.
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    \1\ See, for example, Dodd-Frank Act Stress Test 2018: 
Supervisory Stress Test Methodology and Results, June 2018, and 
Comprehensive Capital Analysis and Review 2018: Assessment Framework 
and Results, June 2018.
    \2\ In addition to those public disclosures, the Federal Reserve 
has published detailed information about its scenario design 
framework and annual letters detailing material model changes. The 
Federal Reserve also hosts an annual symposium in which supervisors 
and financial industry practitioners share best practices in 
modeling, model risk management, and governance.
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    The Federal Reserve routinely reviews its stress testing and 
capital planning programs, and during those reviews, the Federal 
Reserve has received feedback regarding the transparency of the 
supervisory stress test models.\3\ Some of those providing feedback 
requested more detail on modeling methodologies with a focus on year-
over-year changes in the supervisory models.\4\ Others, however, 
cautioned against disclosing too much information about the supervisory 
models because doing so could permit firms to reverse-engineer the 
stress test.
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    \3\ During a review that began in 2015, the Federal Reserve 
received feedback from senior management at firms subject to the 
Board's capital plan rule, debt and equity market analysts, 
representatives from public interest groups, and academics in the 
fields of economics and finance. That review also included an 
internal assessment.
    \4\ Some of the comments in favor of additional disclosure 
included requests that the Federal Reserve provide additional 
information to firms only, without making the additional disclosures 
public. Doing so would be contrary to the Federal Reserve's 
established practice of not disclosing information related to the 
stress test to firms if that information is not also publicly 
disclosed.
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    The Federal Reserve recognizes that disclosing additional 
information about supervisory models and methodologies has significant 
public benefits, and is committed to finding ways to further increase 
the transparency of the supervisory stress test. More detailed 
disclosures could further enhance the credibility of the stress test by 
providing the public with information on the fundamental soundness of 
the models and their alignment with best modeling practices. These 
disclosures would also facilitate comments on the models from the 
public, including academic experts. These comments could lead to 
improvements, particularly in the data most useful to understanding the 
risks of particular loan types. More detailed disclosures could also 
help the public understand and interpret the results of the stress 
test, furthering the goal of maintaining market and public confidence 
in the U.S. financial system. Finally, more detailed disclosures of how 
the Federal Reserve's models assign losses to particular positions 
could help those financial institutions that are subject to the stress 
test understand the capital implications of changes to their business 
activities, such as acquiring or selling a portfolio of assets.
    The Federal Reserve also believes there are material risks 
associated with fully disclosing the models to the firms subject to the 
supervisory stress test. One implication of releasing all details of 
the models is that firms could conceivably use them to make 
modifications to their businesses that change the results of the stress 
test without actually changing the risks they face. In the presence of 
such behavior, the stress test could give a misleading picture of the 
actual vulnerabilities faced by firms. Further, such behavior could 
increase correlations in asset holdings among the largest banks, making 
the financial system more vulnerable to adverse financial shocks.\5\ 
Another implication is that full model disclosure could incent banks to 
simply use models similar to the Federal Reserve's, rather than build 
their own capacity to identify, measure, and manage risk. That 
convergence to the Federal Reserve's model would create a ``model 
monoculture'' in which all firms have similar internal stress testing 
models, and this could cause firms to miss key idiosyncratic risks that 
they face.\6\
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    \5\ For example, if firms were to deem a specific asset as more 
advantageous to hold based on the particulars of the supervisory 
models, and an exogenous shock were to occur to that specific asset 
class, the firms' losses would be magnified because they held 
correlated assets.
    \6\ See Til Schuermann, ``The Fed's Stress Tests Add Risk to the 
Financial System,'' Wall Street Journal, March 19, 2013.
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I. Proposed Enhanced Model Disclosure

    On December 15, 2017, the Board invited comment on a proposal to 
enhance the disclosures of those models.\7\ The proposed enhancements 
were designed to balance the costs and benefits of model disclosure in 
a way that would further enhance the public's understanding of the 
supervisory stress test models without undermining the effectiveness of 
the stress test as a supervisory tool. The proposed enhanced 
disclosures contained three components: (1) Enhanced descriptions of 
supervisory models, including key variables; (2) modeled loss rates on 
loans grouped by important risk characteristics and summary statistics 
associated with the loans in each group; and (3) portfolios of 
hypothetical loans and the estimated loss rates associated with the 
loans in each portfolio.\8\
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    \7\ 82 FR 59547 (December 15, 2017).
    \8\ The second and third components would have been provided for 
the models used to project losses on the most material loan 
portfolios.
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    The proposed enhanced descriptions of the models would have 
expanded the existing model descriptions in two ways. First, they would 
have provided more detailed information about the structure of the 
models by including certain important equations that characterize 
aspects of the model. Second, they would have included a table that 
contains a list of the key variables that influence the results of a 
given model, and the table would show the relevant variables for each 
component of the model (e.g., PD, LGD,

