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Macroeconomic shocks and credit Macroeconomic

shocks and
risk stress testing the Iranian credit risk
stress
banking sector
Fatemeh Abdolshah
Faculty of Economics, Allameh Tabatabai University, Tehran, Iran
Received 3 November 2019
Saeed Moshiri Revised 14 April 2020
Department of Economics, St. Thomas More College, University of Saskatchewan, Accepted 15 April 2020

Saskatoon, Canada, and

Andrew Worthington
Department of Accounting, Finance and Economics, Griffith University,
Queensland, Australia

Abstract
Purpose – The Iranian banking industry has been greatly affected by dramatic changes in macroeconomic
conditions over the past several decades owing to volatile oil revenues, changing fiscal and monetary
policies, and the imposition of US sanctions. The main objective of this paper is to estimate potential credit
losses in the Iranian banking sector due to macroeconomic shocks and assess the minimum economic
capital requirements under the baseline and distressed scenarios. The paper also contrasts the applications
of linear and nonlinear models in estimating the impacts of macroeconomic shocks on financial
institutions.
Design/methodology/approach – The paper uses a multistage approach to derive the portfolio loss
distribution for banks. In the first step, the dynamic relationship between the selected macroeconomic variables
are estimated using a VAR model to generate the stress scenarios. In the second step, the default probabilities
are estimated using a quantile regression model and the results are compared with those of the conventional
linear models. Finally, the default probabilities are simulated for a one-year time horizon using Monte-Carlo
method and the portfolio loss distribution is calculated for hypothetical portfolios. The expected loss includes
the loss given default for loans drawn randomly and uniformly distributed and exposed at default values when
loans are assigned a fixed value.
Findings – The results indicate that the loss distributions under all scenarios are skewed to the right, with
the linear model results being very similar to those of quantile at the 50% quantile, but very unlike those at
the 10% and 90% quantiles. Specifically, the quantile model for the 90% (10%) quantile generates estimates
of minimum economic capital requirement that are considerably higher (lower) than those using the
linear model.
Research limitations/implications – The study has focused on credit risk because of lack of data on other
types of risk at individual bank level. The future studies can estimate the aggregate economic capital using a
risk aggregation approach and a panel data (not presently available), which could further improve the accuracy
of the estimates.
Practical implications – The fiscal and monetary authorities in developing countries, specially
oil-exporting countries, can follow the risk assessment approach to assess the health of their banking
system and adapt policies to mitigate the impacts of large macroeconomic shocks on their financial
markets.
Originality/value – This is the first paper estimating the portfolio loss distribution for the Iranian banks
under turbulent macroeconomic conditions using linear and nonlinear models. The case study can be applied to
other developing and emerging countries, particularly those highly dependent on natural resources, prone to
extreme macroeconomic shocks.
Keywords Credit risk, Loss distribution, Capital requirement, Wilson model, Quantile regression, Stress
testing
Paper type Research paper

Journal of Economic Studies

© Emerald Publishing Limited
0144-3585
JEL Classification — C21, E17, G21 DOI 10.1108/JES-11-2019-0498
JES 1. Introduction
The Iranian banking industry has been greatly affected by dramatic changes in
macroeconomic conditions over the past several decades owing to volatile oil revenues,
changing fiscal and monetary policies, and the imposition of US sanctions. With the ending of
international sanctions, including banking restrictions, in a January 2016 deal in which
Tehran agreed to curb its nuclear program, Iran strived to overhaul its banking sector by
tackling nonperforming loans (NPL) and imposing tougher capital requirements, initially
under Basel I (Strohecker and Saul, 2015).
However, Iran’s banks are continuing to struggle with the accumulated bad debt of the
more than decade-long sanctions era, with the ratio of nonperforming loans to total loans
officially 11% (down from 15% in 2013) amounting to some US$27.1 billion in bad debts
(Financial Tribune, 2016), but unofficially according to market estimates as much as $40
billion (Strohecker and Saul, 2015). The impact of the sanctions on banking was also
compounded by several Iranian banks having heavy exposures to the domestic real estate
market, which experienced a severe downturn in 2012, again leaving many problem loans in
the system. Further, a dramatic fall in oil export revenues due to the recent oil price decline,
high unemployment rate (14%) and high inflation (15%) remain ongoing macro challenges
(Paivar, 2015) [1].
Credit risk, the risk of change in the value of a loan portfolio that arises from borrowers
failing to repay their debts, is rather high in the Iranian banking sector due to the high level of
nonperforming loans. Since financial markets are not deep in Iran, the banking sector has
been obliged to maintain its role as the most important source of financing, not only for
households, but also businesses. For this reason, adverse effects on bank loan portfolios
arising from high levels of credit risk and large amounts of nonperforming loans have the
capacity to rapidly worsen overall economic conditions.
For instance, a severe oil shock involving a fall in the price of oil (Iran’s leading export by
far) would mean that nonperforming loans to banks would not only increase yet further, but
that banks would also lose the ability to repay their own loans, placing themselves at risk of
default given their extremely low levels of capital. In fact, in some Iranian banks, the amount
of nonperforming loans itself exceeds total capital [2]. Therefore, the management of credit
risk associated with default is an important element of a comprehensive risk management
approach, and an essential requirement for the success of both banks and the economy.
Bank managers need the estimation of potential losses to consider the capital level that
must be held by banks to meet the liquidity requirement of customers and creditors. At
present, stress testing as a risk management tool is used in many financial institutions to
determine how much stress particular scenarios influence the value of their portfolios. For
instance, commercial banks use stress tests to weigh the amount of risk inherent in a portfolio
against its expected returns. Nevertheless, stress tests also allow policymakers to assess the
resilience of banks to macroeconomic shocks and to ensure there is sufficient capital to deal
with these shocks. Having enough capital not only protects banks from the risk of
bankruptcy, but also prevents the spread of a banking crisis to an overall economic crisis and,
therefore, it is of national interest.
Although stress tests are conventionally done at the level of individual financial
institutions, central banks are also interested in aggregate stress testing as monetary
authorities are more concerned about the stability of entire financial system than a single
bank or portfolio. This is particularly the case in countries like Iran, where the banking
system enjoys a greater degree of homogeneity owing to the fact that the largest banks are
publicly owned and highly regulated. Central banks can use aggregate stress tests to assess
the risk-bearing capacity of the banking system under different scenarios. While the objective
of stress tests by a commercial bank is to determine how much risk is acceptable for a given
level of expected return of a portfolio, central banks perform stress tests to analyze structural
vulnerabilities in the entire financial system. These aggregate stress tests are important to Macroeconomic
monetary authorities because it allows them to become well-informed about these shocks and
vulnerabilities, enabling them to take counteractive measures to avoid a financial crisis
with economy-wide impacts (Kalirai and Scheicher, 2002). Aggregate stress tests are also
credit risk
conducted by the IMF and World Bank as part of the Financial Stability Assessment stress
Program (FSAP, 1999).
In this paper, given the potentially important role of credit risk in the Iranian banking
sector, we consider the effects of plausible macroeconomic shocks to a selected
macroeconomics variables on system wide credit losses using aggregate stress tests. We
perform these stress tests with a focus on the distributions possible under the alternative
macroeconomic scenarios. Importantly, as the stress test includes severe yet empirically
plausible adverse scenarios, it would appear that the conventional linear approach would be
unable to provide an accurate estimation of any bank losses resulting from extreme events,
because the effects of such shocks are typically asymmetric. For this reason, we predict credit
losses in the banking sector using the quantile regression method and compare the results
with those of the commonly used linear model.
The remainder of the paper is organized as follows. Section 2 reviews the empirical
literature and Section 3 discusses the research methodology. Section 4 explains the data
structure and analyzes the stress testing results followed by concluding remarks in Section 5.

