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Stress Testing Credit Risk: The Great Depression Scenario

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  • Simone Varotto

    (ICMA Centre, University of Reading)

Abstract

By using Moody's historical corporate default histories we explore the implications of scenarios based on the Great Depression for banks' economic capital and for existing and proposed regulatory capital requirements. By assuming different degrees of portfolio illiquidity, we then investigate the relationship between liquidity and credit risk and employ our findings to estimate the Incremental Risk Charge (IRC), the new credit risk capital add-on introduced by the Basel Committee for the trading book. Finally, we compare our IRC estimates with stressed market risk measures derived from a sample of corporate bond indices encompassing the recent financial crisis. This allows us to determine the extent to which trading book capital would change in stress conditions under newly proposed rules. We find that, typically, banking book regulation leads to minimum capital levels that would enable banks to withstand Great Depression-like events, except when their portfolios have long average maturity. We also show that although the IRC in the trading book may be considerable, the capital needed to absorb market risk related losses in stressed scenarios can be more than twenty times larger.

Suggested Citation

  • Simone Varotto, 2010. "Stress Testing Credit Risk: The Great Depression Scenario," ICMA Centre Discussion Papers in Finance icma-dp2010-03, Henley Business School, University of Reading.
  • Handle: RePEc:rdg:icmadp:icma-dp2010-03
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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. Pompella Maurizio & Dicanio Antonio, 2016. "Bank Vulnerability and Financial Soundness Testing: The Bank Resilience Index," Ekonomika (Economics), Sciendo, vol. 95(3), pages 52-63, December.
    3. Abildgren, Kim, 2014. "Far out in the tails – The historical distributions of macro-financial risk factors in Denmark," Nationaløkonomisk tidsskrift, Nationaløkonomisk Forening, vol. 2014(1), pages 1-31.
    4. 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.
    5. Kanno, Masayasu, 2020. "Credit rating migration risk and interconnectedness in a corporate lending network," Research in International Business and Finance, Elsevier, vol. 54(C).
    6. Busch, Ramona & Koziol, Philipp & Mitrovic, Marc, 2018. "Many a little makes a mickle: Stress testing small and medium-sized German banks," The Quarterly Review of Economics and Finance, Elsevier, vol. 68(C), pages 237-253.

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    More about this item

    Keywords

    Credit Risk; Financial Crisis; Economic Capital; Basel II; Liquidity Risk;
    All these keywords.

    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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