Survey of Retail Loan Portfolio Stress Testing

Joseph Breeden

The concept of stress testing is straightforward. What is the expected portfolio performance given the current portfolio and a specific (usually severe) economic scenario? With Basel II there is an additional assumption that we are looking at total default losses over the next 12 months, but the modelling problem remains essentially unchanged.

Successful stress test models do not require that the analysis be done either on segment vintages or individual accounts. That decision is driven by the modelling framework chosen. Because a portfolio can be comprised of many disparate products and customer groups, we usually assume that better results will be obtained by segmenting the portfolio at least along product lines, assessing the shift in losses under economic stress for each segment, and then adding the individual loss estimates. Beyond this initial high-level segmentation, any further disaggregation of data is a modelling decision and effective models exist at multiple levels of data aggregation.

For a collection of accounts within a segment, the important dynamic is that of a shifting distribution across the probability of default (PD), see Figure 7.1. The models we describe