Nigel Jenkinson: Developing a framework for stress testing of financial stability risks Comments by Mr Nigel Jenkinson, Executive Director, Financial Stability, Bank of England, at the ECB High Level Conference on “Simulating Financial Instability”, Frankfurt am Main, 12-13 July 2007. I am very grateful to Adrian Penalver, Prasanna Gai, Geoff Coppins and Piergiorgio Alessandri for input and helpful comments. *  *  *  1 Developing a rigorous, coherent and robust framework to analyse the resilience of the financial system to withstand strain presents many well-known and formidable challenges. Financial system behaviour is very difficult to model, particularly under stressed conditions when strategic interactions between participants and risks of spillover and contagion come to the fore. And, thankfully, episodes of stress are rare, so history offers only limited assistance. 2 We are currently witnessing a period of major change in financial markets. The global financial system is evolving at a tremendous pace, fuelled by rapid innovation and crossborder integration, and supported by lower macroeconomic volatility. Innovation and integration may have a profound impact on the behaviour of the financial system under pressure. In particular, risks may have been dispersed more broadly through credit risk transfer and increased participation in capital markets. The resulting reduction in credit risk concentration may have strengthened the robustness of the financial system to withstand small to medium shocks. But equally, greater market integration has strengthened the ties between financial firms within and across borders, both through direct exposures and through common exposures to asset markets.
Financial System Risks in the UK – Issues and Challenges (John Gieve) (July 2006) www.bankofengland.co.uk/publications/speeches/2006/speech280.pdf . BIS Review 81/2007  1  To deliver these objectives effectively, the aim is also to use a rigorous and consistent analytical framework which integrates behavioural responses, interactions and feedback effects, to ensure that the system-wide implications are fully captured 5 So where is current practice against that ideal? A typical or traditional “macro” stress test has the stylised form set out in Chart A. The first stage is to put together a coherent stress scenario, typically using a macro-econometric model (which may include some assumed endogenous policy response). By mapping important propagation channels, an estimate of likely financial sector credit losses is produced; for example, by modelling the impact of the macro stress on corporate and household balance sheets and gauging the consequent impact on the probability of default and likely recovery rate on banks’ credit exposures. Market losses are estimated by judging the impact of the macro stress on different asset classes. Total bank losses are calculated by aggregating credit and market losses, perhaps including an additional allowance for the impact of the stress scenario on net interest income and on funding costs.