General Information & Client Services
  • Americas: +1.212.553.1653
  • Asia: +852.3551.3077
  • China: +86.10.6319.6580
  • EMEA: +44.20.7772.5454
  • Japan: +81.3.5408.4100
Media Relations
  • New York: +1.212.553.0376
  • London: +44.20.7772.5456
  • Hong Kong: +852.3758.1350
  • Tokyo: +813.5408.4110
  • Sydney: +61.2.9270.8141
  • Mexico City: +001.888.779.5833
  • Buenos Aires: +0800.666.3506
  • São Paulo: +0800.891.2518

This article discusses two conceptual approaches for modeling stressed credit losses: top-down and bottom-up. It highlights the benefits and challenges of using each approach and regulatory expectations.

As stress testing requirements in the US mature and the next “batch” of institutions begin to comply with Dodd-Frank Act Stress Testing requirements, methodologies for loss estimation will continue to evolve. While standards of practice are beginning to form, guidance on methodological and modeling approaches to date is creating confusion. It is also causing a divergence of practices and a variety of modeling approaches among financial institutions – the benefits and pitfalls of each are widely debated.

Often lost in the discussion is that the Interagency Guidance on Stress Testing (SR 12-7) suggests multiple approaches to properly manage and control model risk: “an effective stress testing framework employs multiple conceptually sound stress testing activities and approaches.” This guidance applies across the capital planning process, including credit loss estimation, liabilities, new business volumes, and pro-forma balance sheet and income statements. This article focuses on two conceptual approaches for modeling stressed credit losses: top-down and bottom-up.

A top-down modeling approach

In top-down modeling, exposures are treated as pools with homogeneous characteristics. Scenarios (i.e., macroeconomic or idiosyncratic event-driven) are correlated to historical portfolio experiences. Examples of such approaches include transition matrices, roll-rate models, and vintage loss models. The outputs from this approach are intuitive and easily understood outside of the credit risk function and can be readily calibrated and back-tested against ongoing actual and projected performance. This is increasingly important, as stress testing and capital planning requirements are forcing stress testing analytics to be coordinated among the treasury, finance, and risk groups. Such top-down approaches can also be easier to develop as pool modeling is not exposed to the idiosyncrasies or noise of modeling single firm financial statements. Additionally, historical data is readily available at most institutions, as the same type of data is needed for modeling allowances for loan losses. A bank’s own loss experience can, therefore, be incorporated into the analysis, satisfying an element of the “use-test” criteria for model validation.

"…an effective stress testing framework employs multiple conceptually sound stress testing activities and approaches.” (Interagency Guidance on Stress Testing – SR 12-7)

Top-down modeling has been widely adopted for some retail portfolios as both champion and challenger models, where homogeneous groupings are more easily identifiable. At the same time, this approach can ignore important risk contributors and nuances for more heterogeneous portfolios (e.g., commercial real estate, commercial and industrial loans, project finance, and municipal exposures). For these portfolios, top-down models serve better as a secondary or “challenger” modeling approach, rather than a firm’s primary modeling methodology.

A bottom-up modeling approach

Bottom-up modeling refers to counterparty or borrower-level analyses. Typically, the risk drivers for a specific segment or industry are correlated to macroeconomic variables. Granular, borrower-level analysis goes beyond regulatory-mandated stress testing and can serve as a foundation for risk-based pricing, improved budgeting and planning, economic capital modeling, and limit- and risk-appetite setting. It can also highlight the most desirable banking relationships while isolating the riskiest relationships and concentrations.

While expediency to meet requirements is critical, it is equally important to ensure the firm’s modeling architecture is designed to be leveraged and re-used once the firm is ready to graduate to a more comprehensive and holistic approach.

Methodologically, there are several approaches to bottom-up modeling. Many banks use actuarial modeling to determine credit risk transition, delinquency, and default, as well as loss frequency and magnitude. However, they often miss critical factors such as the timing of delinquency, default, and losses, which require cash flow based approaches. One major challenge is that many organizations do not possess the required data necessary to calibrate credit-adjusted, cash flow models. Few institutions have systemically collected borrower-level financial statements and default and loss data over several business cycles. Many treasury and asset-liability committee (ALCO) members, however, prefer to think of balance sheet risk in a cash flow (i.e., option-adjusted) fashion. As a result, many organizations are required to supplement internal modeling with external data, modeling, and model calibration techniques from third parties, leading to longer development cycles.

