Stress testing a bond portfolio : a focus on credit risk

Abstract

The aim of this dissertation is to investigate the problems faced by financial institutions with respect to capital adequacy. This is done in order to predict whether these banks can face future crises and the amount of capital that banks should have to be able to cover the risks incurred (focusing mainly on credit risk) in their lending and financing operations. The problem of capital adequacy became more important after the global financial crisis that left many banks and financial institutions rigorously under-capitalised. Researchers became more interested in understanding the vulnerabilities of financial systems and used stress testing as a key technique to quantify these vulnerabilities. This study discusses the two main stress testing approaches and the different techniques used for stress testing. It also provides a general description of the key risks involved and a detailed description of credit risk. In order to be able to measure credit risk and to estimate the banks' 'distance' to default, the author developed a modified structural model using hypothetical data. This study concluded that both an increase in the Probability of Default and an increase in asset correlation will cause the value of the expected loss to increase due to the higher risk of default. Were this model to be applied in Malta using actual bank data, the conclusion would most likely be that the bank would require additional capital to cover the expected losses incurred from its operations only if the available capital were not enough to cover such expected losses.