Dodd-Frank Stress Tests - Federal Housing Finance Agency

169 Pages·2014·3.83 MB·English

2015 Report Cycle
Dodd-Frank Stress Tests
Summary Instructions and Guidance
December 1, 2014
Accompanying Order Nos.
2014-OR-B-3, 2014-OR-FNMA-2, and 2014-OR-FHLMC-2

Federal Housing Finance Agency
Contents
Introduction ................................................................................................................................................ 3
Stress Test Scenarios .............................................................................................................................. 3
Reporting Format and Timing ............................................................................................................. 6
Stress Test Governance .......................................................................................................................... 6
Use of Stress Test Results ...................................................................................................................... 6
Incomplete Data ..................................................................................................................................... 7
Evaluation of Stress Test Processes ..................................................................................................... 7
Appendix 1: Regulatory Expectations for a Stress Testing Process ................................................... 8
Appendix 2: FHFA DFA Reporting Schedules - Enterprises ............................................................ 14
Appendix 3: FHFA DFA Reporting Schedules - FHLBanks ............................................................. 67
Appendix 4: Baseline Scenario - Domestic…………….…………………………………………….113
Appendix 5: Baseline Scenario - International………………………………………………………115
Appendix 6: Adverse Scenario - Domestic…………………………………………………………..117
Appendix 7: Adverse Scenario - International……………………………………………………....119
Appendix 8: Severely Adverse Scenario - Domestic………………………………………………..121
Appendix 9: Severely Adverse Scenario - International……………………………………………123
Appendix 10: Global Market Shock - Adverse…………………………………………………..….125
Appendix 11: Global Market Shock - Severely Adverse…………………………………………...147
Appendix 12: Data Notes……………………………………………………………………………...169

