Journal of Risk Model Validation

Stress-testing retail loan portfolios with dual-time dynamics

Joseph L. Breeden, Lyn Thomas and John W. McDonald III


Stress-testing has become an important topic in retail lending since the introduction of the new Basel II guidelines. Here we use a scenario-based forecasting approach developed explicitly for retail lending in order to provide a suitable stress-testing approach. We first decompose the historical vintage performance data into a maturation function of months-on-books, a quality function of vintage origination date and an exogenous function of calendar date. In a second step, the exogenous function is modeled with macroeconomic data or factors representing portfolio management impacts. Stress tests are performed by extrapolating the exogenous function using externally provided scenarios for extreme macroeconomic events. The resulting scenario is combined with the known maturation and quality functions. This process is repeated for each member of a key set of rates, such as default rate, exposure at default and loss given default in the context of Basel II. These key rate forecasts are combined to create total portfolio forecasts and stress tests. This approach is demonstrated in an analysis of the US mortgage markets.

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