Sensitivity of stress testing metrics to estimation risk, account behaviour and volatility for credit defaults

Abstract

One approach to stress testing the amount of capital required by a bank for credit risk is to use parameterised account level models with credit application characteristics, behavioural characteristics and macroeconomic factors as predictors. The standard methodology underestimates the amount of capital required because it fails to include uncertainty over the model parameters, over the future trajectory of behavioural variables and over volatility. We provide a methodology for estimating the magnitudes of these additional losses and so a methodology to gain a more accurate estimate of the amount of capital required.