2. Review of previous studies

Since 1996, when the Basel Committee on Banking Supervision first commended its use in
internal modeling, numerous studies have examined macro stress test theory and its
empirical applications. At the same time, aggregate stress tests have been fully incorporated
in the financial sector assessment program (FSAP) conducted jointly by the International
Monetary Fund and the World Bank, with central banks worldwide periodically conducting
stress tests for financial stability assessment.
In the core of the stress tests is the modeling of credit and economic risks and simulations
to create the loss distribution. In general, the relationship between economic conditions and
credit risk is specified using the following two approaches. In a seminal work, Merton (1974)
formulated a model that priced a variety of financial institutions, the idea being to define a
default event as a fall in asset return below a defined threshold. Other studies follow the
approach introduced by Wilson (1997a, b), which explicitly links the default rate with
macroeconomic variables using a logistic function in the regression analysis. Subsequently,
Boss (2002) introduced a model based on the credit portfolio approach to stress test Austrian
banks. However, because of a lack of suitable data, it was not possible for Boss (2002) to model
default probability for different industrial sectors. Consequently, the total probability of
default is modeled as a function of macroeconomic variables and a simulated path of future
default probability used to determine the distribution of losses. Later, Virolainen (2004) also
applied Wilson model to estimate the probability of default in a number of Finnish industries
using the SURE model to determine the effects of macroeconomic variables on sectoral
default rates. In that study, the macroeconomic variables found to have the most explanatory
power for loan default were GDP growth, the level of debt and interest rates.
Based on aggregate data on the volume of credits and on loan loss provisions, Kalirai and
Scheicher (2002) conducted an aggregate stress test to predict credit risk in the Austrian
banking sector. They used a linear regression approach to describe the relation between loan
loss provisions and the state of the economy measured by selected macroeconomics
variables. Drehman et al. (2007) investigated the effect of macroeconomic shocks on credit
risk using a non-linear VAR model and Merton’s approach. They found a nonlinear impact of
macro shocks on credit risk: Linear models overestimate the effect of small monetary shocks
JES and underestimate the effect of large shocks. Francisco et al. (2012) also used a macro credit
risk stress test for the banking industry in Brazil. However, they used the NPL distribution
instead of the default probability distribution and a VAR model to simulate distressed
macroeconomic scenarios. They used a microeconomic model to assess the sensitivity of
NPLs to these scenarios and a credit VaR model to estimate the ability of bank capital to cover
tail credit losses under the distressed scenarios.
It is important to note that all the aforementioned studies involve linear models. However,
because stress tests do not generally consider small shocks, the data generating process is
unlikely linear. For this reason, recent studies have attempted to address the limitations of the
linear models by employing nonlinear regressions. For example, Ricardo and Wanger (2011)
examined the relationship between credit risk and macroeconomic variables in Brazil using
both the linear model and quantile regression. Stress tests on a one-year horizon for Brazilian
households showed that the unemployment rate had the most devastating impact on losses
while inflation and interest shocks exerted a greater effect over a longer time. The results also
showed that the quantile regression approach based on a comparison of the vertical gap
between the tails of conditional and unconditional cumulative distributions of credit risk were
typically more conservative. Subsequently, Francisco et al. (2014) used the fixed effects
quantile autoregressive (FE-QAR) and the fixed effects ordinary least square (FE-OLS)
methods to estimate the losses of bank holding companies (BHCs) under distressed
macroeconomic scenarios. The key difference that emerges from these two econometric
models is that the projected densities generated by the FE-QAR model exhibit significantly
heavier tails. The results also showed that the likelihood of FE-OLS underestimating banking
capital shortfalls was considerably less than those implied by FE-QAR.
Allen et al. (2010) investigated the effect of fluctuations in the value of assets on capital
adequacy and the default probability of Japanese banks using quantile regression and the
Merton (1974) structural credit model. Their findings indicated a substantial difference in the
distance to default between the 50 and 95% quantiles and that there was a significant
increase in the assessment of credit risk using quantile regression when compared to the
traditional Merton (1974) approach.
In more recent studies, Kabir et al. (2016) also investigated the effect of different stress
scenarios on bank’s capital adequacy ratio in Turkey. They ran different scenarios on credit
risk, market risk, and operational risk and found that banks in Turkey were more sensitive to
sudden changes in exchange rates and increased non-performing loans. Deming et al. (2018)
conducted a stress test for portfolios loans and showed that HPI changes are negatively
related to default probabilities and unemployment rates are positively related to auto loan
defaults. Kok et al. (2019) projected the fee and commission income ratio under baseline and
adverse macroeconomic scenarios in a stress test. Based on a panel data estimation, they
reported that the fee and commission income ratio is varying in particular with changes in its
own lag, the short-term interest rate, stock market returns and real GDP growth. Gambetta
et al. (2019) also investigated the connection between the bank risk factors and the macro
stress testing impact on capital in the EU. The findings show that the results of stress test
largely depend on efficiency and complexity of the financial institutions. The results also
suggest the stress tests disciplinary role as a risk management strategy.
There have been a few studies on the impacts of macroeconomic changes on banking
system performance in Iran. For instance, Heidari et al. (2010) studied the effect of
macroeconomic variables on non-performing loans (NPL) in Iran’s banking industry for the
period 1999–2009. Using the impulse-response functions and variance decomposition
techniques, they showed that an increase in interest rate, liquidity and inflation increases
bank’s NPL. Noroozi (2015) estimated the macroeconomic determinants of credit risk for
Iranian banks using the GMM method and showed that credit risk increases with
unemployment rate and inflation rate and decreases with GDP growth. Hemati et al. (2010)
also conducted a similar study showing that the credit risk is negatively correlated with the Macroeconomic
level of GDP and inflation rate and positively correlated with the GDP growth. None of these shocks and
studies have calculated the losses and the required capital for the banking system facing
different macroeconomic shocks.
credit risk
In this paper, we apply a macro stress test to estimate potential credit losses in the Iranian stress
banking sector arising from various macroeconomic shocks. Iran is an interesting case study
as the country has experienced a variety of extreme macroeconomic shocks arising from
sharp oil price changes, prolonged US sanctions, fiscal imbalances and monetary expansions
over recent decades. The banking system is also heavily regulated with interest rates set by
the central bank, which implies that the response of banks to shocks is rather limited. The
financial depression argument also applies as the real interest rate is kept low (negative in
most years), but the actual allocation of loans is at government discretion. Although private
and semi-private banks have been allowed to operate in Iran in recent years, publicly owned
banks continue to dominate the banking industry. To the best of our knowledge, this is the
first study to conduct an aggregate stress test, simulate the default probabilities under
various scenarios concerning macroeconomic shocks and calculate the minimum economic
capital requirements for the banking system in Iran using linear and nonlinear methods.

