Spurious Default Probability Projections in Credit Risk Stress Testing Models

Paper: arXiv 2401.08892

Authors: Bernd Engelmann

Abstract

Credit risk stress testing has become an important risk management device which is used both by banks internally and by regulators. Stress testing is complex because it essentially means projecting a bank’s full balance sheet conditional on a macroeconomic scenario over multiple years. Part of the complexity stems from using a wide range of model parameters for, e.g., rating transition, write-off rules, prepayment, or origination of new loans. A typical parameterization of a credit risk stress test model specifies parameters linked to an average economic, the through-the-cycle, state. These parameters are transformed to a stressed state by utilizing a macroeconomic model. It will be shown that the model parameterization implies a unique through-the-cycle portfolio which is unrelated to a bank’s current portfolio. Independent of the stress imposed to the model, the current portfolio will have a tendency to propagate towards the through-the-cycle portfolio. This could create unwanted spurious effects on projected portfolio default rates especially when a stress test model’s parameterization is inconsistent with a bank’s current portfolio.

Complexity vs Empirical Score

• Math Complexity: 5.5/10
• Empirical Rigor: 4.5/10
• Quadrant: Lab Rats — theoretically deep, empirically untested

Why this score: The paper identifies an important structural flaw in credit risk stress testing models where macroeconomic projections inherently pull current portfolios toward an implicit through-the-cycle state. While mathematically sound in framing Markovian transition dynamics and baseline consistency, the provided text focuses primarily on theoretical mechanisms rather than extensive empirical backtesting.

Research Flowchart

  flowchart TD
    A[Research Goal: Evaluate Spurious Default Rate Projections in Credit Risk Stress Tests] --> B[Input Data: Current Portfolio State & Macroeconomic Stress Scenarios]
    B --> C[Methodology: Apply Model Transformations to Through-the-Cycle Parameters]
    C --> D[Computational Process: Project Portfolio Transition over Multi-Year Horizon]
    D --> E[Key Finding: Model Parameters Imply a Unique TTC Portfolio Unrelated to Current Assets]
    E --> F[Outcome: Portfolio Drift Causes Spurious Default Rate Effects Due to Parameter Mismatch]