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Introduction

Section 165(i)(2) of the Dodd-Frank Act FHFA’s stress testing rule establishes the
requires certain financial companies with basic requirements for each regulated entity
total consolidated assets of more than $10 to conduct Dodd-Frank Stress Tests and
billion, and which are regulated by a report the results. This summary instructions
primary federal financial regulatory agency, and guidance document supplements the
to conduct annual stress tests to determine rule. FHFA expects each regulated entity to
whether the companies have the capital follow the instructions and guidance in
necessary to absorb losses as a result of conducting stress tests and reporting and
adverse economic conditions. The Federal publishing results under the rule. FHFA may
Housing Finance Agency (FHFA) is the communicate specific instructions to address
primary federal financial regulator of Fannie particular issues relevant only to some of the
Mae, Freddie Mac, and the twelve Federal regulated entities’ completion of the stress
Home Loan Banks (Banks) referred to herein tests. Each regulated entity is also expected
as each of the Banks (any of the Banks to adhere to such individualized
singularly, Bank; Fannie Mae and Freddie instructions.
Mac collectively, the Enterprises; the
General instructions and guidance are
Enterprises and the Banks collectively,
provided relating to:
regulated entities; any of the regulated
 Scenario assumptions
entities singularly, regulated entity).
 Reporting and timing
Each regulated entity has total consolidated  Stress test process governance
assets of more than $10 billion, and therefore,  Use of stress test results
is required to conduct the annual stress test.  Incomplete data
The Enterprises’ capital positions, supported  Evaluation of stress test processes
and restricted by the Senior Preferred Stock  Correspondence related to stress tests
Purchase Agreements with the Department
of the Treasury are unique. Nonetheless, the Stress Test Scenarios
Enterprises incorporate capital into their
The stress tests are based on portfolios as of
business decision making processes. FHFA
September 30, 2014. The planning horizon
expects the Enterprises to have processes and
for the stress test is nine quarters starting
procedures for managing their businesses
with the fourth quarter of 2014 and
notwithstanding Treasury’s support.
extending through the fourth quarter of
Therefore, FHFA’s rule on Stress Testing of
2016. The regulated entities are required to
Regulated Entities, 12 C.F.R. pt. 1238, and
submit the results of stress tests based on
these instructions and guidance apply
three scenarios: Baseline, Adverse, and
equally to the Enterprises and the Banks.
Severely Adverse. Assumptions for the
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variables in each scenario may be found in stress scenarios. The regulated entities
Appendices 4 through 9. should assume no recoveries of the losses
generated by the global market shock over
FHFA expects each regulated entity to use the nine quarters. The capital impact of the
those variables that are relevant to the global market shock is carried over the
entity’s line of business and that are planning horizon.
consumed by the entity’s models. However,
FHFA expects each regulated entity to apply The regulated entities should assume that
all of the relevant global market shocks the combined losses from the global market
provided. Regulated entities are expected to shock and the macroeconomic scenario do
indicate which variables are included in their not exceed the losses resulting from the
stress tests in their reports to FHFA and the greater of the global market shock losses or
Federal Reserve Board of Governors (Board). the macroeconomic losses.
FHFA also expects each regulated entity to
extrapolate any of the aforementioned Counterparty Default Scenario Component
variables beyond the projection date as
The counterparty default scenario
required. A year of scenario assumptions
component of the global market shocks
beyond the nine-quarter planning horizon
should be treated as an add-on to the
will be provided and may be utilized, if
macroeconomic and financial market
needed. Historical data is provided in the
scenarios specified in the Adverse and
event that models require that information.
Severely Adverse scenarios. The
It is important to note that the scenarios and counterparty default scenario component
assumptions provided are not forecasts, but involves an instantaneous and unexpected
rather hypothetical scenarios and default of a regulated entity’s largest
assumptions to be used to assess the counterparty across the regulated entity’s
financial strength of the regulated entities. secured and unsecured lending, securities
lending, repurchase/reverse repurchase
Global Market Shock Assumptions agreements (collectively Securities Financing
Transactions or SFTs) and derivative
The global market assumptions provided by
exposures, and the potential losses and
FHFA are to be applied to the regulated
effects on capital associated with such a
entities’ trading securities, available-for-sale-
default. The regulated entity should identify
securities and other fair value assets as of
their largest counterparty by the
September 30, 2014, for the Adverse and
counterparty that represents the largest total
Severely Adverse scenarios.
net stressed loss if the counterparty
The result of the global market shock is to be
defaulted on its obligations. Net stressed
taken as an instantaneous loss and reduction
losses for the counterparty are calculated
of capital in the first quarter of the planning
after applying the instantaneous market
horizon. The global market shock should be
shock to any non-cash SFT assets
treated as an add-on that is exogenous to the
(securities/collateral) posted or received,
macroeconomic and financial market
and, for derivatives, to the value of the trade
environment specified in the supervisory
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position and non-cash collateral exchanged1. expectations for future business and should
The as-of-date for the counterparty default conform to its strategic plans. Additionally,
scenario component is September 30, 2014 – the Enterprises should ensure that the size
the same date as the global market shock. and composition of their books of business
All estimated losses from the counterparty during the stress test are consistent with the
default scenario component should be goals in FHFA's Conservatorship Scorecard.
assumed to occur instantaneously and
Capital Actions
should be reported in the initial quarter of
the planning horizon.
For capital actions, the Banks should take

into account their actual capital actions as of
More detailed instructions for implementing
the end of the calendar quarter preceding the
certain assumptions and calculating other-
first quarter of the nine-quarter planning
than-temporary-impairments follow:
horizon. For each succeeding quarter, they
should either assume payment of stock
House Prices
dividends equal to those paid in the year
The House Price Index assumptions
ending at the end of the first quarter of the
provided by FHFA will describe the path of
planning horizon or follow any established
national house prices. FHFA expects each
rules they have for dividends payments.
regulated entity to extrapolate the national
house price path beyond the projection date The Banks should either assume that they do
as needed. FHFA also expects each not redeem or repurchase any capital
regulated entity to translate the national instrument over the planning horizon or that
house price path in each scenario to regional their capital actions will accord with their
house price paths as appropriate for each established capital plans.
regulated entity’s models and to interpolate
They should also assume that they will
the house price paths to accommodate the
redeem all mandatorily redeemable capital
frequency of data required by their models.
stock per their usual practice unless
Missing Variables restricted from doing so by FHFA actions.
The regulated entities should use their own
Finally, they should assume that they will
assumptions for variables that their models
cease dividend payments, capital
consume but that FHFA does not provide.
redemptions, or repurchases (as applicable)
when retained earnings fall to zero.
Balance Sheet Evolution
The Enterprises should comply with the
The regulated entities should also make the
terms of the Senior Preferred Stock Purchase
necessary assumptions for rolling their
Agreements, as amended, to determine the
balance sheets forward through the nine-
level of dividends to pay over the planning
quarter projection period. Each entity’s
horizon.
assumptions should reflect its reasonable

Other-than-temporary-impairments and
1 In selecting its largest counterparty, a regulated entity will not 
consider certain sovereign entities (Canada, France, Germany, Italy,  Estimated Acquired Member Assets (AMA)
Japan, the United Kingdom, and the United States) or designated 
Losses
central clearing counterparties. 
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FHFA expects the Banks to use the common environment and that the components of
platform for estimating other-than- their results are internally consistent within
temporary impairments on Private Label each scenario.
Securities in each stress test scenario. For
The regulated entities are required to report
estimating AMA losses, the Banks are
the results using the Dodd Frank Act (DFA)
expected to use their existing modeling
schedules provided in Appendices 2 and 3.
processes and may use the common
platform.
The regulated entities also are required to
submit qualitative information describing
Operational Risk Losses
the methodologies, including any
Operational risk losses are those losses that
simplifying or other assumptions used to
arise from external events or from
produce the estimates, as well as any other
inadequate internal processes, people, or
information necessary to fully support the
systems. The regulated entities shall
reasonableness of the stress test results.
estimate operational risk losses for each
scenario and submit the results to the FHFA. Each regulated entity must submit its results
and any supporting information to FHFA
Reporting Format and Timing
through a secure site. The Enterprises must
use the secure server. The Banks must use
The Enterprises must submit results of the
the secure bank portal.
Baseline, Adverse, and Severely Adverse
scenarios to FHFA and the Board by
Stress Test Governance
February 5 (30 days after required reporting
