Economic Scenarios
The Financial Services Authority (FSA) have indicated that economic stress testing of capital requirements should be performed based on an economic downturn with a likelihood of 1 in 25. This begs the question of what exactly a 1 in 25 scenario is? For example, what variables should be included and what value of those variables represents a 1 in 25 likelihood of occurrence?
At Volterra we have developed an approach based on statistical method and historic experience to directly link likelihoods and outcomes based on past data. The unique and key feature of the Volterra approach is that it explicitly quantifies risk based on evidence. The approach can take a given scenario and inform on the probability of occurrence, or work the other way around, taking a given probability and returning the associated values of economic variables.
Our approach looks at the variables that actually drive lenders' PD, LGD and stress testing models. We then look at the joint probability of adverse events. This can be linked back to lenders' own models, which can then be projected forward to look at the capital impact. The approach enables lenders to look at the probability of specified events, such as 20% fall in house prices, for example. It is possible to select scenarios that meet business needs, such as corporate planning, as well as those set by the FSA.
The advantage of this approach over others is that it links likelihoods to outcomes based on the best available evidence, providing objectivity to the definition of stress scenarios. Where scenarios are based on subjective judgement they will always be subject to the nagging question of whether the scenario represents a sufficiently harsh experience. By creating an explicit link to likelihood of outcome based on evidence, we can give an objective answer to this question.