Retail credit stress testing using a discrete hazard model with macroeconomic factors

We present a stress testing approach based on a dynamic model of default. Retail credit models are implemented using discrete survival analysis which enables macroeconomic conditions to be included directly as time-varying covariates. In consequence, these models can be used for stress testing by determining changes in default given downturn economic scenarios. In particular Monte Carlo simulation is used to generate a distribution of estimated default rates from which extreme Value at Risk and expected shortfall are computed. Several macroeconomic variables are considered and factor analysis is employed to model the structure between these variables. Two large UK data sets are used to test this approach, resulting in plausible dynamic models and stress test outcomes. Credit Research Centre Working Paper 10/2