Macroeconomic Shocks on Model Parameters: Stress Testing Mortgage Loan Default Rate
31 Pages Posted: 29 Oct 2019
Date Written: October 2, 2019
We simulate default rate (DR) distributions based on models built on crisis and tranquil time periods using U.S. mortgage loan data to explore the impact changes in model parameters between different scenarios have on stress testing results. We apply the parameter posterior distribution obtained in a Bayesian approach to stress testing to reduce the estimation risk that results from using parameter point estimates. We compute the VaRs and required capital using a model built on crisis time period data and a Bayesian coefficient posterior distribution with both the effect of macroeconomic shocks on model parameters and the estimation risk considered. The results are compared with those obtained when coefficient changes in stress testing models or coefficient uncertainty is neglected. We find that the required capital is underestimated by nearly 40% when neither parameter instability nor estimation risk is addressed.
Keywords: Stress testing, Financial crisis, Parameter instability, Coefficient uncertainty, Default rate
JEL Classification: G21, G01, E32, E37
Suggested Citation: Suggested Citation