Stress-test Modelling for Loan Losses and Reserves

Michael Carhill and Jonathan Jones

The widespread use of macroeconomic and financial factors in the quantitative models that banks use to forecast their credit losses has been an important development. The financial crisis of 2007–09, and the associated recession, underscored the need for banks to incorporate economic and market conditions into their retail and wholesale credit risk models to produce credible stress loan-loss estimates. Prior to the financial crisis, few financial institutions estimated stressed credit losses, although stress testing for market risk and banking book interest rate risk was routine. Since the crisis, a number of banks have determined that models capable of estimating credit losses conditional on economic scenarios were necessary for enterprise-wide capital planning and stress testing.

Several supervisory and regulatory developments also have accentuated this trend. First, the largest US banks that are subject to the advanced internal ratings-based (AIRB) approach of Basel II are required to conduct a cyclicality stress test in Pillar 1 and a forward-looking stress test of credit risk as part of the Internal Capital Adequacy Assessment Process (ICAAP) in Pillar 2. Second, the Basel