[[Page 6786]]

EAD), along with information about the source of the variables.
    The proposed enhanced disclosure would have included estimated loss 
rates for groups of loans with distinct characteristics, which would 
allow the public to directly see how supervisory models treat specific 
assets under stress. To shed more light on the degree of heterogeneity 
of loans within a given group, the proposed enhanced disclosure would 
also have included summary statistics associated with the loans in each 
group.
    The proposed enhanced disclosure would have included the 
publication of portfolios of hypothetical loans, along with supervisory 
projected loss rates on the portfolios. The portfolios of hypothetical 
loans would have been designed to mimic the characteristics of the 
actual loans reported by firms participating in the stress test, but 
would not have contained any individual firm's actual loan portfolio or 
any actual loans reported by firms. The set of variables included for 
each portfolio would have been designed such that the public could 
independently estimate loss rates for these portfolios, although the 
set would not necessarily have included every variable that might be 
included in a loss model for the relevant loan type.
    Under the proposal, the Board would have provided enhanced versions 
of the supervisory model descriptions that are currently published in 
the model description appendix of the Board's annual disclosures of 
supervisory stress test results, and the Board would also have provided 
modeled loss rates on groups of loans and the loss rates associated 
with portfolios of hypothetical loans for the most material loan 
portfolios. The Board would have expected to publish its enhanced 
disclosure in the first quarter of each calendar year, and the annual 
disclosure in any given year would reflect updates to supervisory 
models for that stress test cycle, but would be based on data and 
scenarios from the prior stress test cycle.

II. Summary of Comments

    The Board received twelve comment letters in response to the 
proposal. Commenters included public interest groups, academics, 
individual banking organizations, and trade and industry groups. 
Commenters generally expressed support for the proposal, and provided 
suggestions regarding future model disclosures.

A. Fully Disclosing Models for Notice and Comment

    Commenters were divided in their views on the appropriate level of 
transparency. Some commenters recommended full disclosure of 
supervisory models published by the Board through the public notice and 
comment process, suggesting that this would result in more accurate 
models. Other commenters expressed the view that the Federal Reserve 
should fully disclose material aspects of the models such as underlying 
formulas, equations, model backtesting, validation outcomes, and 
limitations, to enable the public to evaluate the reliability of the 
Federal Reserve's results. However, other commenters opposed full 
transparency of supervisory models, indicating that it is important for 
the stress test to remain flexible and for it not to be perfectly 
predictable by the companies subject to it. One commenter cited a 
historical study of the Office of Federal Housing Enterprise Oversight 
(OFHEO) stress test, noting that the full disclosure of the OFHEO 
stress test model rendered that stress test ineffective.
    As discussed above, the proposed enhancements were designed to 
balance the costs and benefits of disclosure in a way that would 
further facilitate the public's understanding of the supervisory stress 
test models without undermining the effectiveness of the stress test as 
a supervisory tool. More detailed disclosures can enhance the 
credibility of the stress test and lead to its improvement, but full 
disclosure of all details related to supervisory models could make the 
financial system at large more vulnerable by allowing firms to make 
modifications to their businesses that would change their supervisory 
stress test results without materially changing their risk profile. The 
Board views the proposal as striking an appropriate balance between 
enhancing model transparency and maintaining the efficacy of the stress 
test, and is therefore adopting the enhancements as proposed, with 
modifications as described below. The Board intends to continue to 
improve its disclosures and to consider ways to further increase the 
transparency of the stress test.

