Macroprudential Stress Tests: A Reduced-Form Approach to Quantifying Systemic Risk Losses

46 Pages Posted: 15 Nov 2018

See all articles by Zineddine Alla

Zineddine Alla

Sciences Po

Raphael A. Espinoza

International Monetary Fund (IMF)

Qiaoluan Li

International Monetary Fund (IMF)

Miguel Segoviano Basurto

International Monetary Fund (IMF) - Monetary and Financial Systems Department

Date Written: March 2018

Abstract

We present a novel approach that incorporates individual entity stress testing and losses from systemic risk effects (SE losses) into macroprudential stress testing. SE losses are measured using a reduced-form model to value financial entity assets, conditional on macroeconomic stress and the distress of other entities in the system. This valuation is made possible by a multivariate density which characterizes the asset values of the financial entities making up the system. In this paper this density is estimated using CIMDO, a statistical approach, which infers densities that are consistent with entities' probabilities of default, which in this case are estimated using market-based data. Hence, SE losses capture the effects of interconnectedness structures that are consistent with markets' perceptions of risk. We then show how SE losses can be decomposed into the likelihood of distress and the magnitude of losses, thereby quantifying the contribution of specific entities to systemic contagion. To illustrate the approach, we quantify SE losses due to Lehman Brothers' default.

Keywords: Systemic risk, Macroprudential policies and financial stability, Financial crises, Stress testing, Stress testing; systemic risk; financial stability, financial stability, Government Policy and Regulation, Financial Markets and the Macroeconomy

JEL Classification: G28, G01, E44

Suggested Citation

Alla, Zineddine and Espinoza, Raphael A. and Li, Qiaoluan and Segoviano Basurto, Miguel, Macroprudential Stress Tests: A Reduced-Form Approach to Quantifying Systemic Risk Losses (March 2018). IMF Working Paper No. 18/49, Available at SSRN: https://ssrn.com/abstract=3285232

Zineddine Alla (Contact Author)

Sciences Po ( email )

27 rue Saint-Guillaume
Paris Cedex 07, 75337
France

Raphael A. Espinoza

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

HOME PAGE: http://oxford.academia.edu/RaphaelEspinoza

Qiaoluan Li

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

Miguel Segoviano Basurto

International Monetary Fund (IMF) - Monetary and Financial Systems Department ( email )

Washington, DC
United States

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