A Common Pitfall in Bank Stress Testing : Macroeconomic Factors and Model Instability

Macroeconomic factors can affect both the output and input of a credit risk model, as well as the measurement errors in the observed input variables. Failure to account for all these effects leads to biased and unstable estimates. We propose a two-stage filtered-input approach to obtain unbiased estimates of the effects of macroeconomic factors and to maintain a model's predictive power. The findings of this study offer important insights that help model developers improve the reliability of their models in bank stress testing