Stress-testing credit risk parameters: an application to retail loan portfolios

ABSTRACT Financial institutions are faced with the challenge of forecasting future credit portfolio losses. It is common practice to focus on portfolio models consisting of a limited set of parameters, such as the probability of default, asset correlation, loss given default, or exposure at default. A simple portfolio model is also used in the Basel II framework for calculating regulatory capital. With regard to the stability of the financial system, these models have to be approved by regulators who have an interest in a conservative assessment of the credit portfolio risk and require the stress-testing of risk estimates. The present paper is the first in its kind to develop a framework to stress the smallest building block, the sensitivities of risk drivers and therefore any derivative such as a risk parameter or the credit portfolio loss. As a result, estimation uncertainties as well as the correlations are taken into account. In an empirical analysis, the stress scenarios for different loan categories are analyzed for US retail borrowers and the implications for economic as well as regulatory capital explored.