Using data from a representative survey, information on household income, expenses and liquid assets, the BCL calculated the probability of Luxembourg households to default on loans and assessed bank’s sensitivity to it, i.e., the aggregate bank exposure at default (EAD).

According to the paper, “Aggregate bank exposure at default (EAD) is obtained by multiplying the household-level of PD (probability to default) by their corresponding volume of outstanding loans and summing across the population of households.”

Aggregate bank loss given default (LGD), the amount of money a bank loses when a borrower defaults on a loan, was then calculated, assuming that banks recover real estate assets from defaulting households and liquidate them.

To simulate adverse economic conditions, the exercise was repeated with scenarios combining severe but plausible shocks (i.e., tail risk) to real estate prices, bonds and stocks, household income and interest rates.

The study concluded that, "Compared to the no-shock baseline, the LGD rose by a multiple of eight, reaching 4.2% of total bank exposure to the household sector. Thus, bank losses appear to be quite sensitive to severe stress. The high-stress scenario also generated a relatively high percentage of defaults among socio-economically disadvantaged households (i.e., low net wealth, low income, low education, three or more dependent children)."