Region and Sector Effects in Stress Testing of Commercial Loan Portfolio

The estimation of future loan losses is not only important for financial institutions to effectively control the credit risk of a commercial loan portfolio, but also an essential component in the capital plan submitted for regulatory approval in the annual CCAR and DFAST stress testing. Under the regulatory guidelines, banks must demonstrate in their stress testing methodology that the risk characteristics of a loan portfolio are properly captured at a granular risk-sensitive level to adequately reflect the region and sector effects when incorporating the impact of macroeconomic scenarios. This chapter presents a methodology of estimating the point-in-time (PIT) default probability that can vary according to macroeconomic scenarios and also capture the credit risk at the region and industry sector levels using external rating agency data.