Title: On stress testing of credit default
Authors: Jonathan Crook - University of Edinburgh (United Kingdom) [presenting]
Viani Djeundje - University of Edinburgh (United Kingdom)
Abstract: The Bank of England requires large UK banks to undertake an annual stress test of their regulatory capital. The ECB and the Federal Reserve Board require periodic stress tests and stress testing is a requirement under the Basel Accords. The usual procedure is for the central bank to provide a macroeconomic scenario and for each bank to predict the amount of capital it would be required to hold for credit, market and operational risk to protect depositors against plausible but unexpected adverse events. Much of the literature considers methods to predict the capital required at a portfolio level for credit risk losses. However uncertainty over the state of the macroeconomy is only one source of risk when predicting the amount of capital needed for credit risk. There is also a growing literature on model risk and the literature on stress testing usually omits this source of uncertainty. We consider sources of uncertainty other than macroeconomic risk. We estimate hazard functions for the probability of default using a large sample of credit card accounts. We estimate the separate impact of mis-estimation risk, volatility risk and behavioural risk on the value at risk and expected shortfall and so on the amount of capital needed to protect depositors. We find that each type of risk is relatively modest. The work differs from the literature by undertaking an account level analysis and by estimating the relative magnitudes of different types of model risk.