3. Methodology
Prediction of credit risk is the main interest of financial industry participants, particularly
under a capital adequacy framework (Basel II), which encourages banks to assess their
exposure to credit risk and potential losses. This can be done by estimating the default
probability, which is the primary input in systematic risk assessment and stress testing. In
general, there are two approaches for analyzing credit risk and stress testing: The market-
based approach and macroeconomic- or fundamentals-based approach. In brief, market-
based approach draws on option pricing theory and depends on the prices of traded securities
(Merton, 1974; Lee, 2011). In contrast, macroeconomic approach is useful especially when
firms do not have tradable securities or where prices in secondary markets are not reliable
because of low levels of liquidity. In this study, we adopt the latter to conduct the aggregate
stress test, mainly because of lack of information on financial market data for the Iranian
banks [3].
Our methodology follows Borio et al. (2014), who identify four elements in macro stress
tests: The risk factor, shock scenarios based on a macro model, relation between the macro
model and the risk variable, and prediction of the scenario outcomes. We specify the
probability of default as a proxy for credit risk subjected to stress. Our choice of default
probability for the macro stress test is based on the data availability and the fact that credit
risk remains a significant challenge to the Iranian banking system that has not been
addressed yet. We then set up a macroeconomic model to analyze the impacts of various
scenarios for external shocks on the banking system. In the next step, we feed the output of
the macro model into an auxiliary model that incorporates the credit risk variable. Finally, we
use a credit VaR model to estimate the required capital for banks as outcome to cover credit
losses under distressed scenarios. The details of the process are described below and a
schematic presentation of the process is provided in the appendix Figure A2.

3.1 Stress scenarios

Distressed scenarios are often set up based on historical events and generally regarded as
being more plausible as the events have already taken place (Breuer et al., 2009). However,
historical scenarios may lead to a risk of ignoring alternative scenarios that have not yet
happened but their likelihood is not zero. Therefore, hypothetical shocks representing sever
JES yet plausible changes in the external environment regardless of the historical experience can
also be considered.
In this study, we perform the stress tests based on one, two, or three standard deviations to
the macroeconomic variable means. However, since the Iranian economy has been subjected
to some extreme shocks for the past decades, we also analyze the impacts of the historical
scenarios. To avoid undue complexity, we focus on univariate scenarios comprising shocks to
only a single macro variable. Our selected macroeconomic variables, explained in the next
section, include unemployment rate, GDP growth, exchange rate, and inflation rate. We
simulate the impacts of the scenarios for a one-year time horizon (2016:q2-2017:q2).

3.2 Macroeconomic model and credit risk

Our macroeconomic-based approach to stress test is based on McKinsey’s Credit Portfolio
View (CPV) as discussed by Wilson (1997a, b). The process involves two steps:
(1) Specify a macroeconomic model to explain the relation between the macroeconomic
variables and to set up the scenarios. Macroeconomic variables are typically assumed
to follow a dynamic process such as AR(P):
X
p
xk;t ¼ γ k;0 þ γ k;j xk;tj þ vk;t ; k ¼ 1; . . . ; K (1)
j¼1

where x is the variable of interest, γ j ¼ ðj ¼ 1; . . . ; pÞ is a set of regression coefficients to

be estimated for the kth macroeconomicP variable, and vk;t is an iid error terms with zero
means and variance-covariance matrix .
v:
(1) Feed in the macroeconomic estimation outcome into a regression equation to estimate
the impact of scenarios on the measure of credit risk like the probability of default
(PD). PD can explicitly be linked to specific macroeconomic variables as a logistic
process as follows:
1
pt ¼ (2)
1 þ e−yt
where pt is the default probability and yt is a macroeconomic index determined by the
macroeconomic factors under consideration:
yt ¼ β0 þ β1 x1;t þ β2 x2;t þ . . . þ βk xK;t þ εt (3)

where xt ¼ ðx1;t ; x2;t ; . . . ; xK;t Þ is the set of selected macroeconomic factors specified in
step 1 above, β ¼ ðβ0 ; β1 ; . . . ; βk Þ is the set of regression coefficients which determine the
impact of the explanatory factors on the default probability, and εt is an iid error term with
zero mean and constant variance. The default probability (p) in (2) can be estimated by
evaluating the impacts of shocks to the macroeconomic variables through Equation (3).
In this study, we make two modifications to the basic model above. First, we use a dynamic
system of equations for our macro model, instead of the single equation AR model, to allow for
a richer dynamics and interactions between the macroeconomic variables. Second, as the
stress test scenarios include extreme shocks, a linear approach will be unable to provide an
accurate estimation of the losses caused by extreme events. Therefore, we use a nonlinear
quantile regression model to predict bank losses and compare the results with those of a
linear model as a benchmark.
The quantile regression, as first discussed by Koenker and Bassett (1978), allows to
estimate different quantile functions of the conditional distribution, where each quantile
function is a unique point (the tail or center) of the conditional distribution. This should yield a
more complete distribution of the original distribution. In general, the quantile regression can Macroeconomic
be specified as shocks and
Yi ¼ xi βθ þ εθi ; credit risk
stress
and the conditional quantile θ ∈ ð0; 1Þ of the Y variable, which is given by:
Qθ ðY jxi Þ ¼ xi βθ i ¼ 1; . . . ; n; (4)

where Qθ ðY jxi Þ is the θth conditional quantile of Y given xi, xi ¼ ð1; xi1 ; . . . ; xik Þ represents a
vector of given variables, and βθ ¼ ðβ0 ; β1 ; . . . ; βk Þ is a vector of unknown parameters. With
these two modifications, our base model is thus specified as follows:
1
pt ¼ (5)
1 þ e−yt
Yti ¼ xti βθi þ εθi ; i ¼ 1; . . . ; n; βθ ¼ ðβ0 ; β1 ; . . . ; βk Þ; θ ∈ ð0; 1Þ (6)
X
q
Xt ¼ γ 0 þ γ j Xt−j þ vt ; vt ∼ iid ð0; Σv Þ (7)
i¼1
   
εt Σε Σε;v
E¼ ∼ N ð0; ΣÞ; Σ ¼ (8)
vt Σv;ε Σv

Equation (6) represents the quantile regression model, Equation (7) the vector autoregressive
(VAR) model, and Σ in (8) the variance-covariance matrix of error terms in (6) and (7).
The VAR model is a rich macroeconomic model that allows for studying the dynamic
relations among macro variables and analyzing the impacts of shocks on the variables
through time. It is also a theoretical model avoiding the endogeneity problem often exists in
macroeconomic models by treating all variables as endogenous. However, the VAR model is
data intensive limiting the number of variables that can be used, especially when the high
frequency data in not available. This leads us to select only a few variables from the list of
variables with potential effects on the probability of default. The list of potential variables
that have also been used in the literature includes GDP, GDP growth, stock price index,
exchange rate, unemployment rate, inflation rate, housing prices, oil revenues and the
liquidity growth rate.
There are different approaches to select the subset of variables from the pool of relevant
variables depending on the objectives of the research. For instance, one might follow a
specific-to-general approach through which the estimation starts with one variable and then
continues with adding other variables stepwise. In contrast, the general-to-specific approach
entails regressions starting with all potential variables and removing variables one at a time.
In either case, different metrics such as the significance level of the estimated coefficients and
measures of prediction errors can be used to find the right model (Jarocinski and Mackowiak,
2011). Since our objective is to assess the impact of macro shocks on credit risk, the significant
relation between the macro variables and the credit risk would be a suitable criterion for the
variable selection. We therefore follow the approach in Boss (2002) to select the variables for
our VAR model. In this method, a series of macroeconomic variables are regressed on the
probability of default in a variety of univariate and multivariate regression models and then
the most effective indicators are selected.
The regression results show that four major macroeconomic variables (GDP growth,
unemployment rate, inflation rate and the exchange rate) are the key factors affecting the
default probability in our data [4]. An increase in economic activities represented by high
economic growth and low unemployment rate enables the borrowers to pay off their debts in
JES due time. Therefore, the relationship between the default probability and the GDP growth is
expected to be negative, whereas with unemployment rate positive. Inflation rate decreases
the real value of the loans making it easier for the borrowers to pay off their debts. However,
higher inflation rates reduce the real income of fixed earners and may reflect uncertainty
about the future economic conditions and policies, leading to higher probability of default.
With fixed interest rate, the higher inflation rate decreases the real interest rates increasing
demand for funds. However, given the supply of loanable funds, the lower real interest rate
paves the road to rent seeking behavior and discretionary allocation of loans, with often high
probability of default.
The depreciation of real exchange rate may have a negative impact on the default
probability, because of improving the net exports (Kalirai and Scheicher, 2002), but it may
also generate opposite effect if domestic production heavily relies on imports of intermediate
goods or if the loss of domestic currency value is perceived as weak economic conditions and
prospects. The changes in the real exchange rates also reflect the changes in oil prices and
revenues as one of the key factors in the Iranian economic performance, a well-known
phenomenon as Dutch disease. Higher (lower) oil prices are often associated with the
appreciation (depreciation) of the real exchange rates and a boom in the non-traded sectors,
such as construction and real estate activities. Therefore, the probability of default effect of
the changes in real exchange rate will depend on the relative strengths of these opposing
factors, which will be determined by the data.

3.3 Simulation and stress testing

After modeling the credit risk and macroeconomic system, we simulate the model using
the Monte Carlo method and the internal ratings-based (IRB) approach to obtain the loss
distribution and estimate the required capital as outcome. The IRB approach as
incorporated in Basel 2 focuses on the frequency of bank insolvencies arising from credit
losses (BCBS, 2005), such that the minimum capital required is determined by the loss
distribution caused by default in the bank’s loan portfolio. Under this approach, banks are
required to provide their estimation of the following parameters as components of credit
losses: The probability of default (PD), the loss given default (LGD), and the exposure at
default (EAD). As explained by BCBS (2005), the expected loss (LE) can be written as
follows:
EL ¼ PD  EAD  LGD