Bottom-up modeling for stress testing will soon be applied to Basel III, potentially making it the preferred methodology in the long-term. For bank officers embarking on developing a stress testing program who are less familiar with data and risk quantification requirements associated with bottom-up modeling, development, and firm-wide adoption of obligor-level analysis may require additional time and cross-organizational buy-in. While rapid implementation timelines driven by regulation, flexibility, and intuitiveness of the approach may make top-down modeling more attractive in the short-term for many banks, it is equally important to ensure a firm’s modeling architecture is designed to be leveraged and reused once they are ready to graduate to a more comprehensive and holistic bottom-up modeling approach.

Using multiple approaches

While no single modeling approach has been blessed by the regulatory agencies or emerged as a best practice, two things have become clear. First, the use of multiple, conceptually sound approaches is prudent given the imprecision of existing “state-of-the-art” modeling techniques. And second, selected developmental data samples should have sufficient granularity and robust timelines appropriate for the portfolio being modeled.

SUBJECT MATTER EXPERTS
As Published In:
Related Insights

What Should Firms be Considering for CECL that They Might Not be Today?

In this video, Anna Krayn discusses her observations on how institutions can prepare for CECL implementation, including improvements to technology and processes and conducting quantitative impact studies.

October 2017 WebPage Anna Krayn

What are Some of the Biggest CECL Implementation Challenges You are Observing in the Industry Today?

In this video, Anna Krayn explains the key challenges institutions are facing with data, modeling, governance, and technology due to the new CECL accounting standard.

October 2017 WebPage Anna Krayn

Expected Loss Quantification: Factors that Will Move the Needle

In this webinar, Anna Krayn and Masha Muzyka discuss the importance of accounting for risk differentiation and rank ordering for pass-rated loans, common flaws of risk rating systems and the potential financial impact on ALLL.

September 2017 WebPage Anna KraynMasha Muzyka

Expected Loss Quantification: Factors that Will Move the Needle Presentation Slides

In this presentation, Anna Krayn and Masha Muzyka discuss the importance of accounting for risk differentiation and rank ordering for pass-rated loans, common flaws of risk rating systems and the potential financial impact on ALLL.

September 2017 Pdf Anna KraynMasha Muzyka

Getting Ready for CECL - Why Start Now? Presentation Slides

The FASB's new impairment standards won't take effect until 2020, but institutions should start planning now. This presentation outlines key considerations for early CECL preparation, including: main challenges; expectations of auditors, regulators, and investors; planning in firms of varying sizes; and how to get started.

September 2017 Pdf Anna Krayn

CECL Methodologies Q&A

American Banker spoke with Anna Krayn from Moody's Analytics about CECL, the new FASB accounting standards on current expected credit loss.

February 2017 Pdf Anna Krayn

Getting Ready for CECL

The FASB’s new impairment standards won’t take effect until 2020, but institutions should start planning now. This webinar outlines key considerations for early CECL preparation, including: main challenges; expectations of auditors, regulators, and investors; planning in firms of varying sizes; and how to get started.

October 2016 WebPage Anna KraynEmil Lopez

CECL Spotlight with Anna Krayn

As firms begin their implementation process for CECL, there are still more questions than answers as firms are beginning to plan for eventual implementation. However, there are some key benefits to early CECL adoption. In this live interview, Anna Krayn gives her perspective and recommendations.

September 2016 WebPage Anna Krayn

The Long Road to CECL: Implementation Considerations

In this video cast, we will discuss the implications of the final CECL standard and approaches to implementation.

September 2016 WebPage Anna KraynEmil Lopez

CECL: Disclosures and Timelines

In this webinar, we explore the implications of new disclosure requirements and the effective dates for CECL implementation. We explain why banks should start preparing for CECL now and what are the advantages to early implementation.

