Stress-testing probability of default and migration rate with respect to Basel II requirements

ABSTRACT Basel II implementation requires the estimation of probability of default (PD) and migration rate under hypothetical or historically observed stress scenarios. Typically, financial institutions first forecast selected macroeconomic variables under these stress scenarios and then estimate the corresponding stressed PD and migration rates. These stressed parameters are in turn used in estimating the capital requirement and marked-tomarket losses within the capital adequacy assessment framework. In this paper, we demonstrate a practical methodology to estimate both stressed PD and migration rates in a consistent fashion while conditioning on the selected explanatory variables. The estimation methodology allows for the robust use of external data, which is essential in the absence of long enough internal data. The proposed methodology is consistent with the economic model underlying the Basel II Pillar I risk-weight function, and it is compatible with the financial institutions' existing internal risk rating systems making the implementation and operations cost effective. It also allows for stress testing at the overall portfolio level as well as for specific industries. An example of its implementation in the oil and gas sector is provided at the end of the paper. Although the paper is presented within the context of Basel II implementation, the proposed approach can be used as a sound risk management practice to identify, examine and quantify the effect of stress events.