EAD and LGD are often assumed to be constant and, therefore, PD is the key input into the
portfolio models that should be estimated by the banks. In this paper, the loss distribution
merely considers the losses arising from default state and not the losses arising from any
unexpected changes in credit quality.
Credit portfolio risk is usually determined by two important parameters, namely, expected
loss (EL) and unexpected loss (UL), as specified by the probability distribution of losses.
Expected loss is the average of the loss distribution, and usually covered by financial
institutions with provisions and write-offs. Unexpected losses relate to potentially large
losses that occur at different frequencies and are therefore covered by bank capital, where UL
is the standard deviation from the mean at a certain confidence level. It is also referred to as
credit Value at Risk (VaR). For example, the UL of a portfolio at a 99% confidence level will be
expressed as follows:
ULð99%Þ ¼ VaRð99%Þ  EL
Credit capital is the amount of economic capital (EC) that a bank must maintain to cover Macroeconomic
unexpected losses caused by default. Therefore, at a given confidence level, the EC required shocks and
for banks is equal to the unexpected loss.
To derive the loss distribution, the probability of default estimated in the base model is
credit risk
simulated one-step ahead. That is, substituting the current values for time t by the respective stress
forecasts for time tþ1 after a time step and repeating the simulation steps, a forecast of the
default probability for time tþ2 is obtained. This procedure can be repeated until the desired
time horizon H is reached. This method thus yields a path of future default probability
ðptþ1 ; ptþ2 ; . . . ptþH Þ. Monte Caro simulation steps iterated several times and the new default
probability obtained at each time. Finally, the entire loss distribution can be obtained over all
simulated paths of the default probabilities. The determination of the loss distribution
involves the following steps (Ruben and Manuel, 2014):
(1) Construction of a hypothetical portfolio consisting of 7,000 loans.
(2) The exposure at default (EAD) for each loan is determined randomly by a uniform
distribution. Random exposures and the number of loans are drawn until the
aggregated amount of exposure of the hypothetical portfolio equals the aggregate
nonperforming loans held by the banks (about USD 31 billion in 2016).
(3) Focusing on the IRB approach, the loss given default (LGD) is set to 0.45.
(4) The simulated default probabilities are used in the arbitrary portfolio and the loss
distribution is estimated over a one-year time horizon.
(5) The expected and unexpected losses and VaR are calculated from the loss
distribution.
A Monte Carlo simulation with 10,000 simulation steps is performed for the baseline
scenario (with no macroeconomic shocks) and the distressed scenarios to determine the
loss distribution and to estimate the required capital as outcome. The stress test is
performed by comparing the credit loss distributions of the distressed scenarios to those
of the baseline scenario. In this paper, we create the macro scenarios for the second
quarter of 2016 and calculate their results for the second quarter of 2017 (a one-year time
horizon).

4. Results
4.1 Data structure
Our quarterly date represents the Iranian banking industry and macroeconomic conditions
from 2004: Q1 to 2016: Q2. The purpose of the aggregate credit risk stress test is to measure
structural vulnerabilities and the risk situation in the entire financial system by identifying
losses resulting from borrower default. Since the aggregate nonperforming loans (NPL) ratio
is the only data made available by the Central Bank of Iran, we use it at the end of each quarter
as a proxy of the default rates. The data on unemployment rate, GDP growth, inflation rates
and the exchange rates are collected from the Statistical Center of Iran and the Central Bank
of Iran.
Table 1 presents a summary of the data used in the model. The mean default probability is
15% during the period 2004–2016 with nearly a symmetric distribution. As Figure 1 shows,
among the macroeconomic variables, the unemployment rate is most stable, while the
inflation rate, the growth of real exchange rate and GDP growth exhibit sharp fluctuations,
particularly in recent years. In evidence, the inflation rate, the growth of GDP and real
exchange rates during the sample period have varied from 7% to 43%, 6.6% to 12%, and
13.9% to 32.88%, respectively. Changes in oil prices along with the US and the UN
JES sanctions on the oil and banking sectors in Iran were the main causes of the recent
fluctuations in the economy. We use a dummy variable to control for the sharp changes in the
real exchange rates in 2012.

4.2 Estimation results

We first conduct a series of diagnostic tests on the data. All the tests, estimations, and
simulations are done in R. Table A1 in appendix shows that all variables, except for
unemployment rate in the ADF test and inflation rate in the PP test, have unit root. Therefore,
we use growth rates of GDP and the real exchange rate, and unemployment rate and inflation
rate as our main variables in the model. Table A2 in appendix shows the correlation matrix of
the variables. We also use Variance Inflation Factor (VIF) to assess the collinearity between
the variables. Since the VIF is close to 1, there is no correlation among the kth predictor and
the remaining predictor variables.
Table 2 provides the results for the VAR model. According to the Schwartz information
criterion, one lag, and the Hannan-Quinn criterion, two lags are the optimal lag length
(Table A3 in appendix). Given the seasonality of the data, we use two lags in the estimation
model [5]. The results of a stability test presented in Figure A1 in the appendix show that all

Variable Description Min Mean SD Max

PD Probability of default 0.09 0.15 0.03 0.22

Y Logistic transformation of default rate 2.29 1.77 0.25 1.27
UR Unemployment rate (percent) 9.50 11.38 1.23 14.60
GDPR GDP growth (percent) 6.60 2.93 4.20 12.34
Table 1. ER Growth of real Exchange rate (percent) 13.9 0.35 7.74 32.88
Descriptive statistics, IR Inflation rate (percent) 7.20 18.12 8.60 42.00
2004–2016 Source(s): Central Bank of Iran, Statistical Center of Iran, authors’ calculations

GDP growth
Inflation rate
Unemployment rate
Growth of real exchange rate
40
30
20
10
0

Figure 1.
-10

Trends of
macroeconomic 2005 2007 2009 2011 2013 2015
variables (%), 2004:Q1- Year
2016:Q2
Source(s): Central Bank of Iran and authors’ calculation
roots are inside the unit circle and, therefore, the estimated model is stable. An F-statistic Macroeconomic
confirms the significance of all four regressions. shocks and
To link the macro model to the credit risk factor, we estimate the quantile regression as
specified in (4). We also run a linear model used in the literature to compare the results with
credit risk
the quantile model. Table 3 provides the results of the linear model and quantile regressions stress
for the 10%, 50 and 90% quantiles. The coefficients have the expected signs for all variables
in both models but their levels of significance differ. The Jarque–Bera test results also
indicate that the hypothesis of normal distributions cannot be rejected at 5 percent
significance level and the Durbin–Watson test result leads us to reject the presence of
autocorrelation in residuals.
The unemployment rate is positively related to the probability of default as it provides a
measure of the income state of households. Higher unemployment implies less disposable
income which in turn indicates borrowers are more likely to default on their debts. GDP
growth indicating the state of economy is inversely related to the default probability. Higher
GDP growth suggests that the economic outlook is favorable leading to greater confidence in
the economy and increasing economic activities. Therefore, when borrowers are in better
financial positions, loan default decreases, but when GDP growth declines, borrowers are
more likely to default due to adverse economic conditions.
The inflation rate is positively related to loan default, although the effect is not significant
statistically. Generally, the relationship between the inflation rate and the credit risk is

Variables UR GDPR ER IR

Cons 0.027 (0.832) 0.007 (0.941) 0.047 (0.050) 0.008 (0.884)

