System-Wide Stress Testing: How Micro Behaviour Affects Aggregate Financial Stability Outcomes

Stress tests were instituted at many central banks (such as at the Bank of England, the Federal Reserve, and the European Central Bank) as an integral part of their regulatory framework a few years after the financial crisis, which took place in 2007-2008. The financial crisis showed that banks and other financial institutions are able to default, bring down other financial institutions, and thereby affect the real economy. Stress tests aim to assess the resilience of the financial system and individual institutions therein. The stress test outcome-based regulatory actions are meant to help such a crisis happening again.
Although the current regulatory stress tests have brought back confidence in the financial system, have given insight into the previously opaque balance sheets, and have provided a useful mechanism for recapitalising banks, stress tests have a few significant shortcomings due to which these are not able to accurately assess the actual systemic risk in the financial system. First, stress tests do not take into account interconnections (e.g. interbank exposure, common asset holdings, derivative exposures) between financial institutions. Therefore, contagion (i.e. spread of stress), which was the main driver of defaults in the financial crisis, is not captured. Instead, the stress tests shock balance sheets. Second, the stress tests focus on one type of financial institution (e.g. bank stress tests, pension fund stress tests, insurer stress tests), instead of taking all the tightly interconnected types of financial institutions in the financial system into account.
To address these shortcomings I am collaborating with the Bank of England to develop a system-wide stress test that does take into account different types of financial institutions and their interconnections. In particular, we are developing an Agent Based Bodel (ABM) of the financial system. We model:

1) Agents (as a balance sheet composed of financial contracts)
2) Financial contracts (stipulating the interconnections between financial institutions)
3) Binding constraints (such as those coming from regulation, e.g. leverage constraint, and obligations associated to financial contracts, these constrain financial institution in their behaviour)

4) Profit-seeking behaviour

5) Financial markets (i.e. the venues where two counter parties match, agree upon financial contracts, and prices are formed).

Given that the model is initialised with regulatory data on the multiplex network of financial system, the model can be used for stress testing purposes to assess the stability of the financial system. We can define a few systemic risk measures and assess the sensitivity of this measure to various parameters in the financial system. Specifically, we will investigate how the choice of micro-behaviour in response to shocks affects aggregate financial stability (i.e. the systemic risk measures).


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