• Variables displaying a wrong way sign contribution to a model are too often dismissed without further consideration
• If sign remains wrong after all due diligence it should be welcomed as an opportunity to deepen our understanding of the model

Long run multiplier effects

• Takes the example of the unemployment rate as unique factor to model delinquency
• The initial impact of rising unemployment rate is larger than the long term impact of unemployment on default probability
  • Should thus expect the lagged unemployment terms to take negative signs compared to the instantaneous unemployment variable which takes a larger positive coefficient
  • by including the lagged effects we can boost the scale of the short term effect giving higher stressed projections
• In many situations it is enough to demonstrate that the total effect of a shock “goes the right way” and that the model fits the observed data well

Omitted variables

• Management actions related variables are correlated with economic outcomes
• Omitting those variables will bias the effect of the economic variables on performance
• Moody’s view is that they should be included for stress testing and model should take into account of past management shifts

Ceteris paribus conditions

• Multicollinearity is a fact of life
• The FED’s scenario reflect the fact that a rapidly rising unemployment rate will be accompanied by commensurate shifts in all other aspects of the economy.
• The direct result of rising cost of money should be to increase losses
• Intuitively we should see positive signs on interest rate variables in as standard PD regression model
• Higher interest rates are symptoms of a booming economy
• Strong correlations are generally far more effective in reducing prediction errors than weak causations
• Interest rates in credit loss models have the advantage of being reasonably easy to forecast
• Model with negative interest rate coefficients should not overly trouble stress-test model validators

Conclusion

• Banks generally do not move in lock step with the economic cycle
• Models that are not permitted to capture these timing effects and casual relationships are next to useless for assessing bank capital adequacy
• In a situation where model validators and Fed regulators are insisting on tiny models that assume coincidence with the economic cycle is an elaborate form of economic window dressing
• We need to move to a situation where stress test models at least attempt to shine light on sometimes complex underlying processes even if the ban manager
• s are sometimes left scratching their heads about the data.