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Credit risk stress testing has become an important risk management devicewhich is used both by banks internally and by regulators. Stress testing iscomplex because it essentially means projecting a bank's full balance sheetconditional on a macroeconomic scenario over multiple years. Part of thecomplexity stems from using a wide range of model parameters for, e.g., ratingtransition, write-off rules, prepayment, or origination of new loans. A typicalparameterization of a credit risk stress test model specifies parameters linkedto an average economic, the through-the-cycle, state. These parameters aretransformed to a stressed state by utilizing a macroeconomic model. It will beshown that the model parameterization implies a unique through-the-cycleportfolio which is unrelated to a bank's current portfolio. Independent of thestress imposed to the model, the current portfolio will have a tendency topropagate towards the through-the-cycle portfolio. This could create unwantedspurious effects on projected portfolio default rates especially when a stresstest model's parameterization is inconsistent with a bank's current portfolio.

Spurious Default Probability Projections in Credit Risk Stress Testing Models