Financial Institute Stress Testing on Credit Risk
Stress Testing on Credit Risk
Covers the background and terminologies involved in stress testing on credit risk
Many of us still remember how the 2008 Subprime Mortgage Crisis reshaped the world financial systems. During the crisis, several major financial institutions ended up either bankrupted or bailed out by governments.
As a reponse to the crisis, in 2011, Basel III was published, which requires banks to maintain proper leverage ratios and keep certain levels of reserve capital on hand. Meanwhile, governments around the world also took steady steps to strengthen the regulatory on risk reporting in the financial sector. For example, the Federal Reserve now conducts two types of stress testing annually: Comprehensive Capital Analysis and Review (CCAR) and Dodd-Frank Act supervisory stress testing (DFAST).
There are various risk that a financial institute need to control, including market risk, operation risk, and credit risk. Market risk refers to the change in the portfolio value due to the changes of market risk factors, such as interest rate, foreign exchange rate, and stock prices. Operation risk mostly summarizes the human error risk. Credit risk refers to the possible loss resulting from the failure of…
