Integrating Stress-Testing Frameworks

Daniel Rösch and Harald Scheule

Bank regulators (compare Basel Committee on Banking Supervision 2006) expect financial institutions to provide sufficient Tier I and Tier II capital to cover future worst-case credit portfolio losses. These worst-case losses are based on conservative assumptions for a set of parameters such as the probability of default (PD), asset correlation, loss given default (LGD) or exposure at default (EAD)

  • Stress of PD: probability of default is based on a one factor, non-linear model where the factor equals the 99.9th percentile of a systematic standard normally distributed variable and the sensitivity is based on the so-called asset correlation.

  • Stress of EAD and LGD: EAD and LGD are modelled based on economic downturn conditions.

  • Stress of asset correlations: asset correlations can be interpreted as a measure of the sensitivity of PD to the business cycle and therefore have a major impact on the stress of the PD. As a matter of fact, the Basel Committee specifies values that are significantly higher than estimates observed in various empirical studies (see, for example, Dietsch and Petey 2004, Rösch and Scheule 2004, 2005). Examples are 15% for residential mortgage, 4% for

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