B. Content of Disclosures of Models

    Commenters were generally supportive of the proposed enhancements 
to the model disclosures. Several commenters asserted that the 
portfolios of hypothetical loans in particular would help the public 
understand the models. Consistent with the proposal, commenters 
requested that the Board provide detailed descriptions of modeling 
assumptions and equations.
    Some commenters expressed the view that the Board should publish a 
more detailed model disclosure than the one provided in the proposal. 
These commenters requested decompositions that explain the proportion 
of changes from scenarios, portfolio composition, model changes, and 
additional details about model backtesting and assumptions. One 
commenter stated that the Board should provide a comprehensive 
explanation of the cost and benefit analysis used to determine the 
content of its proposed enhanced model disclosure.
    The Board intends to publish enhanced versions of the supervisory 
model descriptions that are currently published in the model 
description appendix of the Board's annual disclosures of supervisory 
stress test results, and to publish the loss rates on groups of loans 
and portfolios of hypothetical loans and associated loss rates for the 
most material loan portfolios. In prior stress test results 
disclosures, the Board has discussed the key drivers of the supervisory 
stress test results, such as changes in firms' portfolio composition, 
and the Board intends to continue to consider ways to provide 
additional information on key drivers of aggregate results as 
appropriate.
    One commenter outlined proposed variables on which to group loan 
loss rates in the enhanced disclosure. The segments the commenter 
suggested for corporate loans were generally consistent with those 
segments the Board provided in the example of disclosure for the 
corporate loan loss model in the proposal.

C. Disclosure of Specific Models

    Commenters requested more detail on the models used to project pre-
provision net revenue (PPNR) and operational-risk losses in the 
supervisory stress test. Several commenters specifically requested 
enhanced disclosure of the components of PPNR (i.e., net interest 
income, noninterest income, and noninterest expense), including 
additional detail on the structure, characteristics, and variables used 
to model each component of PPNR. One commenter requested forecasted 
PPNR metrics by scenario for hypothetical firms.
    Commenters also requested that enhanced disclosure be provided for 
a number of other models, including the models used to project other-
than-temporary losses on securities, other comprehensive income, losses 
associated with the global market shock and associated losses, deferred 
tax assets, loan loss provisions, the purchase accounting treatment for 
material business plan changes, and transfer pricing revenues. One 
commenter requested that the Board

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release supervisory models used to project losses for previous stress 
tests.
    The Board intends to include in its enhanced model disclosure 
detailed descriptions of the supervisory models that are currently 
addressed in the model description appendix of the Board's annual 
disclosure of supervisory stress test results, including the models 
used to project PPNR and operational-risk losses. These descriptions 
would contain the structural form of key model equations and key input 
variables. Further, the Board intends to publish projections of certain 
components of PPNR, including net interest income, noninterest income, 
and noninterest expense, for each covered company in its annual results 
disclosure.
    The detailed disclosure of modeled loss rates similar to the 
example provided in the proposal requires loan- or security-level data 
reported to the Board on a regular basis; therefore, such disclosures 
are not feasible for certain types of models or calculations, such as 
the calculation of deferred tax assets. The Board intends to publish 
enhanced modeled loss rate disclosures for the most material loan 
portfolios over the next several years, starting with two of the most 
material loan portfolios in 2019. Over time, the Federal Reserve will 
extend enhanced modeled loss rate disclosures to non-loan portfolios, 
such as securities. The specific portfolios and the level of detail 
provided for each portfolio will depend on constraints such as those 
related to vendor data contracts, where applicable.
    Models used in previous years are described in the Board's annual 
disclosure of supervisory stress test results.

D. Timing of Enhanced Model Disclosure

    Some commenters requested that enhanced disclosure be provided in 
early January of each calendar year. Another commenter asserted that 
the benefits of a stress test model disclosure are maximized and costs 
are minimized when disclosure takes place after the stress tests are 
completed.
    Consistent with the proposal, the Board expects to publish details 
about the models in the first quarter of each calendar year. 
Specifically, the Board expects to publish enhanced model descriptions 
for all models and enhanced modeled loss rate disclosures for two of 
the most material loan models in the first quarter of 2019. In 2020, 
the Board intends to revise enhanced model descriptions, as 
appropriate, and to publish enhanced modeled loss rate disclosures for 
two additional models.
    Publication of the supervisory model disclosure prior to the 
release of the supervisory stress test results will help firms and the 
public anticipate the extent to which changes in supervisory results 
may result from changes in the models. In recent years, the Board has 
increased the information it provides to the public about supervisory 
models, and has detailed material model changes in an annual letter 
published in advance of the stress test. The Board believes that the 
benefits of providing that information in advance of the stress test 
outweigh the costs of doing so.

    By order of the Board of Governors of the Federal Reserve 
System, February 22, 2019.
Ann Misback,
Secretary of the Board.
[FR Doc. 2019-03505 Filed 2-27-19; 8:45 am]
 BILLING CODE 6210-01-P