Stress Testing: The Use and Abuse of Lagged Default Probabilities in “Forbidden” Credit Models

As the Federal Reserve’s 2015 Comprehensive Capital Analysis and Review stress testing exercise moves to its conclusion, a steady stream of well-intended but incorrect models are coming into public view. In particular, many analysts have been using lagged default probabilities as inputs to their 13 quarter stress tests, a modeling strategy that ProfessorsJoshua Angrist and Jorn-Steffen Pischke label “forbidden models” in their classic econometrics text “ Mostly Harmless Econometrics: An Empiricist’s Companion” (2009).

We explain why such models, however well intended, are usually invalid and unacceptable from a model validation point of view using quotes from Angrist and Pischke.




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