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Abstract
For a given set of banks, how big can losses in bad economic or financial
scenarios possibly get, and what are these bad scenarios? These are the
two central questions of stress tests for banks and the banking system.
Current stress tests select stress scenarios in a way which might leave
aside many dangerous scenarios and thus create an illusion of safety;
and which might consider highly implausible scenarios and thus trigger
a false alarm. We show how to select scenarios systematically for a
banking system in a context of multiple credit exposures. We demon-
strate the application of our method in an example on the Spanish and
Italian residential real estate exposures of European banks. Compared
to the EBA 2016 stress test our method produces scenarios which are
equally plausible as the EBA stress scenario but yield considerably
worse system wide losses.
∗
This is a revised version of the working paper “Systematic Systemic Stress Tests”,
Oesterreichische Nationalbank, WP 225. Supported by the Jubiläumsfonds der Oester-
rreichischen Nationalbank, Grant No. 17671.We are grateful to Martin Jandačka for
computational support. Mathematica notebooks with the calculations for Sections 3 and 5
are available from the authors.
†
Thomas Breuer, University of Applied Sciences Vorarlberg, Research Centre
for Business Informatics, Hochschulstraße 1, A-6850 Dornbirn, Austria, E-mail:
thomas.breuer(AT)fhv.at, Tel: +43-5572-792-7100, Fax: +43-5572-792-9510.
‡
Martin Summer, Oesterreichische Nationalbank, Economic Studies Division, Otto-
Wagner-Platz 3, A-1090 Wien, Austria, E-mail: martin.summer(AT)oenb.at, Tel: +43-1-
40420-7200, Fax: +43-1-40420-7299
1
1 Introduction
Stress testing of banks is a form of economic and financial scenario analysis
with two key questions: How severe can losses in adverse scenarios be?
Which plausible scenarios lead to losses that are able to substantially impair
a bank or the financial system? An answer to these two questions requires
identifying dangerous scenarios in a systematic way, and evaluating potential
losses in that scenario.
We claim that current stress testing methodologies need to be improved
because they fail in systematically identifying dangerous and plausible sce-
narios. We propose an approach which delivers a systematic identification of
plausible stress scenarios.
We believe that systematic scenario identification is one methodological
aspect of stress testing that should have a high priority in improving current
stress testing methods. Current stress testing methods concentrate mainly
on loss evaluation. Stress scenarios are selected in an involved and opaque
bureaucratic process, which is often highly politicised. The outcome consists
of one or two stress scenarios. Then a complex loss evaluation procedure
follows, involving supervisors as well as banks to find out the amount of
potential impairments in these two scenarios.
Proceeding in this way the stress test may leave aside other more danger-
ous scenarios, and so create an illusion of safety. It also bears the danger of
considering scenarios which are very implausible. This may create a false
sense of alarm.
Our paper is mainly related to the literature on quantitative risk manage-
ment (McNeil et al. [2015]), coherent risk measures (Artzner et al. [1999]),
model risk (Studer [1999], Breuer and Csiszár [2013], Breuer and Csiszár
[2016]), and reverse stress testing (Glassermann et al. [2015], Flood and
Korenko [2015]). Our paper takes a slightly different perspective in that it
deals with stress tests of a banking system, not of individual banks.
The literature on quantitative risk management is mainly focused on
statistical risk measurement. There the question is: What is the probability of
big losses and how much capital is needed to make this probability sufficiently
small? By contrast, in a stress test we ask: Which are the scenarios that
lead to big losses? The answer to the stress testing question suggests risks
reducing actions. Our paper is related to the coherent risk measure literature
because our procedure of systematic scenario selection builds on a coherent
risk measure. For our approach to scenario selection we need the concept of
a generalized scenario, which builds on various contributions to the literature
on model risk. In contrast to the reverse stress testing literature, which
usually starts from a given hypothetical loss and asks which are the most
plausible scenarios generating this loss, we look for the stress scenarios in
a different way. In reverse stress testing, the loss level is an input and one
searches for the most plausible scenario achieving this loss level. In our
2
approach, the plausibility is a constraint and one searches for the worst
expected loss satisfying the constraint.
Our paper is also related to the various efforts by stress testing practi-
cioners of developing modern stress testing frameworks, such as the Compre-
hensive Capital Analysis and Review Process (CCAR), the Dodd-Frank-Act-
Stress Tests (DFAST), the Stress tests of the European Banking authority
(EBA) or the stress testing framework of the Bank of England and other
major central banks.
The paper is organized as follows. Section 2 introduces the basic concepts
of stress testing and discusses a useful generalisation of the concept of a
scenario. In that section we also describe our proposal for finding stress
scenarios in a systematic way. Section 3 presents a discrete and a continuous
model of credit risk for one exposure. In Section 4 these models are extended
to multiple exposures and a multivariate framework, for an application to
systematic system-wide stress tests. Section 5 develops an example on
European loan exposures to the residential Spanish and Italian real estate
markets using public bank exposure data from the EBA 2016 stress test as
well as other public data. Section 6 concludes.
