A Financially Justifiable and Practically Implementable Approach to Coherent Stress Testing

We present an approach to stress testing that is both practically implementable and solidly rooted in well-established financial theory. We present our results in a Bayesian-net context, but the approach can be extended to different settings. We show i) how the consistency and continuity conditions are satisfied; ii) how the result of a scenario can be consistently cascaded from a small number of macrofinancial variables to the constituents of a granular portfolio; and iii) how an approximate but robust estimate of the likelihood of a given scenario can be estimated. This is particularly important for regulatory and capital-adequacy applications.