Work by J.D. Farmer, A.M. Kleinnijenhuis, P. Nahai-Williamson, T. Wetzer

Microprudential stress tests have been credited for restoring confidence in the banking system and allowing for a successful recapitalisation of banks (Bernanke (2013)). They have gained enormous importance in the post-crisis regulatory toolkit. Their core goal is to assess systemic risk.

Despite their victories, microprudential stress tests lack interconnections, and thereby their ability to consider endogenously-amplified systemic risk. This fundamental deficiency impairs their ability to assess resilience, which has led various academics and regulators to call for system-wide stress tests (e.g. Brazier (2017)). Yet, no generic method exists yet (An- derson et al. (2018)). Challenges include (Anderson et al. (2018)): to capture systemic risk amplification mechanisms comprehensively and consistently; to encapsulate the behavioural responses to shocks; to encompass interactions between constraints and behaviour; to con- sistently incorporate non-banks; to reflect the heterogeneity of objectives, resources and constraints (Danielsson and Shin (2003)); to flexibly adjust to a changing financial system; and to deal with a lack of sufficiently granular and well-covered data.

In this paper, we propose a novel method for system-wide stress testing – that is, to our knowledge, the first to jointly tackle these challenges. It consists of five building blocks: institutions, contracts, constraints, markets, and behaviour. Together, these allow to track contagious dynamics in a multiplex network and assess fragility under various policy set- ups. We illustrate the power of this method by providing an implementation of the building blocks. We show that systemic risk may be significantly underestimated if microprudential stress tests are not supplemented with a ‘macroprudential overlay’.

Based on the tool’s foundations, credible stress system-wide stress tests can be built to crown the macroprudential toolkit.


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