25 Pages Posted: 3 Oct 2012
Date Written: August 2012
This paper presents a simple heuristic measure of tail risk, which is applied to individual bank stress tests and to public debt. Stress testing can be seen as a first order test of the level of potential negative outcomes in response to tail shocks. However, the results of stress testing can be misleading in the presence of model error and the uncertainty attending parameters and their estimation. The heuristic can be seen as a second order stress test to detect nonlinearities in the tails that can lead to fragility, i.e., provide additional information on the robustness of stress tests. It also shows how the measure can be used to assess the robustness of public debt forecasts, an important issue in many countries. The heuristic measure outlined here can be used in a variety of situations to ascertain an ordinal ranking of fragility to tail risks.
Keywords: Stress Testing, Forecasting, Stability, Banks, Economic Models, Public Debt
Suggested Citation: Suggested Citation
Taleb, Nassim Nicholas and Canetti, Elie R.D. and Kinda, Tidiane and Loukoianova, Elena and Schmieder, Christian, A New Heuristic Measure of Fragility and Tail Risks: Application to Stress Testing (August 2012). IMF Working Paper No. 12/216. Available at SSRN: https://ssrn.com/abstract=2156095.64