Within the Bank of England, we are building a suite of models that allow the transmission channels for potential financial system stress to be mapped out accurately and comprehensively, including in the form of loss distributions. The outputs can also be compared to measures of financial system buffers, such as profits, to provide summary statistics of systemic vulnerability. 4 Others too have been pursuing a similar course. For example, the Austrian central bank has developed a Systemic Risk Monitor to characterise the interaction between shocks and the structure of the banking system and inform the internal policy debate. 5 11 A schematic for the planned suite of models is set out in Chart D and will be described more fully in future papers. The left-hand side of the diagram emphasises the transmission of shocks to the system through conventional channels of credit and market risk. On the righthand side, asset-pricing models can be used to facilitate inferences about banks’ balance sheet positions and vulnerability to default from market price data (such as equity prices). Given the limitations of balance sheet data and the difficulty of identifying new types of  4  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. 5  Oesterreichische Nationalbank (2006), "Systemic Risk Monitor: A Model for Systemic Risk Analysis and Stress Testing of Banking Systems", Financial Stability Report 11, by Michael Boss, Gerald Krenn, Claus Puhr, Martin Summer.
If a shock is sufficiently large, the financial network may consequently act as a conduit for transmitting rather than absorbing risk. So the flip side of greater integration is that it may have lowered the frequency but increased the magnitude of potential financial crises. 1 3 Improving the toolkit for financial stability analysis is consequently a very high priority for public authorities and for major financial institutions. Enhancing the capability to model the financial system under stress is the key challenge. 4 In recent years, many central banks and supervisory agencies, charged with the public policy goal of supporting the maintenance of financial stability, have sought to develop a socalled “top down” or “macro” stress-testing capability. Utilising information on balance sheet exposures, the authorities draw on macroeconomic and financial models to try to assess the impact of adverse shocks on the financial system. Several inter-related high level objectives can perhaps be set for an “ideal” stress test: •  To assess the vulnerability of the financial system to extreme but plausible shocks  •  To improve the understanding of the transmission of shocks through the financial system (and, in a worst case, the potential propagation of financial crises)  •  To identify “weak spots” in the financial system, to guide risk reduction priorities and crisis management planning  1  Systemic risk in modern financial systems: analytics and policy design by Prasanna Gai, Nigel Jenkinson and Sujit Kapadia, Journal of Risk Finance Vol8, No2, 2007.