How to Improve the Model Selection Procedure within a Stress Testing Framework

Jiří Panoš, Petr Polák

This paper aims to introduce a contemporary, computing-power-driven approach to econometric modeling in a stress-testing framework. The presented approach explicitly takes into account model uncertainty of satellite models used for projecting forward paths of financial variables employing the constrained Bayesian model averaging (BMA) technique. The constrained BMA technique allows for selecting models with reasonably severe but plausible trajectories conditional on given macro-financial scenarios. It also ensures that the modeling is conducted in a sufficiently robust and prudential manner despite the limited time-series length for the explained and/or explanatory variables.

JEL codes: C11, C22, C51, C52, E58, G21

Keywords: Bayesian model averaging, model selection, model uncertainty, probability of default, stress testing

Issued: December 2019

Download: CNB WP No. 9/2019 (pdf, 1.3 MB)