Stress Testing Credit Risk: The Great Depression Scenario

Abstract: By employing Moody's corporate default and rating transition data spanning the last 90 years we explore how much capital banks should hold against their corporate loan portfolios to withstand historical stress scenarios. Specifically, we shall focus on the worst case scenario over the observation period, the Great Depression. We find that migration risk and the length of the investment horizon are critical factors when determining bank capital needs in a crisis. We show that capital may need to rise more than three times when the horizon is increased from one year, as required by current and proposed regulation, to three years. Increases are still important but of a lower magnitude when migration risk is introduced in the analysis. Further, we find that the new bank capital requirements under the so called Basel 3 agreement would enable banks to absorb Great Depression style losses. But, such losses would dent regulatory capital considerably and far beyond the capital buffers that have been proposed to ensure that banks survive crisis periods without government support.