dates for financial institutions with $50 The board of directors of each regulated
billion or more of assets) and publish results entity or a designated committee thereof is
of only the Severely Adverse scenario responsible for reviewing and approving
between April 15 and April 30. The Banks policies and procedures established to
are to report results of the Baseline, Adverse, comply with the rule. The board should also
and Severely Adverse scenarios to FHFA and receive and review the results of the stress
the Board by April 30 (30 days after required tests for compliance with the rule and
reporting dates for financial institutions with established policies and procedures. Senior
less than $50 billion of assets) and publish management of each regulated entity is
results of only the Severely Adverse scenario responsible for establishing and testing
between July 15 and July 30. controls. Senior management and each
member of the board of directors are to
The results of a regulated entity’s analysis
receive a summary of the stress test results.
for each scenario should encompass all
potential losses and other impacts to net Use of Stress Test Results
income and capital that the regulated entity
The rule requires that each regulated entity
might experience under the scenarios. In all
take the results of the annual stress test into
cases, regulated entities should substantiate
account in making any changes, as
that their results are consistent with the
appropriate, to its capital structure
specified macroeconomic and financial
(including the level and composition of
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capital); its exposures, concentrations, and Federal Housing Enterprises Financial Safety
risk positions; any plans for recovery and and Soundness Act of 1992, as amended (12
resolution; and to improve overall risk U.S.C. 4501 et seq.) (Safety and Soundness
management. Consultation with FHFA staff Act) and the Federal Home Loan Bank Act,
is expected in making such improvements. If as amended (12 U.S.C. 1421 through 1449)
a regulated entity is under FHFA (Bank Act).
conservatorship, any post-assessment actions
Evaluation of Stress Test Processes
would require FHFA’s prior approval.
and Results
Results should include effects on capital as
FHFA will focus particular attention on the
required under the DFA stress testing rule.
processes surrounding the implementation
Specifically, and in accordance with the rule,
of the scenarios to ensure that these
each regulated entity must calculate how
processes are robust and that they capture
each of the following is affected during each
and stress key vulnerabilities and
quarter of the stress test planning horizon,
idiosyncratic risks facing the firm; and that
for each scenario:
the translation of the scenario into loss,
 Potential losses, pre-provision net revenue, and capital projections is
revenues, allowance for loan losses, conceptually sound and implemented in a
and capital positions over the well- controlled manner. FHFA will
planning horizon; and evaluate the extent to which stress testing
 Capital levels and capital ratios, processes at the regulated entities adhere
including regulatory capital and net to the regulatory principles outlined in
worth, each Bank’s leverage and Appendix 1. FHFA will also review the
permanent capital ratios, and any stress results for reasonableness.
other capital ratios, as specified by
FHFA will review those assumptions for
FHFA.
reasonableness and consistency with the
Incomplete Data assumptions used by other regulated
entities. In all cases, FHFA may require a
All regulated entities are required to report
regulated entity to adjust assumptions or
all data elements in the attached FHFA DFA
resubmit results where it deems the stress
schedules. Failure to submit complete data to
test results, assumptions, or processes are
FHFA in a timely manner may result in any
unacceptable.
remedy or penalty authorized under the

