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A systematic approach to multi-period stress testing of portfolio credit risk

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Author Info

  • Breuer, Thomas
  • Jandačka, Martin
  • Mencía, Javier
  • Summer, Martin

Abstract

We propose a new method for analysing multi-period stress scenarios for portfolio credit risk more systematically than in current macro stress tests. The plausibility of a scenario is quantified by its distance from an average scenario. For a given level of plausibility, we search systematically for the most adverse scenario. This ensures that no plausible scenario will be missed. We show how this method can be applied to some models already in use by practitioners. While worst case search requires numerical optimisation we show that we can work with reasonably good linear approximations to the portfolio loss function. This makes systematic multi-period stress testing computationally efficient and easy to implement. Applying our approach to data from the Spanish loan register we show that, compared to standard stress test procedures, our method identifies more harmful scenarios that are equally plausible.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Banking & Finance.

Volume (Year): 36 (2012)
Issue (Month): 2 ()
Pages: 332-340

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Handle: RePEc:eee:jbfina:v:36:y:2012:i:2:p:332-340

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Web page: http://www.elsevier.com/locate/jbf

Related research

Keywords: Stress testing; Credit risk; Worst case search; Maximum loss;

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References

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  1. Thomas Breuer & Martin Jandacka & Klaus Rheinberger & Martin Summer, 2009. "How to Find Plausible, Severe and Useful Stress Scenarios," International Journal of Central Banking, International Journal of Central Banking, vol. 5(3), pages 205-224, September.
  2. Miroslav Misina & David Tessier & Shubhasis Dey, 2006. "Stress Testing the Corporate Loans Portfolio of the Canadian Banking Sector," Working Papers 06-47, Bank of Canada.
  3. Til Schuermann & Björn-Jakob Treutler & Scott M. Weiner & M. Hashem Pesaran, 2003. "Macroeconomic Dynamics and Credit Risk: A Global Perspective," CESifo Working Paper Series 995, CESifo Group Munich.
  4. Gordy, Michael B., 2003. "A risk-factor model foundation for ratings-based bank capital rules," Journal of Financial Intermediation, Elsevier, vol. 12(3), pages 199-232, July.
  5. Philippe Artzner & Freddy Delbaen & Jean-Marc Eber & David Heath, 1999. "Coherent Measures of Risk," Mathematical Finance, Wiley Blackwell, vol. 9(3), pages 203-228.
  6. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-70, May.
  7. Rodrigo Alfaro & Mathias Drehmann, 2009. "Macro stress tests and crises: what can we learn?," BIS Quarterly Review, Bank for International Settlements, December.
  8. Claudio Borio & Mathias Drehmann, 2011. "Toward an Operational Framework for Financial Stability: “Fuzzy” Measurement and Its Consequences," Central Banking, Analysis, and Economic Policies Book Series, in: Rodrigo Alfaro (ed.), Financial Stability, Monetary Policy, and Central Banking, edition 1, volume 15, chapter 4, pages 063-123 Central Bank of Chile.
  9. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
  10. Virolainen , Kimmo, 2004. "Macro stress testing with a macroeconomic credit risk model for Finland," Research Discussion Papers 18/2004, Bank of Finland.
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Citations

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Cited by:
  1. McNeil, Alexander J. & Smith, Andrew D., 2012. "Multivariate stress scenarios and solvency," Insurance: Mathematics and Economics, Elsevier, vol. 50(3), pages 299-308.
  2. Breuer, Thomas & Csiszár, Imre, 2013. "Systematic stress tests with entropic plausibility constraints," Journal of Banking & Finance, Elsevier, vol. 37(5), pages 1552-1559.
  3. Michal Franta & Jozef Baruník & Roman Horváth & Katerina Smídková, 2014. "Are Bayesian Fan Charts Useful? The Effect of Zero Lower Bound and Evaluation of Financial Stability Stress Tests," International Journal of Central Banking, International Journal of Central Banking, vol. 10(1), pages 159-188, March.
  4. Bellotti, Tony & Crook, Jonathan, 2013. "Forecasting and stress testing credit card default using dynamic models," International Journal of Forecasting, Elsevier, vol. 29(4), pages 563-574.

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