September 2016 WebPage Anna KraynEmil Lopez

CECL: The Road to CECL

In this webinar, we discuss what the new CECL standard is and why the FASB is changing Impairment Accounting. Key topics include the timeline for implementation, key differences are in the new impairment models compared with the existing ones, and how the allowance calculation process is likely to change.

September 2016 WebPage Anna KraynEmil Lopez

The Long Road to CECL: Implementation Considerations Presentation Slides

As firms prepare for CECL, there are still many questions about the best approaches to implementation and how the regulatory requirements will impact adoption. In this webcast, we answer practitioners questions and provide suggested approaches for implementation.

September 01, 2016 Pdf Anna KraynEmil Lopez

Implications of the FASB's New Credit Loss Impairment Standard

On June 16, FASB issued the much anticipated financial instruments impairment standards update. The implications of this standard are significant and will change the way credit losses are measured for most financial assets (e.g. receivables, debt securities and loans).

June 2016 WebPage Anna KraynChristian Henkel

DFAST Quick Takes: Looking Toward CCAR Results

This article outlines recent approaches to managing credit risk when facing regulatory capital requirements. We explore how institutions should best allocate capital and make economically-optimized investment decisions under regulatory capital constraints, such as those imposed by Basel or CCAR-style rules.

June 2016 WebPage Anna KraynDavid LittleEd Young

Reading the Tea Leaves of Recent Regulatory Guidance

In this article, we review the common themes reflected in recent regulatory guidelines released by the Federal Reserve and the BCBS.

June 2016 WebPage Anna KraynDavid LittleEd Young

Reading the Tea Leaves of Recent Regulatory Guidance

December 2015 was a busy month for regulatory agencies and global standard setters. Throughout the year the industry has been waiting for additional guidance on high impact topics including capital planning and allowance methodologies, and in the final stretch of 2015 both the Federal Reserve and the Basel Committee on Banking Supervision (BCBS) complied. This paper will primarily focus on common themes in the two releases.

January 2016 Pdf Anna KraynEd YoungDavid Little

Using a Risk Appetite Framework to Align Strategy and Risk

In this article, we provide an overview of some common problems organizations face and introduce a solution to develop an integrated, transparent, measurable, and actionable Risk Appetite Framework.

December 2015 WebPage Anna KraynEd Young

From the Editor

Post-crisis regulatory drivers are giving rise to better risk management practices that will provide a competitive advantage. With this in mind, this edition of Risk Perspectives looks at the future of risk management, and the best practices of today that will form the successful risk management practices of the future.

December 11, 2015 WebPage Anna Krayn

Learnings from CCAR 2015 and Beyond

In this webinar, Moody's Analytics experts revisit the CCAR 2015 scenarios, review industry results and discuss how to identify and quantify Systemic Risk.

April 2015 WebPage Mark Zandi, Anna KraynDr. Samuel W. Malone

Comparing DFAST 2014 Estimates for CCAR Banks Under the FRB's Severely Adverse Scenario

This quantitative analysis of CCAR 2014 Severely Adverse scenarios, Moody's Analytics finds that the Federal Reserve Bank's (FRB's) and banks' own modeled estimates of capital ratios, revenue, net income, and loan credit losses are generally well aligned, although variations in all measures and across all banks are evident. In addition, the FRB's estimates are generally more conservative than those of the individual banks, reflecting differences in the FRB's industry-based models vs. the banks' portfolio specific models, treatment of missing or invalid data in the FRB's modeling approach, and assumptions about projected balance sheet volumes. The wide variation among bank modeled estimates and their overall alignment with FRB modeled estimates argues against banks targeting general industry benchmarks (such as average loss rates) and in favor of building models around their own business models and portfolio characteristics.

July 2014 Pdf Danielle Ferry, Daniel BrownAnna Krayn

Credit Loss Estimation - Industry Challenges and Solutions for Stress Testing

Thomas Day, Senior Director, Mehna Raissi, Director, and Chris Shayne, Director discuss credit risk management and loss modeling in a stress testing environment.

May 2014 WebPage Thomas Day, Mehna Raissi, Chris Shayne

Learn the Fundamentals of Managing Liquidity Under U.S. Basel III Webinar

In this webinar, recorded on May 1, 2014 Anna Krayn and Olivier Brucker discuss key aspects of the planned US Basel III liquidity regulations, critical challenges in implementing these regulations, and a best practice framework for delivering compliance with the US Basel III directive.