UR (t–1) 0.433 (0.002) 0.034 (0.744) 0.024 (0.326) 0.101 (0.008)
GDPR (t–1) 0.096 (0.098) 0.421 (0.006) 0.092 (0.008) 0.059 (0.496)
ER (t–1) 0.051 (0.744) 0.099 (0.033) 0.966 (<0.001) 0.030 (0.087)
IR (t–1) 0.259 (0.015) 0.363 (0.007) 0.031 (0.292) 0.982 (<0.001)
Dummy (t-1) 0.48 (0.69) 1.66 (0.6) 7.86 (0.000) 0.54 (0.000)
UR (t–2) 0.14 (0.038) 0.397 (0.052) 0.25 (0.09) 0.69 (0.05)
GDPR (t–2) 0.03 (0.59) 0.05 (0.87) 0.02 (0.78) 0.05 (0.71)
ER (t–2) 0.03 (0.27) 0.56 (0.064) 0.31 (0.086) 0.69 (<0.001)
IR (t–2) 0.042 (0.2) 0.15 (0.062) 0.027 (0.77) 0.486 (<0.001)
Dummy (t-2) 0.15 (0.91) 5.1 (0.18) 0.96 (0.55) 0.1 (0.97)
R2 0.4 0.6 0.86 0.93
Adj. R2 0.27 0.52 0.83 0.91 Table 2.
F-stat 3.26 7.002 30.97 68.3 VAR model estimation
p-value 0.0006 <0.0001 <0.001 <0.001 results

Variables Linear QR (t 5 0.1) QR (t 5 0.5) QR (t 5 0.9)

Cons 2.193*** 3.259*** 1.675*** 1.806***

UR 0.055* 0.006 0.012* 0.058**
GDPR 0.022* 0.005 0.020* 0.021**
ER 0.012*** 0.001 0.013** 0.017***
IR 0.0044 0.014* 0.005 0.001 Table 3.
Note(s): Asterisks denote significance: *** 0.001 ** 0.01 * 0.05. Dependent variable (y) is the logit Estimation results:
transformation of an observable credit risk variable (PD). OLS R2 5 0.61, Adj. R2 5 0.55, F-stat. 5 15.977, linear and quantile
p-value ≤ 0.001 regression models
JES ambiguous. A higher inflation rate leads to a reduction in the real value of the debt repaid in
the future and an increase in the value of real assets, but it is also likely to diminish the
resources available for those with fixed incomes and little savings characterizing many
Iranian households. However, while the overall effect of inflation on loan default depends on
these three forces, the positive effect we identify implies that the effect of inflation in reducing
the resources available for households is stronger.
The estimated coefficient of the real exchange rate is negative and significant. As
discussed in the previous section, the impact of exchange rate on credit risk could take
different directions. Therefore, our result implies that the negative forces of the depreciation
of exchange rates overweight its positive effect on the default probability. Increasing the
exchange rates leads to fewer loan defaults in a number of ways. A depreciation of the
domestic currency improves Iran’s trade balance and, therefore, lowers the loan default
probability. It also leads to an increase in the oil-exports revenues, a main source of
government income, which enables the government to repay its debts to the households and
businesses, putting them in a better position to repay their loans.
Our results are overall consistent with those reported in literature of macroeconomic
impacts on credit risk. For instance, using Iranian data, Noroozi (2015) reports that
unemployment rate and inflation rate are positively correlated and GDP growth is negatively
correlated with credit risk and Hemati et al. (2010) show that the credit risk decreases with the
level of GDP and inflation rate but increases with the GDP growth. In other studies, Francisco
et al. (2012) find that unemployment rate distress produces the most harmful effect, whereas
distressed inflation and interest rate have higher impacts at longer periods. Simons et al.
(2009) also show that there is a significant relationship between GDP growth and oil price
and, to a lesser extent, interest rate and exchange rate with the probability of default. The
results of Deming et al. (2018) also indicate that unemployment rates are positively related to
auto loan defaults.

4.3 Stress test results

4.3.1 Probabilities of default. We first introduce a shock to each of the macroeconomic
variables by one, two, and three standard deviations. The results are reported in Table 4.
We impose the same univariate shocks on the model to compare the effect of different factors
on the loss distributions. Shocks to the unemployment rate, inflation rate and growth of real
exchange rate are defined as positive shocks and to GDP growth negative shocks, mainly
because Iran’s economy has experienced big negative GDP shocks in recent years.
Figure 2 shows the upper tails of the cumulative distribution of the default probabilities
under the baseline scenario (no shocks) and the one-standard deviation shock scenario,
representing a not worst-case scenario for the Iranian economy. The results of the linear
model are not significantly different from the 50% quantile, but they are for the 10% and 90%
quantiles, suggesting that the linear model overestimates the effects of shocks at the 10%
quantile and underestimates them at the 90% quantile. Comparing the CDFs for each shock,
excluding inflation rate, with the baseline scenario CDF indicates that the effect of shocks in
QR (10%) is less than that in QR (90%). This implies that the lower the probability of default
is, the less devastating effects economic shocks will have.

Scenario UR GDPR ER IR

Last obs. (2016: Q2) 12.7 8.25 4.36 9

One-std. dev. shock 9.7 52 177 96
Table 4. Two-std. dev. shock 19 103 355 193
Stress testing scenarios Three-std. dev. shock 29 156 532 289
 CDF, shock: unempolyment rate CDF, shock: GDP growth

0.95
0.95
wilson wilson
QR(0.1) QR(0.1)
QR(0.5) QR(0.5)

F(PD)
F(PD)

0.85
0.85
QR(0.9) QR(0.9)

0.75
0.75
0.10 0.15 0.20 0.25 0.10 0.15 0.20 0.25
PD PD

CDF, shock: exchange rate CDF, shock: Inflation Rate

0.95
0.95
wilson wilson
QR(0.1) QR(0.1)
QR(0.5) QR(0.5)

F(PD)
F(PD)
QR(0.9)

0.85
0.85
QR(0.9)

0.75
0.75
0.05 0.10 0.15 0.20 0.10 0.15 0.20 0.25
PD PD

CDF, Baseline scenario

0.95
wilson
QR(0.1)
QR(0.5)

F(PD)
QR(0.9)

0.85
0.75
0.10 0.15 0.20
PD
Note(s): All scenarios comprise one - std. dev. shock for each variable using Linear model
and QR (10%), QR (50%) and QR (90%)
credit risk
shocks and
Macroeconomic

Figure 2.

