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

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Listed:
  • 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.

Suggested Citation

  • Breuer, Thomas & Jandačka, Martin & Mencía, Javier & Summer, Martin, 2012. "A systematic approach to multi-period stress testing of portfolio credit risk," Journal of Banking & Finance, Elsevier, vol. 36(2), pages 332-340.
    • Handle: RePEc:eee:jbfina:v:36:y:2012:i:2:p:332-340
    DOI: 10.1016/j.jbankfin.2011.07.009
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    References listed on IDEAS

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    1. Pesaran, M. Hashem & Schuermann, Til & Treutler, Bjorn-Jakob & Weiner, Scott M., 2006. "Macroeconomic Dynamics and Credit Risk: A Global Perspective," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(5), pages 1211-1261, August.
    2. 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.
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    6. 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.
    7. Rodrigo Alfaro & Mathias Drehmann, 2009. "Macro stress tests and crises: what can we learn?," BIS Quarterly Review, Bank for International Settlements, December.
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    More about this item

    Keywords

    Stress testing; Credit risk; Worst case search; Maximum loss;
    All these keywords.

    JEL classification:

    • 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
    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • C15 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Statistical Simulation Methods: General

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