Monte Carlo scenario generation for retail loan portfolios

Monte Carlo simulation is a common method for studying the volatility of market traded instruments. It is less employed in retail lending, because of the inherent nonlinearities in consumer behaviour. In this paper, we use the approach of Dual-time Dynamics to separate loan performance dynamics into three components: a maturation function of months-on-books, an exogenous function of calendar date, and a quality function of vintage origination date. The exogenous function captures the impacts from the macroeconomic environment. Therefore, we want to generate scenarios for the possible futures of these environmental impacts. To generate such scenarios, we must go beyond the random walk methods most commonly applied in the analysis of market-traded instruments. Retail portfolios exhibit autocorrelation structure and variance growth with time that requires more complex modelling. This paper is aimed at practical application and describes work using ARMA and ARIMA models for scenario generation, rules for selecting the correct model form given the input data, and validation methods on the scenario generation. We find when the goal is capturing the future volatility via Monte Carlo scenario generation, that model selection does not follow the same rules as for forecasting. Consequently, tests more appropriate to reproducing volatility are proposed, which assure that distributions of scenarios have the proper statistical characteristics. These results are supported by studies of the variance growth properties of macroeconomic variables and theoretical calculations of the variance growth properties of various models. We also provide studies on historical data showing the impact of training length on model accuracy and the existence of differences between macroeconomic epochs. Journal of the Operational Research Society (2010) 61, 399-410. doi: 10.1057/jors.2009.105 Published online 14 October 2009