Backtesting Macroprudential Stress Tests

41 Pages Posted: 10 Oct 2020

See all articles by Amanah Ramadiah

Amanah Ramadiah

University College London - Financial Computing and Analytics Group, Department of Computer Science

Daniel Fricke

Deutsche Bundesbank; University College London; London School of Economics & Political Science (LSE) - Systemic Risk Centre

Fabio Caccioli

University College London

Multiple version iconThere are 2 versions of this paper

Date Written: August 21, 2020

Abstract

In this paper, we consider models of price-mediated contagion in a banking network of common asset holdings. For these models, the literature proposed two alternative classes of liquidation dynamics: threshold dynamics (banks liquidate their investment portfolios only after they have defaulted), and leverage targeting dynamics (banks constantly rebalance their portfolios to maintain a target leverage ratio). We introduce a one-parameter family of non-linear liquidation functions that interpolates between these two extremes. We then test the capability of these models to predict actual bank defaults (and survivals) in the United States for the years 2008-10. We show that the model performance depends on the type of shock being imposed (idiosyncratic versus systematic). We identify the two most relevant asset classes, for which the model has predictive power when these asset classes are exposed to an initial shock. In these cases, the model performs better than alternative benchmarks that do not account for the network of common asset holdings, irrespective of the assumed liquidation dynamics. We also show how the best performing liquidation dynamics depend on the combination of the initial shock level and the market impact parameter, on the cross-sectional variation in the market impact parameter, and on the number of asset liquidation rounds.

Keywords: systemic risk, fire sales, price-mediated contagion, common asset holdings

JEL Classification: G01, G11

Suggested Citation

Ramadiah, Amanah and Fricke, Daniel and Caccioli, Fabio, Backtesting Macroprudential Stress Tests (August 21, 2020). Available at SSRN: https://ssrn.com/abstract=3678600 or http://dx.doi.org/10.2139/ssrn.3678600

Amanah Ramadiah (Contact Author)

University College London - Financial Computing and Analytics Group, Department of Computer Science ( email )

Gower Street
London, WC1E 6BT
United Kingdom

Daniel Fricke

Deutsche Bundesbank ( email )

Wilhelm-Epstein-Str. 14
Frankfurt/Main, 60431
Germany

University College London ( email )

Gower Street
London, WC1E 6BT
United Kingdom

London School of Economics & Political Science (LSE) - Systemic Risk Centre

Houghton St, London WC2A 2AE, United Kingdom
London

Fabio Caccioli

University College London ( email )

Gower Street
London, WC1E 6BT
United Kingdom

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