This study performs a stress testing exercise on the Italian banking system in view of the 2007 financial crisis which was triggered by the crash of subprime mortgages. At the base of the global financial crisis was a failure of finan- cial regulators to quantify the accumulation of endogenous risks. Following the crisis, stress testing has acquired particular emphasis in the field of risk measurement under the Basel II supervisory framework. An econometric rela- tionship between the probability of default and the macroeconomic indicators is modeled according to the Merton approach for structural analysis using data on the Italian banking system. A latent factor model is employed to under- stand the dependence of the credit risk on the changes in the macroeconomic environment. The resulting relationship is exploited to compute the capital requirement under stressed conditions in order to draw inference about the resilience of the Italian banking system. JEL Classification G0, G01, G17, G10, C50, C22 Keywords Financial crisis, macroeconomic stress testing, credit risk, latent-factor model Author's e-mail jacomessi@yahoo.it Supervisor's e-mail petr.gapko@seznam.cz Abstrakt Klasifikace JEL G0, G01, G17, G10, C50, C22 Klíčová slova Financial crisis, macroeconomic stress test- ing, credit risk,...

This dissertation proposes stress testing of a bank’s corporate credit portfolio in a Basel Internal Ratings Based (IRB) framework, using publicly available macroeconomic variables. Corporate insolvencies are used to derive a credit cycle index, which is linked to macroeconomic variables through a multiple regression model. Probability of default (PD) and loss given default (LGD) that are conditional on the worst state of the credit cycle are derived from through-the-cycle PDs and LGDs. These are then used as stressed inputs into the Basel regulatory and Economic capital calculation for credit risk. Contrary to the usual expert judgement stress testing approaches, where management apply their subjective view to stress the portfolio, this approach allows macroeconomic variables to guide the severity of selected stress testing scenarios. The result is a robust stress testing framework using Rösch and Scheule (2008) conditional LGD that is correlated to the stressed PD. The downturn LGD used here is an alternative to the widely used Federal Reserve downturn LGD which assumes no correlation between PDs and LGDs. / Dissertation (MSc)--University of Pretoria, 2014. / gm2014 / Mathematics and Applied Mathematics / Unrestricted