Stressed Testing in Credit Portfolio Models

Abstract

As, in light of the recent financial crises, stress tests have become an integral part of risk management and banking supervision, the analysis and understanding of risk model behaviour under stress has become ever more important. In this paper, we present a general approach to implementing stress scenarios in a multi-factor credit portfolio model and analyse asset correlations, default probabilities and default correlations under stress. We use our results to study the implications for credit reserves and capital requirements and illustrate the proposed methodology by stressing a large investment banking portfolio. Although our stress testing approach is developed in a particular credit portfolio model, the main concept - stressing risk factors through a truncation of their distributions - is independent of the model specification and can be applied to other risk types as well.