Stress Testing the Financial Macrocosm

Abstract

What should the next generation of financial stress tests look like? If recent crises are any guide, our strongly interlinked financial system, economy, and indeed wider society need to be viewed in unison – together, they make up a larger ‘financial macrocosm’. Studying the resilience of that larger macrocosm requires a new generation of stress testing models that capture the interconnections within the financial system, between the financial system and the real economy, and – particularly in the context of climate change – the interconnections between the natural world, the real economy, and the financial system. Such models, informed by large-scale data collection, would enable better evaluation of financial stability risks and support the design of new policy ideas to improve financial stability outcomes. In a rapidly evolving financial system that is constantly facing new threats, they would help policymakers and regulators get back into the driver’s seat. We appreciate that this vision is ambitious – the goal of this chapter is to make it plausible and to articulate what it would take to make it real. We introduce the modelling techniques and conceptual framework such an approach would be based on, outline the modelling innovations and the enabling conditions that are required, and conclude with a brief overview of the improvements to financial regulatory policy such stress tests would enable.

Keywords: Financial Stress Testing, Financial Crisis, Systemic Risk, Financial Stability, Market Ecology, Economic Simulations, Climate Stress Tests, Macroprudential Regulation, Economy-Wide Financial Stress Tests

JEL Classification: C53, C55, C67, C54, G01, G21, G23, G28, G33, P28, Q54