Stress Tests as a Systemic Risk Assessment Tool

Abstract

Turning stress tests into a useful tool for assessing system-wide risk requires the following: (1) incorporating general equilibrium dimensions, so that the outcome of the test depends not only on the size of the shock and the initial buffers of individual institutions, but also on their responses to the shock and their interactions with each other and with other economic agents; and (2) focusing on the resilience of the system as a whole. Progress has been made toward the first goal; several models are now available that capture behavioral responses and feedback effects. But building models that measure correctly systemic risk and the contribution of individual institutions to it has proved more difficult. Further progress in this area would entail using a variety of analytical approaches and scenarios, integrating non-bank financial entities, and exploring the use of agent-based models. Also, stress tests should not be used in isolation but be treated as complements to other tools and--crucially--be combined with micro-prudential perspectives.

Keywords: Banks, Financial Stability, Contagion, Stress Tests, Systemic Risk, Solvency