EU-wide Stress Test: Estimation of Credit Risk Parameters and Impairments

Credit risk impairments pose significant challenges to various economic sectors by impacting their financial stability and overall performance. This study investigates the impact of credit risk impairments on various sectors of the economy, emphasizing the potential ramifications. Banks are obligated to incorporate potential losses stemming from credit defaults into their accounting practices, while considering various future economic scenarios, including both baseline and adverse conditions. The EU-wide Stress Test offers standardized methodologies for the computations regardless being individual or collective impairments. Estimations for the credit risk parameters are necessary for performing these computations. The 2023 Stress Test requires the computation of credit impairments under severe scenarios for various economic sectors, marking the first instance of such a requirement. The primary objective of this study is to identify and develop techniques for estimating credit risk parameters, specifically the probability of default (PD), loss given default (LGD), transition rates (TR), and loss rates (LR) to perform the impairment computation. The analysis and results revealed that certain variables exhibit a negative correlation with credit risk parameters, specifically the gross domestic product (GDP) and the harmonized index of consumer prices (HICP) while on the other side the Unemployment Rate has a positive relationship with credit risk. The utilization of stochastic models has proven to be effective in addressing challenges associated with limited historical data.