Predicting economists: Generating scenarios for stress testing future loss reserves

Abstract

Stress testing under the US Comprehensive Capital Analysis and Review (CCAR) regulations and those of many other countries seeks to assess the full possible financial position of a lender through an economic crisis. The introduction of lifetime loan loss reserves under FASB’s Current Expected Credit Loss (CECL) and IASB’s International Financial Reporting Standards 9 (IFRS 9) rules complicates the task of stress testing, because lenders need to estimate future losses using scenarios that are contingent on the stress testing scenario, but without perfect foresight of the future stress test scenario. This work casts the CECL and IFRS 9 stress testing problem as one of generating future economic scenarios that are consistent with how future economists would create scenarios. To that end, we obtained historic consensus economic scenarios for testing. The results here demonstrate that a second-order Ornstein–Uhlenbeck model fits historic scenarios well and could be used to generate future scenarios that would be a realistic representation of what economists would predict given economic conditions up to that point. This approach was tested for US real gross domestic product (RGDP) and unemployment rate scenarios through the 2009 recession. The RGDP modeling was straight-forward, but we discovered that consensus economic scenarios for unemployment rate appear to be conditional on the phase of the economy.