Reverse Stress Testing Geopolitical Risk in Corporate Credit Portfolios: A Formal and Operational Framework

TL;DR

This paper develops a formal, operational framework for reverse stress testing geopolitical risks in corporate credit portfolios, integrating macro-financial scenarios with explicit risk factors to identify the most probable scenarios breaching capital constraints.

Contribution

It introduces a novel formal approach for reverse stress testing that incorporates geopolitical risks into credit portfolio analysis, enabling sensitivity analysis and governance insights.

Findings

Framework supports internal rating models and sector-level implementation

Identifies most probable stress scenarios breaching capital constraints

Allows sensitivity analysis and governance-oriented interpretation

Abstract

This paper proposes a formal framework for reverse stress testing geopolitical risk in corporate credit portfolios. A joint macro-financial scenario vector, augmented with an explicit geopolitical risk factor, is mapped into stressed probabilities of default and losses given default. These stresses are then propagated to portfolio tail losses through a latent factor structure and translated into a stressed CET1 ratio, jointly accounting for capital depletion and risk-weighted asset dynamics. Reverse stress testing is formulated as a constrained maximum likelihood problem over the scenario space. This yields a geopolitical point reverse stress test, or design point, defined as the most probable scenario that breaches a prescribed capital adequacy constraint under a reference distribution. The framework further characterises neighbourhoods and near optimal sets of reverse stress scenarios, allowing for sensitivity analysis and governance oriented interpretation. The approach is compatible with internal rating based models and supports implementation at the exposure or sector level.