On the Comprehensive Balance Sheet Stress Testing and Net Interest Income P/L Attribution

Abstract

The joint stress testing of net interest income interest rate risk and profit and loss from behavioral risks on a multi-horizon scenario path poses great challenges in enterprise stress testing and earnings risk attributions. We propose a framework for granular level stressed net interest income calculation and P/L attribution. The proposed framework can accommodate net interest income impact from interest rate risk, profit and losses from behavioral risks e.g. prepayments and credit defaults as well as facility and deposit contingent drawdowns at each horizon on a given scenario path. Our net interest income framework uses the matched maturity asset and liability concept to synthetically separate the loan origination risks and the Treasury strategic funding risks. It considerably simplifies the joint market and credit risk stress testing by focusing on the asset versus maturity matched liability net interest income on the asset side and the maturity matched asset versus actual liabilities cash flows on the Treasury side. In this framework there is no need for exact cash flow generation on the asset side. The focus is on the loan net interest income process which requires only the outstanding balance. The loan net interest income process is a stochastic process with behavioral events. At the time of the events, the net interest income process regime-switches to capture the event impact e.g., credit loss or prepayment with associated interest rate impact. The event based net interest income process is suitable for loan-level behavioral state path simulation models with competing risk. We also consider the corresponding net interest income process with conditional default and prepayment rate models. The obtained net interest income process can be applied to both loan-level models as well as pools of homogenous loans. We illustrate the framework with competing hazards and state transition models.