Macroprudential Stress Tests: A Reduced-Form Approach to Quantifying Systemic Risk Losses

By Zineddine Alla, Raphael A Espinoza, Qiaoluan H. Li, Miguel A. Segoviano

March 9, 2018

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Zineddine Alla, Raphael A Espinoza, Qiaoluan H. Li, and Miguel A. Segoviano Macroprudential Stress Tests: A Reduced-Form Approach to Quantifying Systemic Risk Losses, (USA: International Monetary Fund, 2018) accessed November 21, 2024

Disclaimer: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

Summary

We present a novel approach that incorporates individual entity stress testing and losses from systemic risk effects (SE losses) into macroprudential stress testing. SE losses are measured using a reduced-form model to value financial entity assets, conditional on macroeconomic stress and the distress of other entities in the system. This valuation is made possible by a multivariate density which characterizes the asset values of the financial entities making up the system. In this paper this density is estimated using CIMDO, a statistical approach, which infers densities that are consistent with entities’ probabilities of default, which in this case are estimated using market-based data. Hence, SE losses capture the effects of interconnectedness structures that are consistent with markets’ perceptions of risk. We then show how SE losses can be decomposed into the likelihood of distress and the magnitude of losses, thereby quantifying the contribution of specific entities to systemic contagion. To illustrate the approach, we quantify SE losses due to Lehman Brothers’ default.

Subject: Asset and liability management, Asset valuation, Banking, Countercyclical capital buffers, Financial contagion, Financial regulation and supervision, Financial sector policy and analysis, Stress testing, Systemic risk

Keywords: Amplification loss, Asset valuation, Asset valuation model, CIMDO method, Conditional loss, Countercyclical capital buffers, Estimating Se loss, Financial contagion, Financial stability, Financial system, Global, Interconnectedness structure, LB default, Loss propagation, Losses from Se, Market price, Presents loss, Se loss, SRA loss, Stress test loss, Stress testing, Systemic risk, WP

Publication Details

Pages:

45
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2018/049
Stock No:

WPIEA2018049
ISBN:

9781484345344
ISSN:

1018-5941

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