15 February 2018

Vox EU: Macroprudential stress tests

Current stress testing of banks is focused on the resiliency of individual banks to exogenous shocks. This column describes how the next generation of macroprudential stress tests aim to capture the endogenous nature of systemic risk caused by the interaction of all the institutions and markets making up the financial system.

The Global Crisis in 2008 demonstrated that existent financial regulations were inadequate. The authorities missed the excessive amounts of risk-taking and the increasing fragility of banks, which in turn created the conditions that allowed the crisis to happen. Since then, a number of measures have been put in place under the rubric of macroprudential policy.

The aim of macroprudential policy is to contain systemic risk while ensuring the efficient functioning of the financial system. It sits aside microprudential policy, focused on the conduct of individual financial institutions.

An important tool in the policymakers' toolkit is stress testing of banks, which has emerged in the past ten years as the main way the strength and weaknesses of the banking sector is assessed. Initially, the stress tests were microprudential in nature, focused on individual banks’ resilience to exogenous shocks. For many banks, passing their annual stress tests has been the binding regulatory constraint that has driven capital policy and has helped to shape major supervisory decisions.

However, the Global Crisis in 2008 showed that relatively small initial losses in the financial system can be magnified to systemic dimensions and can threaten to bring financial system to a halt; thus, a microprudential perspective that focuses on losses at the individual institution level were proven not enough.

In response, the financial stability authorities are increasingly turning to ‘system-wide stress testing’ as a tool to be better prepared for handling systemic risks. Such stress tests need to capture systemic risk, and hence be focused on the stability of the entire financial system.

What is required from true macroprudential stress tests (MaPSTs)? They should recognise that systemic risk is driven by the interaction of the variety of financial institutions that make up the system and amplification factors to which such institutions are exposed. Thus, interactions and the severity amplification factors define the way shocks are amplified or dampened. This means that systemic risk is endogenous, as noted by Danielsson et al. (2009); hence, stress tests that are supposed to capture systemic risk need to take into account its endogenous nature.

Designing such MaPSTs, however, is not straightforward.

• First, they need to consider the interaction of all the various entities that make up the financial system, from regulated banks to other types of financial institutions, including in the domestic and global financial system.
• Second, they need to account for amplification factors to which institutions might be exposed to. These usually manifest as financial imbalances in the form of excessive leverage, liquidity and maturity mismatches and exposures to overvalued assets.

To identify the current state of development in MaPSTs, the Monetary and Capital Markets (MCM) Department at the IMF joined forces with the Systemic Risk Centre (SRC) at the London School of Economics to produce a definitive report on MaPSTs (IMF-LSE 2018).

The joint IMF-LSE report surveys the current state of research and policy considerations in macroprudential stress tests, identifying some trends in theoretical and empirical modelling.

MaPSTs are just beginning to be implemented and much work is left to be done. While the fundamental theoretic underpinnings of SRAs are by now well understood, the empirical foundations are still evolving. Data remain a challenge.

MaPSTs have the potential to be of considerable benefit to both policymakers and practitioners. Financial policy, including the determination of bank capital and the structure of the financial system will be informed by MaPSTs. Similarly, private sector financial institutions will get better risk management and assessment of tail risk.

Full article 

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