Foundations of System-Wide Financial Stress Testing with Heterogeneous Institutions

83 Pages Posted: 18 May 2020 Last revised: 1 Jun 2020

See all articles by J. Doyne Farmer

J. Doyne Farmer

University of Oxford

Alissa M. Kleinnijenhuis

MIT Sloan School of Management; Golub Centre of Finance and Policy, MIT; University of Oxford - Institute for New Economic Thinking at the Oxford Martin School ; University of Oxford - Mathematical Institute; Oxford-Man Institute of Quantitative Finance

Paul Nahai-Williamson

Bank of England

Thom Wetzer

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

Date Written: May 15, 2020

Abstract

We propose a structural framework for the development of system-wide financial stress tests with multiple interacting contagion, amplification channels and heterogeneous financial institutions. This framework conceptualises financial systems through the lens of five building blocks: financial institutions, contracts, markets, constraints, and behaviour. Using this framework, we implement a system-wide stress test for the European financial system. We obtain three key findings. First, the financial system may be stable or unstable for a given microprudential stress test outcome, depending on the system’s shock-amplifying tendency. Second, the ‘usability’ of banks’ capital buffers (the willingness of banks to use buffers to absorb losses) is of great consequence to systemic resilience. Third, there is a risk that the size of capital buffers needed to limit systemic risk could be severely underestimated if calibrated in the absence of system-wide approaches.

Keywords: Systemic risk, stress testing, financial contagion, financial institutions, capital requirements, macroprudential policy

JEL Classification: G17, G21, G23, G28, C63

Suggested Citation

Farmer, J. Doyne and Kleinnijenhuis, Alissa M. and Nahai-Williamson, Paul and Wetzer, Thom, Foundations of System-Wide Financial Stress Testing with Heterogeneous Institutions (May 15, 2020). Bank of England Working Paper No. 861, Available at SSRN: https://ssrn.com/abstract=3601846 or http://dx.doi.org/10.2139/ssrn.3601846

J. Doyne Farmer

University of Oxford ( email )

Mansfield Road
Oxford, Oxfordshire OX1 4AU
United Kingdom

Alissa M. Kleinnijenhuis

MIT Sloan School of Management ( email )

100 Main Street
Cambridge, MA 02142
United States

Golub Centre of Finance and Policy, MIT ( email )

100 Main Street
Cambridge, MA 02142
United States

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

Oxford
United Kingdom

University of Oxford - Mathematical Institute ( email )

United Kingdom

Oxford-Man Institute of Quantitative Finance ( email )

Oxford
United Kingdom

Paul Nahai-Williamson (Contact Author)

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

Thom Wetzer

University of Oxford, Faculty of Law ( 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

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

Oxford
United Kingdom

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