A Common Pitfall in Bank Stress Testing: Macroeconomic Factors and Model Instability

38 Pages Posted: 12 Jan 2017 Last revised: 31 Jul 2018

See all articles by Han Hong

Han Hong

Stanford University

Deming Wu

Government of the United States of America - Office of the Comptroller of the Currency (OCC)

Qing Wang

Southwestern University of Finance and Economics (SWUFE)

Date Written: July 1, 2018

Abstract

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

Suggested Citation

Hong, Han and Wu, Deming and Wang, Qing, A Common Pitfall in Bank Stress Testing: Macroeconomic Factors and Model Instability (July 1, 2018). Available at SSRN: https://ssrn.com/abstract=2896974 or http://dx.doi.org/10.2139/ssrn.2896974

Han Hong

Stanford University ( email )

Landau Economics Building
579 Serra Mall
Stanford, CA 94305-6072
United States

Deming Wu (Contact Author)

Government of the United States of America - Office of the Comptroller of the Currency (OCC) ( email )

400 7th Street SW
Washington, DC 20219
United States

Qing Wang

Southwestern University of Finance and Economics (SWUFE) ( email )

Chengdu
China

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