Priority of the research project: Current stress tests only consider a handful of scenarios and do not quantify the plausibility of scenarios. Furthermore, second round effects arising from the reaction of financial institutions to shocks are rarely considered. This current approach may lead to an illusion of safety, to premature reaction on alarming stress test results, and to the underestimation of risk.
In this project we aim to develop a second generation stress testing framework, which is both systematic and systemic. It systematically analyses a multitude of sufficiently plausible scenarios in order to identify the worst case for the financial system. It models systemic risk arising from fire sales and contractual networks, where financial institutions are affected by the reactions of others to the stress. Building on results in various strands of the academic literature, we propose to develop a robust model relying on available data and to implement a prototype software for systematic and systemic stress tests.
We propose to develop the core elements of a modern stress testing framework:
We briefly describe the methods to develop the five core elements mentioned above: