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Stress testing retail loan portfolios with dual time dynamics

Stress testing retail loan portfolios with dual time dynamics
Stress testing retail loan portfolios with dual time dynamics
Stress-testing has become an important topic in retail lending since the introduction of the new Basel II guidelines. Here we use a scenario-based forecasting approach developed explicitly for retail lending in order to provide a suitable stress-testing approach. We first decompose the historical vintage performance data into a maturation function of months-on-books, a quality function of vintage origination date and an exogenous function of calendar date. In a second step, the exogenous function is modeled with macroeconomic data or factors representing portfolio management impacts. Stress tests are performed by extrapolating the exogenous function using externally provided scenarios for extreme macroeconomic events. The resulting scenario is combined with the known maturation and quality functions. This process is repeated for each member of a key set of rates, such as default rate, exposure at default and loss given default in the context of Basel II. These key rate forecasts are combined to create total portfolio forecasts and stress tests. This approach is demonstrated in an analysis of the US mortgage markets.
dual-time dynamics, nonlinear dynamics, time series analysis, portfolio forecasting, scenario-based forecasting, retail lending, stress testing, macroeconomic scenarios
43-62
Breeden, Joseph L.
c77fc0aa-b908-4882-8676-f5d188d8a560
Thomas, Lyn
a3ce3068-328b-4bce-889f-965b0b9d2362
Breeden, Joseph L.
c77fc0aa-b908-4882-8676-f5d188d8a560
Thomas, Lyn
a3ce3068-328b-4bce-889f-965b0b9d2362

Breeden, Joseph L. and Thomas, Lyn (2008) Stress testing retail loan portfolios with dual time dynamics. Journal of Risk Model Validation, 2 (2), Summer Issue, 43-62.

Record type: Article

Abstract

Stress-testing has become an important topic in retail lending since the introduction of the new Basel II guidelines. Here we use a scenario-based forecasting approach developed explicitly for retail lending in order to provide a suitable stress-testing approach. We first decompose the historical vintage performance data into a maturation function of months-on-books, a quality function of vintage origination date and an exogenous function of calendar date. In a second step, the exogenous function is modeled with macroeconomic data or factors representing portfolio management impacts. Stress tests are performed by extrapolating the exogenous function using externally provided scenarios for extreme macroeconomic events. The resulting scenario is combined with the known maturation and quality functions. This process is repeated for each member of a key set of rates, such as default rate, exposure at default and loss given default in the context of Basel II. These key rate forecasts are combined to create total portfolio forecasts and stress tests. This approach is demonstrated in an analysis of the US mortgage markets.

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More information

Published date: 2008
Keywords: dual-time dynamics, nonlinear dynamics, time series analysis, portfolio forecasting, scenario-based forecasting, retail lending, stress testing, macroeconomic scenarios

Identifiers

Local EPrints ID: 156513
URI: https://eprints.soton.ac.uk/id/eprint/156513
PURE UUID: 9196082b-f360-4f0d-affd-048b108ce575

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Date deposited: 01 Jun 2010 11:24
Last modified: 18 Jul 2017 12:42

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Contributors

Author: Joseph L. Breeden
Author: Lyn Thomas

University divisions

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