Authors: Angelos Kanas, Philip Molyneux

Title: Macro stress testing the U.S. banking system

Abstract

We extend previous methodologies on macro stress testing by considering an additive semi-parametric quantile analysis which does not suffer from various specification problems and linearity limitations associated with standard stress-testing approaches. Macro stress tests for the aggregate U.S. commercial banking system are conducted and probabilities of default are estimated. The 90% and 95% quantiles of non-performing loans (NPLs) are determined nonlinearly by real GDP growth, the federal debt to GDP ratio and the trade weighted average exchange rate. Linear effects are through the effective federal funds interest rate, a broad-based macroeconomic variable (Leading Index of the Federal Reserve) and labor market (Coincident Economic Activity Index) indicators. The 90% and 95% quantiles of NPLs for various stress tests under adverse scenarios are estimated in the range of 4.27%-4.86%. This level of NPLs can be reduced by policy action in the form of currency appreciation.  The average probability of default is estimated in the area of 0.0010%-0.0020%.