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Macro Stress-Testing on the Loan Portfolio of Japanese Banks

by Akira Otani of the Bank of Japan,
Shigenori Shiratsuka of the Bank of Japan,
Ryoko Tsurui of the Bank of Japan, and
Takeshi Yamada of the Bank of Japan

March 2009

Abstract: In recent years, an increasing number of central banks use macro stress-testing as a main tool to assess the robustness of the financial system against severe stresses to the economy, such as deep recessions and sharp rises in interest rates. This paper describes a framework for macro stress-testing on credit risk currently used at the Bank of Japan (BOJ). That framework takes account of changes in borrowers' creditworthiness over the business cycle, thereby enabling us to examine the robustness of loan portfolios for major banks and regional banks against a severe economic downturn. The simulation results, taken from the September 2008 issue of the BOJ's Financial System Report, show that the framework successfully replicates the asymmetric responses of credit risk between deep recession and subsequent economic recovery by using the combination of borrowers' transition between rating classes and different sensitivity of transition probabilities to economic fluctuations across rating classes.

JEL Classification: C51, E32, E37, G21.

Keywords: Macro Stress-Testing, Credit Risk, Transition Matrix, Robustness of Financial System.

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