A Common Pitfall in Bank Stress Testing: Macroeconomic Factors and Model Instability
38 Pages Posted: 12 Jan 2017 Last revised: 31 Jul 2018
Date Written: July 1, 2018
Macroeconomic factors can affect both the output and input of a credit risk model, as well as the measurement errors in the observed input variables. Failure to account for all these effects leads to biased and unstable estimates. We propose a two-stage filtered-input approach to obtain unbiased estimates of the effects of macroeconomic factors and to maintain a model’s predictive power. The findings of this study offer important insights that help model developers improve the reliability of their models in bank stress testing.
Keywords: Model Instability, Macroeconomic Factor, Measurement Errors, Stress Testing, Credit Risk Model
JEL Classification: C53, G17, G28, G21, C58
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