Macroprudential stress testing of credit risk: A practical approach for policy makers

Drawing on the lessons from the global financial crisis and especially from its impact on the banking systems of Eastern Europe, the paper proposes a new practical approach to macroprudential stress testing. The proposed approach incorporates: (i) macroeconomic stress scenarios generated from both a country specific statistical model and historical cross-country crises experience; (ii) indirect credit risk due to foreign currency exposures of unhedged borrowers; (iii) varying underwriting practices across banks and their asset classes based on their relative aggressiveness of lending; (iv) higher correlations between the probability of default and the loss given default during stress periods; (v) a negative effect of lending concentration and residual loan maturity on unexpected losses; and (vi) the use of an economic risk weighted capital adequacy ratio as the relevant outcome indicator to measure the resilience of banks to materializing credit risk. The authors apply the proposed approach to a set of Eastern European banks and discuss the results.

► We propose a new policy-oriented approach to macroprudential stress testing. ► Country specifics and cross-country experience drive macroeconomic stress scenarios. ► We capture the effects of foreign currency exposures and lending concentration. ► Relative lending aggressiveness traces varying credit standards across banks and assets. ► To measure bank resilience, we use the economic risk-based capital ratio.