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Models for Banks' Loan Impairment Charges in Stress Tests of the Financial System - Part 2

Given the current accounting policies, the banks' loan impairment charge ratios show considerable cyclical variation. Loan impairment charges are relatively high in years when the economy is slowing down and bank earnings are under pressure, while they are relatively low in years with high economic growth and sound bank earnings. The article estimates and compares two specific econometric models for the banks' loan impairment charges. Both models provide a good description of the historical development in loan impairment charges and are able to explain the high loan impairment charge ratios during the crisis from 2008 onwards. The article also discusses the limitations on using such models for macro stress testing. Although financial crises have many similarities, they also differ in some respects. To the extent that a stress scenario contains new risk factors not reflected in the historical relations, it may be necessary to adjust the results calculated on the basis of loan impairment charge models estimated on historical data.