using linear and QR

distribution upper tails

estimates
PD cumulative
stress
JES 4.3.2 Expected and unexpected credit losses. In the next step, using the estimated probability
of default above, we calculate the expected and unexpected losses resulting from credit risk under
the different scenarios. To estimate the economic capital (EC), the capital required to cover
unexpected losses, we take the difference between the value at risk at a given confidence level and
the expected losses. Given that the probability of default is simulated for a one-year time horizon,
the loss distribution also corresponds to the same time period.
The results in Table 5 show that the loss distributions for all scenarios are skewed to the
right. The amount of loss at the 50% quantile is close to the linear model, but unlike those at
the 10 and 90% quantiles. In fact, the QR (90%) model generates a requirement for economic
capital that is considerably higher than those generated by the linear model, and the QR
(10%) model estimates are less than those generated by the linear model. For example, under
the GDP growth shock, the predicted EC by the linear model is about US$5,050 million, which
is greater than US$4,296 million implied by QR (10%) and less than US$5,448 million
estimated by QR (90%).
All distressed scenarios, excluding the growth of real exchange rate scenario, involve
greater loss than the baseline scenarios. The reason is the negative effect of the exchange rate
on the probability of default. Comparing the unexpected losses in the distressed scenarios and
the baseline scenario using the linear model, a GDP growth shock is the most influential factor
on credit risk followed by the exchange rate shock. QR (90%) and QR (50%) also largely
confirm these findings. It is also worth noting that the unexpected losses are considerably
greater than the expected losses. Although unexpected losses are less likely, their large
magnitudes suggest that banks should maintain higher level of capital to cover any
unexpected losses.
As noted earlier, one-standard-deviation shock scenarios do not exemplify the worst
possible economic situation in Iran. In fact, in recent years, the Iranian economy has
experienced three-standard deviation shocks to the unemployment rate, GDP growth and
exchange rate and one-standard-deviation shocks to the inflation rate. Here, we reflect these
empirical realities and perform stress tests based on the following historical scenarios.

Linear QR (10%) QR (50%) QR (90%)

UR VaR 6,741 5,783 6,248 7,425

ES 7,236 6,257 6,686 7,999
Expected loss 2,128 1770 1940 2,417
Unexpected loss 4,612 4,013 4,308 5,008
GDPR VaR 7,492 6,248 7,221 8,133
ES 8,088 6,710 7,814 8,647
Expected loss 2,441 1952 2,344 2,685
Unexpected loss 5,050 4,296 4,877 5,448
ER VaR 5,962 5,746 5,634 6,446
ES 6,397 6,187 6,126 6,914
Expected loss 1846 1782 1757 2019
Unexpected loss 4,117 3,965 3,877 4,427
IR VaR 6,856 6,327 6,713 7,525
ES 7,327 6,792 7,206 8,094
Expected loss 2,162 1982 2,119 2,454
Unexpected loss 4,694 4,345 4,594 5,071
Baseline VaR 6,479 5,798 6,221 7,209
Table 5. ES 6,947 6,221 6,652 7,790
Credit losses under Expected loss 2028 1791 1928 2,338
baseline and Unexpected loss 4,451 4,007 4,293 4,871
alternative stress Note(s): The difference between VaR and expected loss is unexpected loss, which then serves as an estimate of
scenarios economic capital. Figures are in millions of USD
 (1) Unemployment rate shock: An increase in the unemployment rate by 30% as Macroeconomic
observed in 2007: Q3. shocks and
(2) GDP growth shock: A fall in GDP growth by 150% as observed in 2011. credit risk
(3) Exchange rate shock: An increase in the growth of real exchange rate by 340% as stress
observed in 2011: Q4.
(4) Inflation rate shock: A rise in the inflation rate by 100% as observed in 2012: Q1.
A Monte Carlo simulation with 10,000 simulation steps is run for each of the scenarios to
determine the loss distribution and calculate the capital requirements banks should maintain.
Table 6 presents the calculated EC requirements, which is the minimum amount of capital
banks must hold to remain resilient to shocks.
Overall, the EC requirements in case of the shocks to unemployment rate and the GDP
growth are greater than those in the baseline scenario. However, the difference is more
pronounced in the upper tails. In QR (90%), the GDP growth shocks require higher EC,
followed by the unemployment rate, inflation rate, and the real exchange rate shocks. The
capital requirement in the inflation shock scenario is close to that in the baselines scenarios,
implying that inflation shocks do not lead to effective credit losses in the Iranian banking
industry. This may be a result of two competing forces: An increase in the value of real assets
and a decrease in the resources available to families with fixed incomes. The first factor leads
to a reduction in credit losses but the second factor to an increase in credit losses. Nonetheless,
the inflation rate yields different impacts depending on the type of regression. Although the
EC estimated by the linear model and QR (50%) is about US$4,694 million, it is about
US$4,345 million by QR (10%) and about US$5,071 million by QR (90%).
As discussed, if a positive shock to the real exchange rate growth occurs, probability of
default decreases and banks will need to hold considerably less capital compared to the
baseline scenario. While we estimate the EC required for the Iranian banking industry to be
US$4,451 million in the baseline scenario, it is consistently less than that in the linear model
and all quantiles regressions. Overall, our results indicating the importance of applying a
nonlinear model to estimate the losses due to sever shocks to macro variables are in line with a
few studies using the nonlinear models such as Allen et al. (2010), Ricardo and Wanger (2011)
and Francisco et al. (2014).

5. Conclusion
In this paper, we analyze the credit risk stress test and estimate credit loss distributions to
calculate the minimum capital requirement that banks should hold to absorb macroeconomic
shocks in Iran. In the first step, we estimate the relationship between the selected
macroeconomic variables using a VAR model. The output of this stage is the macro scenarios,
which are then fed into an equation linking the probability of default with macroeconomic
variables. We simulate the path of default probability using the Monte-Carlo method under

Linear(OLS) QR (10%) QR (50%) QR (90%)

