Case 087Stress testing and scenariosCore
A bank lends to airlines, oil refiners and road transport. An oil price shock of 60% moves each sector's default rate differently. Compute stressed losses against the base case and say what the stress test tells the bank.
1The situation
Sunderpath Bank lends Rs 800 crore to airlines, Rs 1,200 crore to oil refiners and Rs 2,000 crore to road transport operators. One-year default rates today are 3%, 2% and 2.5%, and loss given default is 50% across the three.
The scenario team's oil shock has crude up 60% for a year. Its sector translations: airline default rates rise to 12%, because fuel is their largest cost and fares lag; refiner default rates fall to 1.5%, because they pass costs on and gain on inventory; road transport rises to 6%, because diesel costs rise faster than freight rates. These loans earn about Rs 100 crore a year after funding and operating costs, before credit losses.
2Your task
What are base and stressed expected losses by sector and in total, and what should the bank do with the result?
Quick check
What happens to total expected loss under the oil shock?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
Expected loss rises from Rs 49 crore to Rs 117 crore, about 2.4 times, more than the Rs 100 crore the book earns in a year. Airlines quadruple to Rs 48 crore and road transport more than doubles to Rs 60 crore, while refiners improve to Rs 9 crore. Airlines are 20% of the lending and 41% of the stressed loss. The result argues for a tighter airline limit and fuel-cost protections in transport loans, not a uniform cut.
Step 1How do you compute the loss in each sector?
Expected loss is exposure times the chance of default times the share lost if it happens. In the base case that is Rs 12 crore for airlines, Rs 12 crore for refiners and Rs 25 crore for transport, Rs 49 crore in all. Under the shock, the same formula with the scenario's default rates gives Rs 48 crore, Rs 9 crore and Rs 60 crore, Rs 117 crore in all.
| Sector | Lent, Rs crore | Base default | Stressed default | Base loss | Stressed loss |
|---|---|---|---|---|---|
| Airlines | 800 | 3.0% | 12.0% | 12.0 | 48.0 |
| Oil refiners | 1,200 | 2.0% | 1.5% | 12.0 | 9.0 |
| Road transport | 2,000 | 2.5% | 6.0% | 25.0 | 60.0 |
| Total | 4,000 | 49.0 | 117.0 |
Step 2Why not just scale every sector by the same factor?
Because a shock hurts some borrowers and helps others. When petrol prices jump, a taxi driver is squeezed and the petrol pump owner is not. A scenario earns its keep by translating one macro move into different sector outcomes; a uniform 60% uplift would give Rs 78 crore and miss both the airline concentration and the refiner offset. The translation itself is the weak link, so the committee should see the reasoning behind each sector's default rate, not only the result.
Step 3What should the bank do with the result?
Read it against earnings and against concentration. A Rs 117 crore loss against Rs 100 crore of earnings means one bad year wipes out the book's profit and eats Rs 17 crore of capital, and 41% of that comes from airlines, which are only 20% of the lending. The actions follow: a lower airline sector limit or a requirement that airline borrowers hedge fuel, fuel price pass-through clauses checked in transport contracts, and the refiner book recognised as a partial natural offset rather than cut.
Then state the limits of the exercise. The scenario assumes default rates move at once and independently by sector; in reality a year-long oil shock also slows the economy, which hits refiners' customers too. A second round, with lower GDP layered on, is the natural next run.
Where candidates lose it
The usual error is applying one multiplier to every sector, which ignores the point of the scenario: an oil shock is a transfer between sectors. Candidates who miss the refiner improvement overstate the loss and miss the natural offset in the book.
The second is reporting the stressed number without comparing it to anything. Rs 117 crore means little until it is set against the Rs 100 crore the book earns in a year.
What the interviewer asks next
- Add a second round: GDP slows and every sector's stressed default rate rises by 1 point. What is the total now?
- How would you set an airline sector limit from this result?
- Loss given default on airline loans is 70% because aircraft values also fall. Redo the airline line.
Company names and figures are illustrative.