By Paul Gernay
The Federal Reserve released on February 1 the awaited 2018 CCAR instructions and scenarios. While the instructions have remained largely unchanged, the Supervisory Severely Adverse Scenario is noticeably harsher, reaffirming the FRB’s intentions to further challenge the resilience of large firms currently under favourable economic conditions. The Adverse and Baseline scenarios, on the other hand, are far more conventional, respectively featuring weakening economic activity and moderate economic expansion. The Global Market Shock (GMS) is also noticeably more severe than the 2017 scenario, across all asset classes.
Given the increased severity of the 2018 Severely Adverse and GMS scenarios, special attention should be given to unexpected results, deficiencies or limitations exhibited by the models. In particular, the Model Risk Management function will play a primordial role, as an increasing number of models are likely to be used under conditions that were not foreseen during the development phase, which may result in the introduction of additional judgmental overlays.
The appropriateness of internal stress scenarios should, in most cases, be re-assessed comprehensively to ensure that they are at least as conservative as the FRB’s. This re-evaluation should encompass the impact of macroeconomic, idiosyncratic (e.g., operational risk and counterparty default) and GMS scenarios.
The impact of the stress scenario also needs to be evaluated in the context of the new tax regime, as the lower tax rate may imply lower loss absorption capacity.
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The Severely Adverse Scenario is of unprecedented severity
The main features of this year’s Severely Adverse Scenario compared to prior scenarios are characterized by significantly higher peak-to-though changes for most variables. In addition, a global aversion to long-term fixed income assets is epitomised by a flat 10-year Treasury yield at 2.4%, affecting prepayments, originations, and losses in specific portfolios (e.g., mortgages).
Interestingly, this year’s global dimension is embodied by a recessionary scenario that is more severe in developing Asia and Japan, but less severe in the Euro area and the United Kingdom.
Global Market Shock (GMS) is significantly more severe than the 2017 scenario across all asset classes
In some cases (e.g., credit indices), the 2018 GMS is more severe than any preceding cycle. It features an increase in US rates, with steepening yield curves, and a waned US dollar, which is inconsistent with a typical risk-off environment characterized by increased cash or U.S. Treasury bonds positions, and may lead to greater losses, as cross-asset hedging proves ineffective.
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