Comprehensive Capital Analysis and Review stress tests: is regression the only tool for loss projection?

ABSTRACT We present a cross-sectional stress test analysis of major US banks, focusing on wholesale commercial and industrial loans in the context of the Comprehensive Capital Analysis and Review promulgated by the US Federal Reserve Board. We model gross charge-off rates for selected banks in the United States and demonstrate how the composition of the bank portfolios affects the overall losses. We compare the results of the autoregressive moving-average model with exogenous inputs with those of the modified one-factor model and, moreover, present an alternative method that uses an extreme value theory approach to compare the results of a traditional directmacro-sensitive model with the results of a model leveraging latent market factors. The results of the comparative analyses show that our proposed method gives the banks an alternative perspective on potential losses under the stress test scenarios and that asset correlations are different between banks. Such differences lead to various gross charge-off dispersions. In fact, the borrower asset correlation increases the unexpected loss. We also show that the expected value of maximum losses in the alternative extreme value theory approach in a given horizon corresponds closely to the severely adverse scenarios prescribed by the US Federal Reserve Board.