Expected losses are then compared to the buffers of profits and capital (perhaps with an adjustment for whether the scenario is likely to be “slow burn” wherein potential future profits might absorb some of the loss, or “fast burn” where pressure falls more immediately on capital) to guide the judgement on the overall impact of the stress scenario on the banking system (and/or on the financial system more broadly). 6 We have utilised this broad approach within the Bank of England to assess the risks to the major UK banks from sources of potential major vulnerability – both individually and in combination. Results have been published in recent Financial Stability Reports (see Chart B). 2  2  Bank of England Financial Stability Report June 2006 and April 2007. The description above applies particularly for the corporate, household and global imbalances stress. See A new approach to assessing risks to financial stability by Andrew Haldane, Simon Hall and Silvia Pezzini, Bank of England Financial Stability Paper No 2 April 2007 for a fuller discussion. 2  BIS Review 81/2007  7 This approach has a number of strengths. First, it draws on a fully consistent macroeconomic scenario and on statistical estimates of the impact of adverse economic conditions on credit and market exposures. Second, building formal “maps” of transmission of economic shocks onto the financial system facilitates greater analytical consistency and provides enhanced clarity on which channels are important. This aids the understanding of risks.
When operational, such distributions should help guide judgements on how overall financial system vulnerability is changing. But the approach should also provide considerable additional information on pressure points within the system and on the channels of transmission and potential contagion. 14 I believe that this broad approach offers an important step forwards in the development of an analytically and empirically robust framework for financial stability work. Of course it is analytically hugely challenging – modelling non-linear tail events with endogenous strategic interactions is always going to be tough! The results will inevitably be subject to major uncertainty. But the approach does start to provide a consistent and coherent framework which should substantially improve the value of top-down stress tests and of risk assessment work. 15 A particular “operational” aim is to use the results to help improve the focus of risk reduction work and crisis management planning, for example through the identification of  BIS Review 81/2007  7  “weak points” in the financial system and through improved assessment of the impact of policy interventions. An important element of risk reduction work is to influence the behaviour of financial firms. “Bottom-up” or firm-level stress-testing practices have developed rapidly in recent years. But one challenge is that, as for the authorities, it is hard for individual firms to gauge the likely “systemic impact” of particular shocks, which takes into account macro and financial system interactions and feedback effects.