3
considered might be so implausible that they should not guide action. A
stress test is systematic if it is based on a quantification of scenario plausibil-
ity. Ideally it would consider all scenarios whose plausibility is above a given
threshold.
4
From the range of possible distances we choose relative entropy because it
appears the most versatile with many applications in statistics, information
theory, and statistical physics. Relative entropy balls are a popular choice
for describing model uncertainty in portfolio selection, asset pricing, and
contingent claim pricing, see e.g. Friedman [2002], Calafiore [2007], Hansen
and Sargent [2008].
Systematic search for the worst case scenario A real valued random
variable on the sample space Ω, the payoff function X, describes how risk
factors impact the portfolio payoff at some given future time horizon. We
admit as plausible enough all distributions for which the relative entropy
from P0 does not exceed some threshold k > 0. The systematic stress test
procedure searches for the worst expected value of the portfolio among the
sufficiently plausible alternative scenarios:
inf EQ (X). (1)
Q:D(Q||P0 )≤k
5
Explicit form of the worst case scenario We report the solution to
problem (1) from Breuer and Csiszár [2013]. A key tool is the G-function,
defined as Z
θ2 X(r)
G(X, θ2 ) := log e P0 (dr) , (2)
Ω
where θ2 is a negative real number. The G-function is not a separate input
to our approach. Rather, G is calculated from P0 and X. The G-function is
determined by the additional requirement that the distributions of the expo-
nential family, exp(θ2 X(r) − G(θ2 )), should be normalised. This requirement
implies (2). This requirement is important because the distributions of the
exponential family turn out to be the worst case distributions, see (4) below.
In standard situations the solution to Problem (1) has the typical form
given below. (In other, more pathological cases, explicit solutions are also
available, see Breuer and Csiszár [2013]. But this is not needed for the
present purpose.) The equation
θ2 G0 (θ2 ) − G(θ2 ) = k (3)
has a unique negative solution θ2 . The worst case distribution Q solving (1)
is the distribution with P0 -density
dQ
(r) := eθ2 X(r)−G(θ2 ) . (4)
dP0
The minimal expected payoff achieved by the worst case distribution Q is
EQ (X) = G0 (θ2 ). (5)
This machinery for finding worst case scenarios works for normal reference
distributions, for more general elliptical distributions, but with arbitrary tail
shape and dependence structure, and also for discrete distributions.
6
Discrete model The space Ω consists of the two states ‘default’ and ‘non-
default’. The estimated distribution P0 assigns the probabilities p and 1 − p
to these states. The payoff function X takes the value f − lf for the state
‘default’ and f for the state ‘non-default’.
In this example, the function G(θ2 ) of (2) equals
For a given k > 0, θ2 results from numerically solving eq. (3) for θ2 , which
takes the form
7
in agreement with (6). The worst case distribution of (4) is
dQ exp(f − lf 1(−∞,K) (r))
(r) = (12)
dP0 p exp(θ2 f (1 − l)) + (1 − p) exp(θ2 f )
Its density is plotted in the centre pane of Fig. 1.
For k = 0.1 the numerical solution to (3) is θ2 = −3.0659. The worst
expected payoff at the plausibility level k = 0.1 equals 0.922 (compared
to 0.9775 under the reference PD). Whereas the reference payment ability
distribution P0 results in the estimated PD of p = 5%, the worst case payment
ability distribution implies a PD of p = 17.3%. (This is the probability mass
of the worst case distribution up to the threshold K.)
The mean of the worst case repayment ability distribution equals -0.267
compared to zero for the reference repayment ability distribution P0 . This
shift of the mean is apparent in the centre pane of Fig. 1, where the blue
worst case distribution has more probability mass to the left.
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0.3
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1.0
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0.1 0.5
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��� ���-��� ��� ���-��� -4 -2 -1.0 -0.5 0.5 1.0 1.5 2.0
Figure 1: Left: Estimated (red) and worst case (blue) probabilities of default and
of non-default. Centre: Density of normal reference distribution P0 (red) and worst
case distribution Q (blue) of the repayment ability of the borrower. Right: Density of
lognormal reference distribution P0 (red) and worst case distribution Qbar (blue) of
the repayment ability of the borrower.
8
dQ exp(f − lf 1(−∞,K) (r))
(r) = (13)
dP0 p exp(θ2 f (1 − l)) + (1 − p) exp(θ2 f )
Its density is plotted in the right hand pane of Fig. 1. The expected payoff
achieved by the worst case distribution Q coincides with (9).
