Spurious Default Probability Projections in Credit Risk Stress Testing Models

Abstract: Credit risk stress testing has become an important risk management device which is used both by banks internally and by regulators. Stress testing is complex because it essentially means projecting a bank's full balance sheet conditional on a macroeconomic scenario over multiple years. Part of the complexity stems from using a wide range of model parameters for, e.g., rating transition, write-off rules, prepayment, or origination of new loans. A typical parameterization of a credit risk stress test model specifies parameters linked to an average economic, the through-the-cycle, state. These parameters are transformed to a stressed state by utilizing a macroeconomic model. It will be shown that the model parameterization implies a unique through-the-cycle portfolio which is unrelated to a bank's current portfolio. Independent of the stress imposed to the model, the current portfolio will have a tendency to propagate towards the through-the-cycle portfolio. This could create unwanted spurious effects on projected portfolio default rates especially when a stress test model's parameterization is inconsistent with a bank's current portfolio.