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a) How do you assess the stress-testing framework of the Central Bank of Condado. Macro stress testing in Condado is primarily concerned with assessing the systemic risk of the banking sector. A bank's ability to survive a shock is determined by the impact on its capital adequacy ratio, in order to see whether the bank has adequate capital buffers. It is feared that a worsening in the current economic situation will lead the banks to tighten lending standards in response to large unexpected credit losses, which could lead to a further deterioration of the macroeconomic environment. The Central Bank does not have the methodology to consider this, which is bad, since this effect could be rather large. Seeing as the economy consists of only 3 banks, perhaps a top-down approach is not so bad? On the other hand, it shouldn't be so hard to find data for only three banks. Something about needing to stress external demand also (perhaps incorporated in FX risk?) 1.b) You may like to analyze the advantages and disadvantages, in particular, of the following: The time horizon for stress tests: When stress testing, it is important to use a time horizon, which is coherent with the objective of the stress test. Seeing as this stress test is designed to stress banks, corporates and households, credit risk is of course important, and thus it is important for the time horizon to be long enough to capture the credit risk, which will usually take a longer time to materialize. The Central Bank of Condado designs stress tests with a one-year time horizon, because of high uncertainty regarding future economic events. They do, however, make a two-year projection for the macro scenarios to aid in the calculation of expected credit losses through 2052. This could be a problem, since the aforementioned credit risk may not materialize. However, the Central Bank of Condado has deemed the benefit of a longer time horizon, to be less than the cost of higher uncertainty, and has thus kept the time horizon at 1 year. This is shorter than what supervisors will usually use, but in the end it is the Central Bank's call. Top-down versus bottom up approach Seeing as the three banks have very different business models, using a top-down approach could be very misleading. The top-down approach could provide a picture of a robust economy, but where two of the banks are very solid, and the last bank is very fragile. This very bad, because the banks are equally large and thus, should one of them default, 1/3 of the banking sector would disappear, a huge number, and something the economy likely could not survive. This is just one of the disadvantages of the top-down approach. Another is a problem with realistic modeling of the links between changes in economic conditions and changes in risk factors are imprecise and the dynamic interaction between economic variables and risk factors captured by these models may not be the relevant ones that would take effect. On the other hand, the top-down approach provides outputs, that are easy to understand and often more intuitive, data is more easily accessible and the output can be easily calibrated and tested against real-life performance. The bottom-up approach is more granular and borrower-level analysis. This approach is great at highlighting the best banking relationships while isolating the riskiest relationships, and is thus must better at finding individual banks that could be in trouble. The downside to this approach is that many organizations do not have the required data needed for this approach and it can be very complex to calculate. Sometimes the sheer sophistication of the modeling can lead to a false sense of security, and can make you lose sight of sound economic analysis.

Seeing as there are only three banks, then using the bottom-up approach might not be so difficult as in fx Spain (with their billion banks). This would also be good thing for calculating PDs and LGDs, since the top-down uses a lot of aggregation, where the bottom-up will go loan-by-loan and should give a more correct picture of a single firm's exposures. Projections of credit risk parameters (PD and LGD) PD for corporate portfolio and other loans is linked to GDP, while PD for the retail portfolio is linked to unemployment. This seems very/too general, and could benefit from using a bottom-up approach, where the PD would be affected by more than one parameter. The stress test shows that the expected one-year PD rises a lot in 2051 from 1,2\% to 5,7 \% for corporate, 0,8 \% to 1,7 \% for retail and 0,2 \% to 0,95 \% for other loans. Corporate and other loans' PDs fall again in 2052, although not to the levels of 2050; corporate falls to 3,9 \% and other loans to 0,65 \%, while the PD of retail rises even further to 3,05 \%. The fact that retail peaks faster than corporate and other loans, could be explained by retail being more affected by credit risk, which is slower to materializes, while corporate and other loans is probably more exposed to market risk, which materializes much faster. LGD is linked to the real estate price index (which includes residential and commercial real estate). The stress test finds that all types of loans are sensitive to the adverse scenario, with LGDs rising from 45\% to 55\% for corporate and other loans, and 61\% for retail loans. Assessment of other risks Populist government risk: We have often seen too populist governments make ignorant economic decisions, in order to please the voters (Berlusconi in Italy), is there a risk that the Condadian government could be prone to this as well? They have a history of populism (lately) and their economic projections seems out of line with the economic observers, in that the government projects the deficit to fall to 3 \% by the end of 2054, while the economic observers thinks that the economic conditions will worsen, before they improve. Risk related to rising inflation: The baseline and adverse scenarios both forecast a falling interest rate, this will make the inflation rate rise. This could be a problem for those with savings and also those with loans denominated in USD, since the higher inflation would create an upward pressure on the currency (pressure for depreciation), which would leave some of the worst mortgages underwater.

2. Do you agree that the scenario developed by the Central Bank of Condado is severe but plausible? The adverse scenario developed by the Central Bank of Condado is definitely severe, seeing as the country goes from 3\% real GDP growth in 2050, to negative real GDP growth of respectively -3\% in both 2051 and 2052. The unemployment doubles from 2050 to 2052, which seems like a lot. Also, the real estate price index falls 30\% from 2050 to 2051 before rising about 7\% in 2052. This scenario is severe for Condado's economy, since, with a worsening of unemployment and real GDP growth, and depreciating CP, the homeowners who have taken out loans in USD will experience major problems in paying their mortgages, since a lot of them will be laid off, and the depreciating currency will hurt those with USD loans, and the falling GDP will hurt all Canadians. Is it plausible? It could be, since Condado is such an open economy, they will definitely be hit hard, should their trading partners struggle. However, two straight years of -3 \% is very severe, and it is probably a worst of worst-case scenario. Looking at a list of emerging economies, then none of the countries experiences so severe GDP rates during the financial crisis and none of them saw their unemployment double in two years.