Models of Financial Stability and Their Application in Stress Tests

Forthcoming, Handbook of Computational Economics (Blake LeBaron and Cars Hommes)

University of St.Gallen, School of Finance Research Paper No. 2018/5

66 Pages Posted: 22 Aug 2017 Last revised: 29 Apr 2018

See all articles by Christoph Aymanns

Christoph Aymanns

London School of Economics & Political Science (LSE) - London School of Economics; University of St. Gallen - School of Finance

J. Doyne Farmer

University of Oxford - Institute for New Economic Thinking at the Oxford Martin School; Santa Fe Institute

Alissa Kleinnijenhuis

University of Oxford - Institute for New Economic Thinking at the Oxford Martin School, Students ; University of Oxford - Oxford-Man Institute of Quantitative Finance, Students ; University of Oxford - Mathematical Institute

Thom Wetzer

University of Oxford, Students ; University of Oxford - Oxford-Man Institute of Quantitative Finance, Students ; Institute for New Economic Thinking at the Oxford Martin School

Date Written: March 22, 2018

Abstract

We review heterogeneous agent-based models of financial stability and their application in stress tests. In contrast to the mainstream approach, which relies heavily on the rational expectations assumption and focuses on situations where it is possible to compute an equilibrium, this approach typically uses stylized behavioral assumptions and relies more on simulation. This makes it possible to include more actors and more realistic institutional constraints, and to explain phenomena that are driven by out of equilibrium behavior, such as clustered volatility and fat tails. We argue that traditional equilibrium models and heterogeneous agent-based models are complements rather than substitutes, and review how the interaction between these two approaches has enriched our understanding of systemic financial risk. After presenting a brief summary of key terminology, we review models for leverage and endogenous risk dynamics. We then review the network aspects of systemic risk, including models for the three main channels of contagion: counterparty loss, overlapping portfolios and funding liquidity. We give an overview of applications to stress testing, including both microprudential and macroprudential stress tests. Finally, we discuss future directions. These include a better understanding of dynamics on networks and interacting channels of contagion, models with learning and limited deductive reasoning that can survive the Lucas critique, and practical applications to risk monitoring using models estimated with the massive data bases currently being assembled by the leading central banks.

Keywords: stress testing, systemic risk, contagion, leverage cycles, multi-layered networks, heterogeneous agent models, financial systems, financial stability, computational economics, complex systems, banks, non-banks, microprudential stress tests, macroprudential stress tests

JEL Classification: B16, B41, C02, C54, C55, C63, E44, E58, F47, G01, G02, G10, G18, G17, G15, G23, G22, G21, G28, K12,

Suggested Citation

Aymanns, Christoph and Farmer, J. Doyne and Kleinnijenhuis, Alissa and Wetzer, Thom, Models of Financial Stability and Their Application in Stress Tests (March 22, 2018). Forthcoming, Handbook of Computational Economics (Blake LeBaron and Cars Hommes) ; University of St.Gallen, School of Finance Research Paper No. 2018/5. Available at SSRN: https://ssrn.com/abstract=3022752

Christoph Aymanns

London School of Economics & Political Science (LSE) - London School of Economics ( email )

United Kingdom

University of St. Gallen - School of Finance

Unterer Graben 21
St.Gallen, CH-9000
Switzerland

J. Doyne Farmer (Contact Author)

University of Oxford - Institute for New Economic Thinking at the Oxford Martin School ( email )

Eagle House
Walton Well Road
Oxford, OX2 6ED
United Kingdom

HOME PAGE: http://www.inet.ox.ac.uk/people/view/4

Santa Fe Institute ( email )

1399 Hyde Park Road
Santa Fe, NM 87501
United States
505-984-8800 (Phone)
505-982-0565 (Fax)

HOME PAGE: http://www.santafe.edu/~jdf/

Alissa Kleinnijenhuis

University of Oxford - Institute for New Economic Thinking at the Oxford Martin School, Students ( email )

Oxford
United Kingdom

University of Oxford - Oxford-Man Institute of Quantitative Finance, Students ( email )

Oxford
United Kingdom

University of Oxford - Mathematical Institute ( email )

United Kingdom

Thom Wetzer

University of Oxford, Students ( email )

Oxford
United Kingdom

University of Oxford - Oxford-Man Institute of Quantitative Finance, Students ( email )

Oxford
United Kingdom

Institute for New Economic Thinking at the Oxford Martin School ( email )

Eagle House
Walton Well Road
Oxford, OX2 6ED
United Kingdom

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