Stress Testing Challenges: Forecasting Consistent Credit & Market Risk Losses JOSE CANALS-CERDA, Federal Reserve Bank of Philadelphia JUAN M. LICARI, Senior Director, Moody s Analytics OCTOBER 2015
Agenda 1. Data and model pitfalls when forecasting portfolio credit losses for stress test analysis 2. Transmission mechanisms: from scenario simulations to conditional risk parameter realizations 3. Producing consistent credit and market risk projections Stress Testing Challenges: Forecasting Consistent Credit & Market Risk Losses, October 2015
2 Transmission Mechanisms: from scenario simulations to conditional risk parameter realizations Stress Testing Challenges: Forecasting Consistent Credit & Market Risk Losses, October 2015
0.05.1 Density.15.2.25-6 -4-2 Cumulative Proportion 0 2 4 Forward-Looking Scenario Generation & Severity Ranking GDP Growth, % Q/Q: Forecasts per Quarter Example of a Marginal Loading into Overall Scenario Rank-Ordering Algorithm +Q1 +Q2 +Q3 +Q4 +Q5 +Q6 +Q7 +Q8 +Q9 Density Function Max Cumulative Drop in GDP growth Scatter over Marginal Rank Order Max cumulative drop in GDP Growth -5 10 15 20 Max Drop in Cumulative GDP Growth, % Stress Testing Challenges: Forecasting Consistent Credit & Market Risk Losses, October 2015 4
-6-4 -2 4 6 8 0 2 4 Unemployment Rate, % 10 12 14 16 Severity of Alternative Macroeconomic Scenarios Core Macro Series Across Scenario Blocks (Rank-Ordering Outcome) GDP Growth, % Q/Q: Over Scenario Blocks Unemployment Rate, %: Over Scenario Blocks Block 1 Block 2 Block 3 Block 4 Block 5 Block 1 Block 2 Block 3 Block 4 Block 5 Stress Testing Challenges: Forecasting Consistent Credit & Market Risk Losses, October 2015 5
Severity of Alternative Macroeconomic Scenarios Scenario Probabilities 1 0.5 0-0.5-1 -1.5 GDP Growth, Q/Q % -- Alternative Severity Points Severity_0_50 Severity_0_90 Severity_0_95 Severity_0_99 Severity_0_999 Severity_0_9999 1 2 3 4 5 6 7 8 9 Prob of better outcome Scenario 0.0041708 CCAR Baseline 0.0455886 ECCA's s1 0.0625286 ECCA's Baseline 0.145155 ECCA's s2 0.206814 ECCA's s5 0.8314903 CCAR Adverse 0.8857924 ECCA's s3 0.9210755 ECCA's s6 0.9801373 CCAR Severely Adverse 0.9907705 ECCA's s4-2 -2.5 Stress Testing Challenges: Forecasting Consistent Credit & Market Risk Losses, October 2015 6
Conditional Risk Parameter Realizations Impact on Government Bond Yields 10 15 Yields, % 10 15 20 Yields, % 10 15 20 Yields, % Yields, % 10 15 20 Government Bond Yields - Leading Maturities Simulations over Scenario Blocks (1 for Good, 5 for Stressed) at +Q9 3 Months 1 Year Block 1 Block 2 Block 3 Block 4 Block 5 Block 1 Block 2 Block 3 Block 4 Block 5 5 Years 10 Years Block 1 Block 2 Block 3 Block 4 Block 5 Block 1 Block 2 Block 3 Block 4 Block 5 Stress Testing Challenges: Forecasting Consistent Credit & Market Risk Losses, October 2015 7
Yields, % 10 15 20 Conditional Risk Parameter Realizations (cont.) Impact on Government Bond Yields (cont.) Government Bond Yield Curves Box-Plots Across Maturities at +Q9 3m 6m 1y 2y 3y 5y 7y 10y 20y 30y Stress Testing Challenges: Forecasting Consistent Credit & Market Risk Losses, October 2015 8
Yield Curve Slope 0 2 4 6 8 10 Yield Curve Slope 0 2 4 6 8 10 0 Density.2.4.6 Conditional Risk Parameter Realizations (cont.) Impact on Government Bond Yields (cont.) Yield Curve Slope (10y vs. 3m ) Analysis Over Quarters and Simulations Distribution for +Q9 Box-Plot for +Q9 0 2 4 6 8 10 Term Premium (10y vs. 3m ) 0 2 4 6 8 10 Yield Curve Slope (10y vs. 3m ) +Q9 Values over Simulations Box-Plots, all +Qs 000 10000 15000 20000 25000 Simulation id (1 for Good, 25000 for Stressed) +Q1 +Q2 +Q3 +Q4 +Q9 +Q6 +Q7 +Q8 +Q9 Stress Testing Challenges: Forecasting Consistent Credit & Market Risk Losses, October 2015 9
0.5 1 1.5 2 Conditional Risk Parameter Realizations (cont.) Impact on Credit Spreads for Financials - over maturities and rating classes Aaa 10 15 10 15 20 A 3m 1y 3y 5y 7y 10y 20y 30y 3m 1y 3y 5y 7y 10y 20y 30y Bbb 10 15 20 25 Corporate Spread Curves - Financials 5 Quarters out of Sample (+Q5) - Across Rating Classes B 3m 1y 3y 5y 7y 10y 20y 30y 3m 1y 3y 5y 7y 10y 20y 30y Stress Testing Challenges: Forecasting Consistent Credit & Market Risk Losses, October 2015 10
0.5 1 1.5 Conditional Risk Parameter Realizations (cont.) Impact on 5Y Credit Spreads for Financials - over quarters and rating classes Aaa 10 15 10 15 20 A +Q1 +Q2 +Q3 +Q4 +Q5 +Q6 +Q7 +Q8 +Q9 +Q1 +Q2 +Q3 +Q4 +Q5 +Q6 +Q7 +Q8 +Q9 Bbb 10 15 20 25 Corporate Spreads over Quarters-out-of-sample Financials - 5 Year Maturity - Across Rating Classes B +Q1 +Q2 +Q3 +Q4 +Q5 +Q6 +Q7 +Q8 +Q9 +Q1 +Q2 +Q3 +Q4 +Q5 +Q6 +Q7 +Q8 +Q9 Stress Testing Challenges: Forecasting Consistent Credit & Market Risk Losses, October 2015 11
Concluding Remarks» Generating dynamic scenario simulations» Challenges in quantifying scenario probabilities» Leveraging stress testing models to produce consistent forward-looking market risk projections» Flexible framework to consolidate credit and market risk analysis (through stress testing equations) Stress Testing Challenges: Forecasting Consistent Credit & Market Risk Losses, October 2015 12
Juan M. Licari, Ph.D. Senior Director +44 (0)20.7772.1208 tel +44 (0)7800.991318 mobile juan.licari@moodys.com Moody's Analytics UK Ltd. moodys.com
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