Stress testing of credit portfolios in light and heavy tailed-models
Natalie Packham – Frankfurt School of Finance & Management & Michael Kalkbrener – Deutsche Bank AG
As, in light of the recent financial crises, stress tests have become an integral part of risk management and banking supervision, the analysis and understanding of risk model behaviour under stress has become ever more important. We analyse asset correlations, default probabilities and default correlations under stress in a generalised Merton-type credit portfolio setup covering light- and heavy-tailed distributions. It turns out that the model behaviour under stress depends strongly on the heaviness of the tails of the risk factors. For realistic severity levels, stressed PD’s are higher in heavy-tailed models. However, contrary to popular belief, light-tailed models show a higher impact in extreme stress scenarios. We use our results to study the implications for credit reserves and capital requirements under stress.
