How do I design a credit stress test for FRM Part II?

Question

AcadiFi · Accepted Answer

Credit stress testing subjects a portfolio to adverse macroeconomic scenarios and measures resulting losses. The CCAR framework used by the Fed illustrates best practice.

Four-step approach:

(1) Define scenarios: baseline, adverse, severely adverse. Severely adverse typically includes GDP contraction of 8%, unemployment spiking to 10.5%, commercial real estate prices falling 35%, equity markets dropping 55%, ten-year Treasury at 1.2%.

(2) Map macro variables to credit drivers: regression of default rates and LGDs against macro variables over historical windows. Coriolis Commercial Bank's residential mortgage portfolio might show PD = 0.4% + 0.12 * unemployment_shock + 0.08 * HPI_decline.

(3) Project nine-quarter loss trajectory: apply scenario paths to stressed PDs and LGDs. For $45B residential portfolio under severely adverse, cumulative nine-quarter losses might reach $2.1B versus $450M baseline.

(4) Assess capital adequacy: project post-stress CET1 ratio. Starting CET1 of 12% with $110B RWA, losses of $2.1B plus other shocks reduce CET1 capital to $11.1B. If RWAs rise to $125B under stress, ratio falls to 8.9%, still above 4.5% minimum plus buffers.

Reverse stress testing flips the question: what scenario causes capital to breach the minimum? Solving backwards identifies vulnerability concentrations. Also consider idiosyncratic overlays like top ten counterparty defaults, legal settlement shocks, and operational event tails. EBA guidelines require banks to document methodology, use, limitations, and board-level oversight.

How do I design a credit stress test for FRM Part II?

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