Macro stress testing of credit risk focused on the tails

This paper investigates macro stress testing of system-wide credit risk with special focus on the tails of the credit risk distributions conditional on adverse macroeconomic scenarios. These tails determine the ex-post solvency probabilities derived from the scenarios. This paper estimates the macro-credit risk link by the traditional Wilson, 1997a and Wilson, 1997b model as well as by 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 revealed more conservative based on a suggested comparison of vertical distances between the tails of the conditional and unconditional credit risk cumulative distributions.

► Macro conditional credit risk tails determine ex-post solvency probabilities.
► Relative importance of macro variables varies along the credit risk distribution.
► Unemployment distress produces the most harmful effect at the one-quarter horizon.
► Which ST approach sees the scenarios more severely depends on the comparison type.
► QR approach is revealed more conservative based on vertical distances between tails.