Rating momentum in the macroeconomic stress testing and scenario analysis of credit risk

Abstract

With the focus on multi-horizon macroeconomic credit loss projection models in stress testing and impairments it is of interest to understand how different model assumptions can impact the projection under stressed and best estimate economic projections. In this paper we focus on the popular multi-factor model to credit risk with the added feature of rating momentum - violating the Markov property of the model. While in retail credit models it is obvious that past delinquency is an important predictor of state path commercial models are often implemented as Markovian conditional on the macroeconomic paths. We find that models that do take into account the stylized fact of rating momentum can accelerate the loss timing significantly compared to the non rating momentum case. The exact effect depends on the scenario time horizon, severity and portfolio quality. In general it takes more time for differences to realize for good quality portfolios while the effect on lower rating quality portfolios can be almost immediate with significant loss underestimation. The multi-factor model sensitivity to the explained part of the macroeconomic factors vs. idiosyncratic effects is well known but must be recognized in practice by regulators as models with a low explained portion by the macroeconomic factors can protect the portfolio loss significantly.