The Role of Stress Testing in Credit Risk Management

by Roger M. Stein of the Moody's Research Labs

June 15, 2011

Abstract: The recent financial crisis has caused risk managers to reevaluate the techniques they use for assessing the risk of extreme losses to their portfolios. Some have argued that the use of distribution-based measures such as VaR and expected shortfall (ES) should be deemphasized in favor of stress-testing and scenario analysis. In this short note we discuss the benefits of stress-testing and scenario analysis. We also describe some limitations of scenario-based approaches as a sole mechanism for assessing portfolio risk. We provide a number of examples to illustrate these limitations. In particular, except in special cases, it is difficult to use stress scenarios alone, ex ante, for allocating capital across disparate portfolios. However, stress-testing and scenario analysis can complement measures such as VaR and ES and thereby better inform both risk assessment and business strategy development. We believe stress testing is integral to prudent credit risk management. Our view is that neither stress testing nor VaR type measures, in and of themselves, provide a complete description of credit portfolio risk. However, combining both approaches results in more robust risk analysis and permits risk managers to combine robust quantitative measures with managerial intuition and judgment to arrive at more comprehensive assessments of both portfolio risk and overall firm strategy.

JEL Classification: C15,C51,C52,E32,E37,G28.

Keywords: stress testing, credit risk, systemic risk, macro-prudential, credit portfolio management, scenario analysis, macro economic scenario

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