For k = 0.1 the numerical solution to (3) is θ2 = −3.0659. The worst
expected payoff at the plausibility level k = 0.1 equals 0.922 (compared
to 0.9775 under the reference PD). Whereas the reference payment ability
distribution P0 results in the estimated PD of p = 5%, the worst case payment
ability distribution implies a PD of p = 17.3%. (This is the probability mass
of the worst case distribution up to the threshold K.) The density of the worst
case distribution is plotted against the density of the presently estimated
distribution P0 in the right hand pane of Fig. 1.
The mean of the worst case repayment ability distribution equals 1.45
compared to 1.65 for the reference repayment ability distribution. Again we
observe the shift of the mean, caused by the shift probability mass to regions
of low payoff.
9
Multiple exposures Stress scenarios as those applied by the EBA often
use a series of PDs for different exposures. Such a list of PDs for different
exposures (p1 , p2 , . . . , pn ) does not describe directly a distribution since the
pi in general do not sum up to one. Therefore such a list of PDs does not
lend itself directly to the approach of worst case distributions. This approach,
described in Section 2, is formulated in terms of distributions, see (1).
One way to translate (p1 , p2 , . . . , pn ) into a distribution is to consider an
n-dimensional distribution with the two possible values {default, no default}
in each dimension taken with probabilities pi and 1−pi . The set Ω of possible
outcomes is given by all 0-1-sequences of length n, where 0 denotes no default
and 1 denotes default of an exposure. The outcome set Ω is n-dimensional
and has 2n elements.
An alternative way to translate (p1 , p2 , . . . , pn ) into a distribution refers
to macroeconomic drivers of default and reduces the number of dimensions as
far as desired and justifiable. It extends the continuous model of Section 3 to
multiple exposures. In order to translate (p1 , p2 , . . . , pn ) into a distribution
we proceed in two steps.
1. Sort the exposures by their PDs, starting from the smallest, so that
0 < ps(1) ≤ ps(2) ≤ ps(n) < 1. (Define ps(0) := 0 and ps(n+1) := 1.)
Given two sequences of PDs, (p1 , p2 , . . . , pn ) and (q1 , q2 , . . . , qn ), one can now
calculate the relative entropy of their increment sequences D(d(q)||d(p)).
This is a discrete model for multiple exposures.
If the PDs are to be considered as driven by a macroeconomic variable, one
takes the inverse of the cumulative distribution function of the macroeconomic
driver at the points ps(i) to get a series of default thresholds Ks(i) . The
PD increments can then be written as d(p)i := CDF(Ki ) − CDF(Ki−1 ) for
i = 1, . . . , n + 1. This is a continuous model for multiple exposures.
In both the continuous and the discrete one-dimensional models of mul-
tiple exposures, not all sequences of PDs can be recovered from varying
the increments resp. the probability mass between the thresholds. These
variations preserve the order s of PDs of the exposures. PD sequences with
a different order are not considered. Information is lost in the dimension
reduction.
10
point r ∈ RN . In each variable, the exposures i for which ri < Kin default.
So Rn is composed of (I + 1)N N -dimensional rectangles, in each of which the
same exposures default. The the payoff function is constant on each rectangle.
The worst case distribution changes the probabilities of the rectangles.
In the normal and lognormal examples of Section 3 we had N = 1
macroeconomic driver and I = 1 exposure. The rectangles were given by
two intervals separated by the default threshold K. In the EBA example of
Section 5 we have N = 2 macroeconomic drivers and I = 23 exposures.
4. We take the plausibility of the EBA stress scenario with respect to the
EBA baseline scenario to be the relative entropy D(P ∗ ||Q∗ ).
11
are organized into an asset structure broken down by country exposures in
different exposure categories along the lines of Cont and Schaanning [2016].2 .
The size of the exposures are given in columns 2 and 3 of Table 1.
In our model of credit risk for residential mortgages, which is a firm
value or threshold model (see McNeil et al. [2015]), we choose Spanish
and Italian house price indices from the the property price statistics of
the BIS3 as risk factors. The means of the Spanish and Italian residential
price index are estimated at 241.3 resp. 155.01, the covariance matrix is
((16.70, 3.2), (3.2, 2.23)).
Clearly in reality house prices are not the only (often even not the
decisive) risk factors for credit risk of residential exposures. A realistic model
approximation to the credit risk of European and international residential
exposures taking into account the institutional heterogeneity of mortgage
lending, would need a separate study.
Results of the worst case analysis The results of the worst case analysis
are also shown in Table 1. The last two column give the worst case PDs
resulting from the worst case distribution which has the same relative entropy
to the EBA baseline PDs as the EBA stress PDs have, namely k = 0.0586.
We see that for most banks the worst case PDs are considerably higher than
2
Readers interested in the data details might consult the appendix of Cont and Schaan-
ning [2016]
3
See https://www.bis.org/statistics/pp.htm
4
In EBA terminology the exposures considered were: 4120 - Retail - Secured by real
estate property - Non SME, 4320 - Retail - Other - Non SME, 4700 - Households, 5000 -
Secured by mortgages on immovable property.
