Systematic Versus Idiosyncratic Risk in Stress Testing Systematic
The Comprehensive Capital Analysis and Review is an annual exercise by the Federal Reserve to assess whether the largest bank holding companies have sufficient capital to continue operations under adverse scenarios for the systematic component. In this paper, we extend Vacisek’s framework by modeling an equally probable stress scenario (a 99.9th percentile event) that can result from either the systematic or the idiosyncratic component. From this composite function, we then select a stress scenario that satisfies two conditions. First, it corresponds to a 99.9th percentile event and, second, it maximizes the conditional probability of default at the portfolio level. The maximization choice varies with asset correlation and portfolio diversification assumptions.
Credit, Probability of Default, Stress Testing, Systematic, idiosyncratic.