UR 4,877 3,816 4,801 5,290

GDPR 5,868 4,719 5,822 6,123
ER 3,338 3,886 3,174 3,259 Table 6.
IR 4,694 4,345 4,594 5,071 Economic capital
Baseline 4,451 4,007 4,293 4,871 under baseline and
Note(s): Figures are in millions of USD stress scenarios
JES different scenarios for macroeconomic shocks. To address the possible nonlinearity of the
shock effects, we use a quantile regression model to estimate the probability of defaults. In the
last step, we calculate the loss distribution of the portfolio and estimate the capital
requirement under the baseline and stress scenarios. The unexpected loss is measured as the
difference between the VaR and expected loss (the expected value of the loss distribution).
A key aspect of stress testing is scenario selection. Stress scenarios should clearly include
extreme yet plausible events. We first simulate scenarios with one-standard-deviation shocks
to compare the results of the shocks to macroeconomic variables on credit losses. We then
perform stress tests based on historical scenarios that have already taken place in the Iranian
economy in recent years and estimate the EC.
The results show that the unemployment rate and inflation rate are positively correlated
with the default rate, but only the former is statistically significant. In contrast, GDP growth
and the growth of real exchange rate are negatively and significantly related to the probability
of loan defaults. Comparing the horizontal distances between CDFs for the impact of each of the
shocks on the probability of default, we find that the results of the linear model are very similar
to those of QR (50%) but very different to those of QR (10%) and QR (90%). This difference
expresses the fact that the linear model overestimates the effects of shocks on probability of
default at the 10% quantile and underestimates them at the 90% quantile. A comparison
between the shock effects in different levels of default probabilities and the baseline scenario
also indicate that the effect of shocks in QR (10%) is less than that in QR (90%). That is, the
lower the probability of default is, the less devastating effects economic shocks will have.
The results further show that the loss distributions for all scenarios are skewed to the
right. The amount of loss for QR (50%) is closest to the linear model but losses for QR (10%)
and QR (90%) are different. In fact, QR (90%) generates a requirement for EC that is
considerably higher than that generated by either model. Comparing unexpected losses in the
baseline and distressed scenarios for the linear and quantile models, we show that a GDP
growth is the most influential factor for credit risk in Iran, followed by the unemployment rate
and the growth of real exchange rate. The inflation rate has the least effect on loan losses.
Our results have important policy implications for fiscal and monetary authorities. Since
the macro shocks; such as extreme changes in GDP growth, unemployment rate, and
exchange rates; have significant negative impacts on banking system exacerbating the
economic conditions and prolonging the downturn, effective macroeconomic management to
avoid those shocks and to prepare the economy to absorb them is critical. For instance, in
many developing oil-exporting countries including Iran, economic activities are highly
correlated with the volatile oil revenues. The governments in those countries also adopt the
price and exchange rate control policies to curb inflation rate. These policies cause distortions
in relative prices and often lead to big jumps in controlled prices and macroeconomic
instability, increasing risks in financial and banking sectors. Adopting a long-run policy
towards diversification of the economy and the short- and medium-run fiscal and monetary
policies to counter the cyclical changes in oil prices would help avoid the negative impacts of
the external shocks to the economy and the banking system. Moreover, building macro
models to generate early warning about the shocks and their impacts on banking system
would help policymakers to be better prepared and respond more effectively to the shocks.
Given the social implications of the banking crisis, banks should also be required to assess
their resilience to the shocks by having a detailed and comprehensive plan for stress testing
and estimating the minimum capital required to deal with such shocks.
There are some caveats to consider in our research results. First, we only focus on credit
risk because of limitations on the data availability and the fact that credit risk is a significant
problem facing the Iranian banking sector, which has not previously been addressed in the
literature. Furthermore, the biggest losses imposed on banks are typically those associated
with credit risk and, therefore, the EC requirement for this type of risk is expected to be
significant. However, the banking system continues to suffer from losses caused by other Macroeconomic
risks such as market risk and operational risk. For this reason, our estimated capital shocks and
requirement to be held by the banks can be thought of as the minimum needed to cover only
credit risk. Second, as the values of some parameters in our analysis are determined
credit risk
randomly, the accuracy of the estimates may have been reduced. Accordingly, as future work, stress
one can assess the aggregate EC using a risk aggregation approach and a panel data (not
presently available), which could further improve the accuracy of the estimates.

Notes
1. Iran’s current macroeconomic problems, including high inflation rates, have been exacerbated
following the resumption of sanctions by the US and its unilateral exit from the G5þ1 nuclear
agreement with Iran in mid-2018. Our study, however, does not include this most recent
development.
2. Economic Indicators of Central Bank of Iran (www.cbi.ir).
3. Only a few banks have recently joined the stock market and the balance sheet and the financial data
on many banks are still not publicly available.
4. To save space, the regression results used to select the variables are not reported here but they are
available upon request.
5. We also run the model with one lag, but the main results remained unchanged.

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Appendix

Levels Growth
ADF PP ADF PP

GDPR 0.050 0.049 0.000 0.000

IR 0.016 0.250 0.001 0.014
ER 0.009 0.020 0.000 0.000
UR 0.170 0.003 0.026 0.000
Note(s): Figures shown are p-values. ADF: Augmented Dickey-Fuller, PP: Phillips-Perron. All variables Table A1.
excluding unemployment rate are not stationary in levels Unit root tests

PD GDPR IR ER UR

PD 1.000 0.164 0.137 0.329 0.210

GDPR 0.164 1.000 0.598 0.487 0.154
IR 0.137 0.598 1.000 0.237 0.222
ER 0.329 0.487 0.273 1.000 0.083 Table A2.
UR 0.210 0.154 0.222 0.083 1.000 Correlation matrix

Optimal lag 1 2 3 4 5

Akaike 4 5.89 5.48 5.52 5.09 5.10

Hannan–Quinn 2 6.19 6.02 6.30 6.11 6.36 Table A3.
Schwarz 1 6.70 6.93 7.61 7.82 8.48 Lag length selection
FPE 4 363.54 246.11 268.20 189.90 225.02 criteria
 JES

VAR model
Figure A1.

stability test
OLS-CUSUM of equation gdpr OLS-CUSUM of equation ER1

0.0 0.5 1.0

0.0 0.5 1.0

-1.0

-1.0

Empirical fluctuation process

Empirical fluctuation process
0.0 0.2 0.4 0.6 0.8 1.0 0.0 0.2 0.4 0.6 0.8 1.0
Time Time

OLS-CUSUM of equation UR OLS-CUSUM of equation dummy

0.0 0.5 1.0

0.0 0.5 1.0

-1.0
-1.0

Empirical fluctuation process

Empirical fluctuation process
0.0 0.2 0.4 0.6 0.8 1.0 0.0 0.2 0.4 0.6 0.8 1.0
Time Time

OLS-CUSUM of equation IR

0.0 0.5 1.0

-1.0
Empirical fluctuation process
0.0 0.2 0.4 0.6 0.8 1.0
Time
 Scenario Macroeconomic
shocks and
Macroeconometric credit risk
External shocks model (VAR) stress

Model
Model linking macro and banking
variables
(Linear and Quantile Regression)

Stressed PDs
Hypotheses
on LGD and
VaR and Stressed EL EAD
Outcome
using simulation

Figure A2.
The structure of macro
stress-testing
Impact on credit risk
capital

Corresponding author
Saeed Moshiri can be contacted at: smoshiri@stmcollege.ca

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