Perfect Foresight Assumption

Definition

The Perfect Foresight Assumption denotes a type of simplification of Stress Testing based on Scenario Analysis where at any point of time in the projection the subsequent path of a random (uncertain, stochastic) variable is assumed to be known and equal to what is given in the scenario

Application in the EBA 2018 EU-Wide Stress Test

For the estimation of LGD and lifetime ECL, it is assumed that there is perfect foresight. Unlike previous EU-wide stress tests, and due to IFRS 9 implementation, the assumption reflects the full impact of the macroeconomic scenario in year 1 of the stress test for initial Stage 2 and Stage 3 assets that require recognition of Lifetime Expected Credit Losses. Hence the macroeconomic scenarios should be seen as known when calculating expected credit losses

For example, if property prices drop 10% over the three year horizon of the adverse scenario then this drop should be reflected in the impairment loss for old Stage 3 assets in 2018. Thus the complete property price shock for all years must be included in the LGD calculation for Stage 1, Stage 2 and Stage 3 exposures in year 1. Future property prices for realising collateral will evolve as described in the given scenarios when the LGD is estimated.

This means that Impairment loss for old Stage 3 assets will be 0 in year 2 and year 3 (with additional provisions on Stage 3 assets coming as they migrate from Stage 1 and Stage 2 and receive their respective provisions with perfect foresight)

Issues and Challenges

• This methodological assumption is part of the EBA Credit risk: Questions for participating banks

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