Why is stress testing a valuable part of credit risk assessment?

Comprehensive and Detailed In-Depth Explanation:

Stress testing evaluates a credit portfolio’s resilience under adverse scenarios (e.g., economic downturns), quantifying impacts on defaults, losses, and capital adequacy. Option D is correct—Basel II’s Pillar 2 mandates stress testing for unexpected outcomes. Option A (common situations) describes standard modeling, not stress testing. Option B (probabilistic expectations) aligns with VaR, not stress testing’s focus on extremes. Option C (optimizing migration) is unrelated to stress testing’s purpose.

Exact Extract from Official Source:

BCBS, "Basel II: International Convergence of Capital Measurement and Capital Standards," June 2006, para. 434: "Stress testing is a critical tool for credit risk assessment, enabling banks to quantify the impact of adverse and unexpected scenarios on their credit portfolios and capital levels."

GARP FRR Study Notes, Credit Risk Section: "Stress testing assesses the effect of severe, unexpected events on credit losses and capital, distinguishing it from routine risk modeling."