Basel II-Type Stress Testing of Credit Portfolios

Ferdinand Mager and Christian Schmieder

Despite advances in the modelling and management of credit risk during the past two decades, recent market turmoil has shown that credit risk management continues to present unsolved challenges. Prominent among these are how to predict possible but unlikely loss scenarios, such as sudden breakdowns in market mechanisms or violations in modelling assumptions. Stress testing is an important means of detecting weaknesses of a single financial institution and threats to financial stability. The regulatory framework of the Basel II Accord (Basel Committee on Banking Supervision 2006 and European Communities 200622See also the respective national legislation on Basel II.) recognises the relevance of stress tests and constitutes a major catalyst for further development of the technique, particularly for determining credit risk and operational risk for banks and similar financial institutions.

This chapter examines stress testing for credit risk. By using realistic data, a fundamental prerequisite for meaningful stress testing, we seek to contribute to the limited existing literature on this subject (eg, Peura and Jokivuolle 2004 and Rösch and Scheule 200733Earlier contributions to the

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