The risks of over simplifying stress test models

Appeared also in May 2013, Moody’s analytics under the title Simple Models and the CCAR

• Over reliance on too few macroeconomic drivers
• The way the supervisory Stress Scenarios are defined suggests that very simple models involving only two or three economic drivers will fail to adequately represent the effect of each scenario
• Many banks only use two variables: House prices and unemployment
• Inflation has an important impact on many aspects of credit performance
• Adverse stagflation is a very interesting test for bank risk managers to apply, holding potential of insights regarding performance of bank portfolios and management actions that may be available to mitigate the situation.