Macroprudential stress tests: a reduced-form approach to quantifying systemic risk losses

Alla, Zineddine, Espinoza, Raphael, Li, Helen and Segoviano, Miguel (2018) Macroprudential stress tests: a reduced-form approach to quantifying systemic risk losses. Systemic Risk Centre Discussion Papers (79). Systemic Risk Centre, The London School of Economics and Political Science, London, UK.

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Abstract

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.

Item Type:	Monograph (Discussion Paper)
Official URL:	https://www.systemicrisk.ac.uk/
Additional Information:	© 2018 The Authors
Divisions:	Systemic Risk Centre
Subjects:	H Social Sciences > HC Economic History and Conditions H Social Sciences > HG Finance
JEL classification:	G - Financial Economics > G2 - Financial Institutions and Services > G28 - Government Policy and Regulation G - Financial Economics > G0 - General > G00 - General E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy
Date Deposited:	31 May 2023 13:09
Last Modified:	11 Dec 2024 19:45
URI:	http://eprints.lse.ac.uk/id/eprint/118930

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