A Comprehensive Framework for Quantitative Stress Tests in Financial Institutions

Abstract

In recent years, the importance of stress tests as a complement to VaR framework is widely recognized by both financial regulators and risk management practitioners.To perform credit risk stress tests in a financial institution, one must quantify the impact of macroeconomic shocks on a credit portfolio.To this end, we enhance the widely used firm-value model by incorporating macroeconomic factors and apply a fast computation technique of moment generating function (MGF) to the enhanced model. Since various risk measures and risk contributions can be obtained by the Laplace inversion of MGF and its derivatives, risk management practitioners can analyze the risk characteristics of their credit portfolio in detail under given macroeconomic conditions. In addition, based on our framework, one can also perform quantitative reverse stress tests. More specifically, one can calculate the conditional distribution of macroeconomic factors under the condition that severe losses have occurred in a credit portfolio. Thus, risk managers can investigate under what macroeconomic conditions their financial institution has difficulty in its management. In this way, our methodology provides a comprehensive stress test framework that can be used for practical risk management.