3 The analysis required to determine such a relationship turns directly upon whether the financial distress of one counterparty is likely to impair the ability of other bank counterparties to make good on their liabilities to the bank. As part of the proposed rules, whenever a bank holding company's net credit exposure to an unaffiliated counterparty exceeds 5% of the bank's eligible capital, the bank must determine whether the counterparty is economically interdependent with any of the bank's other unaffiliated counterparties. Related to the first point, the Fed has recently proposed an update to the rules governing SCCLs for US bank holding companies and foreign banking organizations with at least $50 billion in total consolidated assets. Two other regulatory applications include single counterparty credit limits (SCCL) and compliance issues related to the "living will" portion of Dodd-Frank. While the counterparty default scenario that forms the focus of this article is a key regulatory application of CRC, it is not the only one. Regulatory Context: Other Applications of CRC After discussing other regulatory applications of CRC and providing a brief methodology overview, the case study illustrates the effects that different counterparty and systemic risk events could have for a select group of major US banks under alternative paths for the macroeconomy. EDF forecasts under these scenarios, obtained from Stressed EDF, are modified in response to the default of a small set of counterparties in a way that allows credit risk shocks to propagate more strongly when bank interconnectedness is high. Here, I illustrate the use of the Credit Risk Cascades tool via a case study for US financial firms under the CCAR 2016 baseline and severely adverse macroeconomic scenarios. Using a dynamic network model to obtain PD forecasts under the counterparty shock relative to an appropriate no-shock baselineĪdjusting the Stressed EDFs to take into account the network model results Using Moody's Stressed EDF to obtain EDF paths under a user-selected economic scenario This is accomplished with the following techniques: 2 The CRC model incorporates these three main effects:ĭirect dependence of PD forecasts on the economic scenarioĬredit risk spillovers via network linkagesĪ user-specified path for financial sector interconnectedness In this article, I introduce a new model – Credit Risk Cascades (CRC) – that forecasts PDs of financial institutions under compound scenarios involving economic, counterparty, and systemic risk components. The banking industry needs a streamlined quantitative tool to facilitate stress testing under compound scenarios. In fact, some large banks that conduct sophisticated "war game" exercises as part of their risk management activities already think in these terms, but lack a model that allows a fully coherent evaluation of such shocks together. Tarullo has recently gone on record stating that he ".envisions the stress-testing process moving beyond just examining the performance of individual banks' capital levels under stress and also include the interconnection of institutions under stress as well." 1 When forecasting probability of default (PD) for such purposes, banks require a model that seamlessly integrates macroeconomic, counterparty, and systemic risk projections. In fact, as reported in American Banker, Fed governor Daniel K. For eight bank holding companies, the Fed now requires layering a counterparty default scenario onto standard CCAR exercises, and has recently suggested that next-generation stress tests could feature shocks to bank interconnectedness. Thinking in terms of compound scenarios, which are comprised of macroeconomic, counterparty, and systemic risk components, represents the natural next step of stress testing.
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