May 2014 WebPage Anna Krayn

Learn the Fundamentals of Managing Liquidity Under Basel III Presentation

Changes to liquidity management regulations present significant challenges for organizations based in the United States. In this presentation, our experts discuss key aspects of the planned US Basel III liquidity regulations, critical challenges in implementing these regulations, and a best practice framework for delivering compliance with the US Basel III directive.

May 2014 Pdf Anna Krayn

Data, Analytics, and Reporting Requirements: Challenges and Solutions

In this paper, we first provide a background on stress-testing, discuss infrastructure challenges and issues related to legacy data and remediation requirements, including the costs and benefits of improved data management and the challenges of managing multiple hierarchies and reporting dimensions required by the Supervisory Authorities. Next, we cover data governance issues, the data requirements of meeting U.S. stress-testing mandates, and the basic elements of a sound data management infrastructure.

March 2014 Pdf Thomas Day, John Haley

Enterprise-wide Stress Testing

In this webinar, originally recorded on September 17, 2013, Thomas Day discusses best practices for expected loss and pre-provision net revenue forecasting, integration of stress testing into your business architecture, and transforming stress testing from a regulatory exercise to a strategic management tool.

December 2013 WebPage Thomas Day

When CCAR Met Basel

In this article, we discuss where CCAR and Basel III intersect, with a particular focus on the data, analytics, and reporting layers of a sound CCAR/Basel III IT architecture, and why banks should address both within an integrated platform to meet, and go beyond, regulatory compliance.

November 2013 WebPage Anna Krayn, Michael Richitelli

2013 Mid-Cycle Stress Test Disclosures

This article provides a summary of the mid-cycle stress test results, including observations about scenarios, loss estimates and PPNR, disclosures, and areas for improvement.

November 2013 WebPage Thomas Day

CCAR and DFAST: What will 2014 Bring?

Learn how the Comprehensive Capital Analysis and Review and Dodd-Frank Act Stress Tests will impact banks in 2014 and how banks can best prepare for the changes.

November 2013 WebPage Thomas Day

Stress Testing Webinar Series: Macroeconomic Conditional Pre-provision Net Revenue (PPNR) Forecasting

This webinar discusses the primary challenges confronting banks when forecasting macroeconomic conditional pre-provision net revenue (PPNR), best practices for forecasting macroeconomic conditional PPNR, and the tools and techniques used by Moody’s Analytics to address the challenges.

October 2013 WebPage Thomas Day, Dr. Amnon Levy, Robert Wyle

Stress Testing Webinar Series: Macroeconomic Conditional Loss Forecasting Presentation

In this Moody's Analytics webinar, Thomas Day and other Moody's Analytics experts discuss Macroeconomic Conditional Loss Forecasting. Given the criticality of loss estimation, and the need for different models by asset class, we cover loss estimation for Retail Exposures (non-mortgage), Structured Portfolios, Wholesale C&I (non-public), and Wholesale (public).

October 2013 Pdf Thomas Day, Dr. Cristian deRitis, Luis Amador

Emerging Standards: Liquidity Risk Management

Banks' funding activities and liquidity management will be the focus of increased regulator attention in coming years. This presentation helps risk managers meet best practices.

October 2013 Pdf Thomas Day

Summary of 2013 Comprehensive Capital Analysis and Review and Dodd-Frank Act Stress Tests

This article provides a summary of the 2013 CCAR and Dodd-Frank Act Stress Tests, and compares the results with the 2012 stress tests.

September 2013 WebPage Thomas Day

Breaking the Black Box - Managing Stress Testing, Capital Assessment and Risk Appetite Frameworks in a CCAR World

In an effort to improve transparency and increase confidence, global policy leaders have embarked on an ambitious agenda that has as its centerpiece improvements in data architecture and infrastructure, firmwide stress-testing, capital planning, and risk appetite frameworks. In the United States, this is known as the Comprehensive Capital Assessment and Review (CCAR). CCAR, Basel III, and enhanced liquidity risk management expectations aren't easy problems to solve. To

February 2013 Pdf Thomas Day