Stress Testing in Credit Risk Management

In the previous article, we have already studied how expected and unexpected losses are calculated using statistical techniques. However, there are certain events and their associated credit risks which are not captured by the analyses mentioned above. In order to include them in the calculation, another technique called stress testing is used.

In this article, we will have a closer look at what stress testing is as well as the different types of stress testing techniques present in the market.

What is Stress Testing?

Stress testing is the process of seeing how the values in a portfolio change in reaction to an extreme event in the environment. In this case, the portfolio refers to the portfolio of credit risks.

It needs to be noted that stress testing techniques can also be applied to other market instruments. Also, stress testing is not done for regular scenarios. The changes in the external environment have to be extreme yet possible. The credit analyst has to conjure up several black swan events using their imagination and run simulations on the same for the stress testing exercise to be successful.

The event which triggers the stress test can be of various types. In some cases, the default of an important counterparty may be considered. In some other cases, the collapse of entire industries or economies will be modeled using stress testing techniques. Other extreme events such as a change in interest rates are also simulated if the company has a lot of debt which is linked to benchmark rates such as LIBOR.

Types of Stress Testing Techniques

Stress testing is a subject by itself. This subject has shot to prominence after the 2008 credit crisis. Several different forms of stress testing are commonly used today. Some of these common techniques have been listed below:

1. Sensitivity Analysis: Sensitivity analysis only measures the sensitivity of the outcome to one particular parameter. Hence, instead of varying all the parameters at the same time, the value of one parameter is changed and everything else is held constant.

   For instance, the interest rate can be varied and the output can be checked at different levels to understand how sensitive the company is to interest rate risks. Sensitivity analysis can be carried out on more than one parameter. For instance, first, the company can vary only the interest rate, and then later it can vary only the expected loss value.

2. Scenario Analysis: Scenario analysis, unlike sensitivity analysis, is meant to look at the value of the company’s portfolio if the value of several parameters is changed at once. Scenarios are supposed to represent real-life scenarios. It is for this reason that the scenarios must be constructed by experts since they understand the correlation between different factors. Scenario analysis is often conducted using tools that enable complex mathematical calculations.

3. Event-Driven Scenarios: Event-driven scenarios are triggered by an important public event such as the Lehman Brothers collapse. Based on the exposure of the firm to various countries and companies as well as the prevailing geopolitical scenarios, such scenarios can be conceptualized and the robustness of the company’s finances can be gauged based on how it would react to such shocks.

4. Market-Based Scenarios: In many cases, the fundamental business of the company may remain unchanged. However, it may get affected by a bull or bear run in the market. These events which begin in the market may ultimately impact the credit position of the company. Hence, scenario analysis can be used to see how safe a company is in the face of market volatility.

5. Macro-Economic Scenarios: Companies also use stress testing in order to simulate how their credit portfolio would behave if the economy were to go into a slowdown, recession, or depression. The extent of exposure of the company to various industries as well as how these industries typically react to economic cycles can be used to simulate the outcome.

6. Catastrophe Scenarios: These types of scenarios were not used for stress testing earlier. However, the 2008 crisis brought along a credit freeze. This credit freeze almost led to a global catastrophe. This is the reason that this scenario is not considered to be too far-fetched. Many organizations in the world, particularly the ones related to financial services commonly use this scenario in stress testing.

7. Historical Analysis: As the name suggests, in this case, the data is taken from events that have already taken place in the past. The assumption is that analyzing the past is the best way to predict the future.

   Hence, empirical data must be present if such an analysis has to be conducted. The benefit of historical analysis is that this method is not subjective and hence analysts cannot influence the calculation too much. However, in many industries, the past trends may not be likely to repeat in the future. Hence, the analysis becomes futile and irrelevant.

8. What-If Analysis: The what-if analysis is not based on past data. Instead, it is based on plausible scenarios which can occur but have not occurred empirically. If this analysis is done by experts in an unbiased manner, it can yield great results. However, there is a lot of subjectivity involved. If two different people conduct the same analysis, they might come to very different conclusions.

Stress testing is an invaluable tool that has gained prominence in recent years. However, in most cases, it has been used to manage market risks. However, of late, it has been used extensively in the management of credit risks as well.