Macroeconomic Stress and Worst Case Analysis of Loan Portfolios

Abstract

We introduce the technique of worst case search to macro stress testing. Among the macroeconomic scenarios satisfying some plausibility constraint we determine the worst case scenario which causes the most harmful loss in loan portfolios. This method has three advantages over traditional macro stress testing: First, it ensures that no harmful scenarios are missed and therefore prevents a false illusion of safety which may result when considering only standard stress scenarios. Second, it does not analyse scenarios which are too implausible and would therefore jeopardize the credibility of stress analysis. Third, it allows for a portfolio specific identification of key risk factors. Another lesson from this paper relates to the use of partial stress scenarios specifying the values of some but not all risk factors: The plausibility of partial scenarios is maximised if we set the remaining risk factors to their conditional expected values.

Keywords: macro stress test, worst case, Maximum Loss, risk integration, scenario analysis, foreign currency loans

JEL Classification: C44, C15, E32, G21