BoE paper lays foundation for ‘system-wide stress test’

Research published by the Bank of England sets out the “foundations” of a “system-wide stress test” linking banks and non-banks through various contagion channels.

Doyne Farmer, Alissa Kleinnijenhuis, Paul Nahai-Williamson and Thom Wetzer note most stress tests are micro-prudential and examine the safety of individual institutions. Macro-prudential stress testing remains in its “infancy”, they say, and research to date has typically focused on modelling representative institutions.

By contrast, the authors of the BoE working paper design a framework of “heterogeneous institutions” including banks, investment funds and hedge funds. The model is comprised of five blocks: financial institutions, contracts, markets, constraints and behaviour. The authors say it is important to capture both the changing structure of the financial system over time and the channels through which shocks may be amplified and spread.

The authors test their model in parallel with the European Banking Authority’s 2018 micro-prudential stress test.

They find that for a given result of the micro-prudential test, the system as a whole may be stable or unstable depending on the contagion channels. Banks play an essential role in using capital buffers to absorb stress – if firms are unwilling to use their buffers, this can worsen system-wide losses. Finally, the authors warn that neglecting “endogenous amplification mechanisms” can lead regulators to underestimate optimal capital buffers.