Foundations of system-wide financial stress testing with heterogeneous institutions

J. Farmer, Alissa Kleinnijenhuis, Paul Nahai-Williamson and Thom Wetzer

INET Oxford Working Papers from Institute for New Economic Thinking at the Oxford Martin School, University of Oxford

Abstract: We propose a structural framework for the development of system-wide financial stress tests with multiple interacting contagion, amplification channels and heterogeneous financial institutions. This framework conceptualises financial systems through the lens of five building blocks: financial institutions, contracts, markets, constraints, and behaviour. Using this framework, we implement a system-wide stress test for the European financial system. We obtain three key findings. First, the financial system may be stable or unstable for a given microprudential stress test outcome, depending on the system's shock-amplifying tendency. Second, the 'usability' of banks' capital buffers (the willingness of banks to use buffers to absorb losses) is of great consequence to systemic resilience. Third, there is a risk that the size of capital buffers needed to limit systemic risk could be severely underestimated if calibrated in the absence of system-wide approaches.

Keywords: Systemic risk; stress testing; financial contagion; financial institutions; capital requirements; macroprudential policy (search for similar items in EconPapers)
JEL-codes: C63 G17 G21 G23 G28 (search for similar items in EconPapers)
Pages: 84 pages
Date: 2020-05
New Economics Papers: this item is included in nep-ban, nep-cfn, nep-fdg, nep-isf, nep-ore and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (11)

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Working Paper: Foundations of system-wide financial stress testing with heterogeneous institutions (2020)
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Persistent link: https://EconPapers.repec.org/RePEc:amz:wpaper:2020-14

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