Macro Stress Testing of Credit Risk Focused on the Tails

Abstract

This paper investigates macro stress testing of system-wide credit risk with special focus on the tails of the credit risk distributions conditional on bad macroeconomic scenarios. These tails determine the ex-post solvency probabilities derived from the scenarios. This paper estimates the macro-credit risk link by both the traditional Wilson (1997) model as well as an alternative proposed quantile regression (QR) method (Koenker and Xiao, 2002), in which the relative importance of the macro variables can vary along the credit risk distribution, conceptually incorporating uncertainty in default correlations. Stress-testing exercises on the Brazilian household sector at the one-quarter horizon indicate that unemployment rate distress produces the most harmful effect, whereas distressed inflation and distressed interest rate show higher impacts at longer periods. Determining which of the two stress-testing approaches perceives the scenarios more severely depends on the type of comparison employed. The QR approach is concluded more conservative based on a proposed comparison of vertical distances between the tails of the conditional and unconditional credit risk cumulative distributions.

Keywords: macro stress test, credit risk, financial system, quantile regression

JEL Classification: C14, C15, E32, G28