12
Exposure Exposure PD-ES- PD-IT PD-ES PD-IT PD-ES PD-IT
ES IT EBA EBA EBA EBA worst worst
[mill. e] [mill. e] baseline baseline stress stress case case
Table 1: Spanish and Italian residential real estate loan exposures and PDs. Stress
test of EBA bank exposures to the Spanish and Italian residential real estate market.
23 out the 51 EBA banks have an exposure in at least one of these two markets.
Columns 2 and 3 show the size of the exposures. Columns 4 and 5, resp. 6 and 7,
show the EBA baseline PDs and the EBA stress PDs for these exposures. Column
8 and 9 show the PDs of the worst case distribution which has the same relative
entropy to the EBA baseline PDs as the EBA stress PDs have, namely k = 0.0586.
The last line gives the expected total payoff of all exposures: under the EBA baseline
PDs, under the EBA stress PDs, and under the worst case distribution with the same
relative entropy as the EBA stress PDs. Exposures and expected payoffs are given in
units of million EUR.
13
the EBA stress PDs, but for some banks they are lower, in order to remain
at the same overall level of plausibility.
This can also be seen if we visualise the PDs for Bank 1 to Bank 23 in
a plot. Fig. 2 shows the worst case and EBA stress PDs for each of the 23
banks in the Spanish and Italian real estate loan market. For most bank
exposures, worst case PDs are higher than EBA stress PDs—with some
notable exceptions like Banks 10,12, and 15 in Italy. These exposures are
zero. Therefore a lower PD does not impair severity of the stress test results,
but can improve plausibility of the scenario.
The worst case analysis draws a sharper picture of the vulnerability of
bank exposures to the Spanish and Italian residential real estate market.
This is expressed by the expected total payoffs in the last line of Table 1.
Expected total payoffs are considerably lower under worst case PDs than
they are under EBA baseline PDs or EBA stress PDs: 1 334 926 mill. e vs.
1 344 503 mill. e.
In terms of the macroeconomic driver (Spanish and Italian residential real
estate prices) the worst case distribution is no longer a normal, in contrast to
the reference distribution. The situation resembles the centre pane of Fig. 1
but with 23 thresholds instead of one, and with two macroeconomic drivers
instead of one.
6 Conclusion
The methodology of current stress testing is problematic in the way stress
scenarios are chosen. While most research resources in stress testing over
the last ten years have been invested in constructing very detailed models of
portfolio loss functions, and in constructing statistical-econometric models
that translate very broadly formulated macroeconomic scenarios to the
actual risk parameters of portfolios, scenario selection remained an opaque
regulatory process. Methodical issues with regard to scenario selection were
somewhat neglected.
Our paper calls for changing the focus in stress testing on systematic
scenario selection.The reason is that otherwise, stress tests will be weak in
answering the key questions: “Which scenarios lead to big losses?” and “How
big are the worst losses?”.
Specifically we propose to work with generalized scenarios. We argue that
it is useful to think about scenarios as distributions rather than realisations.
This allows for an integrated analysis of market and credit risk at a common
time horizon. Systematic scenario selection is achieved by an appropriate
form of worst case search over plausibility domains. This method finds among
all equally plausible scenarios the scenario leading to the worst expected loss
for any given portfolio.
We believe that our proposal can be implemented in a fairly straightfor-
14
EBA stress and worst case PDs, Spain
Bank 23
Bank 22
Bank 21
Bank 20
Bank 19
Bank 18
Bank 17
Bank 16
Bank 15
Bank 14
Bank 13
Bank 12
Bank 11
Bank 10
Bank 9
Bank 8
Bank 7
Bank 6
Bank 5
Bank 4
Bank 3
Bank 2
Bank 1
0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00% 9.00% 10.00%
PD-ES-worstcase PD-ES-EBAstresss
Bank 23
Bank 22
Bank 21
Bank 20
Bank 19
Bank 18
Bank 17
Bank 16
Bank 15
Bank 14
Bank 13
Bank 12
Bank 11
Bank 10
Bank 9
Bank 8
Bank 7
Bank 6
Bank 5
Bank 4
Bank 3
Bank 2
Bank 1
Figure 2: PDs per bank in Spain and Italy, in the EBA stress scenario (grey bars)
and in the worst case scenario (black bars). For most bank exposures, worst case PDs
are higher than EBA stress PDs—with some notable exceptions like Banks 10, 12,
and 15 in Italy.
15
ward way without drawing on exotic or new data sources. Our example gives
ideas about how such an approach might work in a more or less traditional
top down stress testing setup. We hope that our ideas provide foundations
for future stress tests to become more systematic.
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