22 February 2017

ECB: STAMP€: Stress-Test Analytics for Macroprudential Purposes in the euro area

Financial sector stress tests have proved to be an important tool for assessing the robustness of the financial system and gauging risks arising at system-wide level from a macroprudential perspective. This guide offers a suite of analytical tools for those interested in stress-testing frameworks.

In 2013, the European Central Bank (ECB) published an occasional paper describing the framework and its various modules for conducting stress tests. These had been used since 2009 to support the EU-wide stress test by the Committee of European Banking Supervisors and later by the European Banking Authority (EBA). Since 2013, new modules and tools have been developed. These tools go well beyond the requirements of the traditional solvency stress tests applied to banks. They include a broader set of institutions than just banks, an analysis of the financial cycle as well as an assessment of systemic risk levels associated with the economic and financial shocks considered in adverse scenarios.

The financial crisis and its aftermath led to a greater use of stress tests and to the establishment of macroprudential policy as a new policy area, with the objective being to identify and limit systemic risk. In the ECB Financial Stability Review, systemic risk is defined as “the risk that financial instability significantly impairs the provision of necessary financial products and services by the financial system to a point where economic growth and welfare may be materially affected”. At the heart of this definition is the notion that the materialisation of systemic risk imposes significant costs on the real economy. 

The literature has identified three broad sources of systemic risk:

• macroeconomic shocks that are significant enough to cause distress in the financial system,
• the unwinding of imbalances in the financial system generated by excessive leverage, and
• contagion risk, created by increasing interconnectedness and herd behaviour. 

Several indicators to measure systemic risk have been proposed since 2008. The first type of indicators has a “micro-level” dimension, i.e. it calculates the contribution of significant institutions individually to systemic risk. The Marginal Expected Shortfall (MES), Conditional Value at Risk (CoVar), CoRisk or Conditional Tail Risk (CRT), for example, fall into this category. Taken in isolation, they do not help to predict future levels of systemic risk, as they tend to use contemporaneous market prices and do not consider the system as a whole. 

Composite indicators such as the ECB’s Composite Indicator of Systemic Stress (CISS) represent a second type of measure. It comprises five aggregate market segments accounted for by a range of variables and time-varying rank correlations between them. Another example is CATFIN, a value-at-risk and expected shortfall measure at system-wide level, calculated with non-normal distributions with fat tails, showing the predictive capacity of financial volatility regarding real economic downturns.

A third type of approach complements these efforts and relates to the concept of the financial cycle, in contrast to that of the economic or business cycle. In fact, a country’s positioning in the financial cycle – with respect to a historical benchmark – can be seen as a systemic risk indicator and be used to predict overall levels of risk in the system. In that context, a first step was taken in a recent ECB working paper building on and extending work done at the Bank for International Settlements (BIS) on the financial cycle. It shows how credit and asset prices share cyclical similarities, captured in a synthetic financial cycle index that outperforms credit-toGDP gap measures in predicting systemic banking crises, on a horizon of up to three years.

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