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Stress testing credit risk: The Great Depression scenario

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  • Varotto, Simone

Abstract

By employing Moody’s corporate default and rating transition data spanning the last 90years we explore how much capital banks should hold against their corporate loan portfolios to withstand historical stress scenarios. Specifically, we will focus on the worst case scenario over the observation period, the Great Depression. We find that migration risk and the length of the investment horizon are critical factors when determining bank capital needs in a crisis. We show that capital may need to rise more than three times when the horizon is increased from 1year, as required by current and future regulation, to 3years. Increases are still important but of a lower magnitude when migration risk is introduced in the analysis. Further, we find that the new bank capital requirements under the so-called Basel 3 agreement would enable banks to absorb Great Depression-style losses. But, such losses would dent regulatory capital considerably and far beyond the capital buffers that have been proposed to ensure that banks survive crisis periods without government support.

Suggested Citation

  • Varotto, Simone, 2012. "Stress testing credit risk: The Great Depression scenario," Journal of Banking & Finance, Elsevier, vol. 36(12), pages 3133-3149.
  • Handle: RePEc:eee:jbfina:v:36:y:2012:i:12:p:3133-3149 DOI: 10.1016/j.jbankfin.2011.10.001
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    Cited by:

    1. Ferrer, Alex & Casals, José & Sotoca, Sonia, 2015. "Capital cyclicality, conditional coverage and long-term capital assessment," Finance Research Letters, Elsevier, vol. 15(C), pages 246-256.
    2. Darne, O. & Levy-Rueff, O. & Pop, A., 2013. "Calibrating Initial Shocks in Bank Stress Test Scenarios: An Outlier Detection Based Approach," Working papers 426, Banque de France.
    3. Alejandro Ferrer Pérez & José Casals Carro & Sonia Sotoca López, 2014. "Conditional coverage and its role in determining and assessing long-term capital requirements," Documentos de Trabajo del ICAE 2014-12, Universidad Complutense de Madrid, Facultad de Ciencias Económicas y Empresariales, Instituto Complutense de Análisis Económico.

    More about this item

    Keywords

    Credit risk; Financial crisis; Stress testing; Basel 3;

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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