Stress Testing with a Bottom-Up Corporate Default Prediction Model∗

We propose a credit stress testing method that puts together: (1) a bottom-up corporate default prediction model capable of translating shocks to its input variables into the default likelihood of a target portfolio, and (2) a set of stress-testing regressions which relate the presumed adverse macroeconomic scenarios to shocks to the inputs of the default prediction model. This method can produce distributions of corporate defaults for any target portfolio (economy or sector) over various horizons of interest. A set of seven macroeconomic variables are used to define stress scenarios, and these seven variables are found to explain a substantial fraction of variations in the input variables of the corporate default prediction model used in our analysis. Our back-testing empirical study focuses on (1) the ASEAN 5 countries because the experience of the 1997 Asian financial crisis makes this group ideal for an out-of-sample performance study over the 2008-09 financial crisis period, and (2) the US and Eurozone for its wider applicability. We also consider the IMF-style V-shaped and protracted stress recovery scenarios to demonstrate our method’s practicality.