Stress testing of credit portfolios in light- and heavy-tailed models

In light of the recent financial crises, stress tests have become an integral part of risk management and bank supervision, and the analysis and understanding of risk model behaviour under stress has become ever more important. This paper analyses asset correlations, default probabilities and default correlations under stress in a generalised Merton-type credit portfolio set-up covering light- and heavy-tailed distributions. It turns out that the model behaviour under stress strongly depends on the heaviness of the tails of the risk factors. For realistic severity levels, stressed probabilities of default (PDs) are higher in heavy-tailed models. Contrary to popular belief, however, light-tailed models show a higher impact in extreme stress scenarios. Results are used to study the implications for credit reserves and capital requirements under stress.