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Appendix 1: Regulatory Expectations for a Stress Testing Process

A regulated entity’s stress testing Both qualitative and quantitative
process should adhere to the following processes for assessing risk should be
principles: transparent, repeatable, and reviewable
by an independent party.
Principle 1: The regulated entity has a
sound risk measurement and • Any identified weaknesses in risk
management infrastructure that measures used as inputs to the stress
supports the identification, testing process should be documented
measurement, assessment, and control and reported to relevant parties, with an
of all material risks arising from its assessment of the potential impact of risk-
exposures and business activities. measurement weaknesses on the
reliability of the stress test results.
• A satisfactory stress testing process
requires (1) a comprehensive risk Principle 2: The regulated entity has
identification process, and (2) complete effective processes for translating risk
and accurate measurement and measures into estimates of potential losses
assessment of all material risks. over a range of stressful scenarios and
environments and for aggregating those
• A regulated entity should measure or estimated losses across the regulated entity.

assess the full spectrum of risks that face
the regulated entity, using both • Stress tests should include
quantitative and qualitative methods, methodologies that generate estimates of
where applicable. potential losses for all material risk
exposures, one of which should be an
• The regulated entity should have data enterprise-wide stress test using scenario
capture and retention systems that allow analysis. Methodologies should be
for the input, use, and storage of complementary, not suffer from common
information required for sound risk limitations, and minimize reliance on
identification and measurement and to common assumptions.
produce reliable inputs for assessments of
capital adequacy. • Using the loss estimation methodologies
for its various risk exposures, a regulated
• Quantitative processes for measuring entity should develop consistent and
risks should meet supervisory repeatable processes to aggregate its loss
expectations for model effectiveness and estimates on an enterprise-wide basis.
be supported by robust model
development, documentation, validation, • A regulated entity should demonstrate
and overall model governance practices. that its loss estimation tools are developed
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using sound modeling approaches, be consistent with balance sheet and other
appropriate for the manner in which they exposure assumptions used for related
are being employed, and that the most loss estimation. Projections should
relevant limitations are clearly identified, estimate all key elements of PPNR,
well documented, and appropriately including net interest income, non-interest
communicated. income, and non-interest expense at a
level of granularity consistent with
• A regulated entity should recognize that material revenue and expense
its loss projections are estimates and should components.
have a good understanding of the
uncertainty around those estimates, • A regulated entity should
including the potential margin of error and demonstrate that its capital resource
the sensitivity of the estimates to changes estimation tools are developed using
in inputs and key assumptions. sound modeling approaches,
appropriate for the manner in which
Principle 3: The regulated entity has a clear they are being employed, and that the
definition of available capital resources and most relevant limitations are clearly
an effective process for estimating available identified, well documented, and
capital resources (including any projected appropriately communicated.
revenues) over the same range of stressful
scenarios and environments used for • A regulated entity should recognize that
estimating losses. its projections of capital resources are
estimates and should have a good
• Management and the Board of understanding of the uncertainty around
directors should understand the loss- those estimates, including the potential
absorption capabilities of the margin of error and the sensitivity of the
components of the regulated entity’s estimates to changes in inputs and key
capital base, and maintain projection assumptions.
methodologies for each of the capital
components included in relevant capital Principle 4: The regulated entity has
adequacy metrics. processes for bringing together estimates
of losses and capital resources to assess the
• In estimating available capital resources, combined impact on capital adequacy in
a regulated entity will need to consider not relation to the regulated entity’s stated
only its current positions and mix of goals for the level and composition of
capital instruments, but also how its capital.
capital resources may evolve over time
under varying circumstances and stress • A regulated entity should have a
scenarios. comprehensive and consistently executed
• As part of a comprehensive enterprise- process for combining loss, resource, and
wide stress testing program, projections of balance sheet estimates to assess the
pre-provision net revenue (PPNR) should
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baseline and post-stress impact of those principles and guidelines used for capital
estimates on capital measures. planning, capital issuance, and usage and
distributions, including internal capital
• A regulated entity should calculate and goals, the quantitative or qualitative
use several capital measures that guidelines for dividend and stock
represent both leverage and risk at repurchase decisions, the strategies for
specified time horizons under both addressing potential capital shortfalls, and
baseline and stressful conditions, the internal governance procedures
consistent with its capital policy around capital policy principles and
framework. Measures should include guidelines.
quarterly estimates for the impact on
• A regulated entity should establish
capital and leverage ratios as well as other
capital goals aligned with its risk appetite
capital and risk measures useful in
and risk profile as well as expectations of
assessing overall capital adequacy.
stakeholders, providing specific targets

for the level and composition of capital.
• The processes for bringing together
The regulated entity should ensure that
estimates of losses and capital resources
maintaining its internal capital goals will
should ensure that appropriately stressful
allow it to continue its operations under
conditions over the regulated entity’s
stressful conditions.
planning horizon have been incorporated
• The capital policy should describe the
to properly address the institution’s unique
decision making processes regarding
vulnerabilities.
capital goals, the level and composition of

capital, capital actions, and capital
• The processes should provide for the
contingency plans, including an
presentation of any information that may
explanation of the roles and
have material bearing on the regulated
responsibilities of key decision makers and
entity’s capital adequacy assessment,
information and analysis used to make
including all relevant risks and strategic
decisions.
factors, as well as key uncertainties and
process limitations. • The regulated entity should outline in
its policy specific capital contingency
Principle 5: The regulated entity has a actions it would consider to remedy any
comprehensive capital policy and robust current or prospective deficiencies in its
capital planning practices for establishing capital position, including any triggers
capital goals, determining appropriate and escalation procedures. The policy
capital levels and composition of capital, should also include a detailed explanation
making decisions about capital actions, and of the circumstances in which it will
maintaining capital contingency plans. reduce or suspend a dividend or
repurchase program, or will not execute a
Capital Policy
previously planned capital action.
• A capital policy is defined as a regulated
• A regulated entity should establish a
entity’s written assessment of the
minimum frequency with which its capital
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