Examination of Bank Failures Requires Systematic and Systemic Stress Tests

Abstract

Stress tests that do not consider systemic risk may be focused only on the initial risk of insolvency due to loan losses and not on the consequent risk of illiquidity that arise from deleveraging. We examine bank failures to find a larger number of banks failing in a larger number of scenarios due to the impact of deleveraging and fire sales on asset prices. The change in the distribution of the risk factors after fire sales, and the increased risk of bank failures under the new distribution, substantiates the need for a systematic and systemic search of stress scenarios. We demonstrate the application of a systematic stress test with and without the consideration of systemic risk. The systematic and systemic search produces scenarios that are equally plausible as the EBA stress scenario but yield considerable worse system wide losses.