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Macrofinancial stress testing: Incorporating systemic risk perspectives into a stress testing framework

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Since the global financial crisis, stress testing has received renewed attention. On one hand, pre-crisis stress tests yielded largely benign results, which called into question the effectiveness of stress testing for detecting financial system-wide risks, namely systemic risks. On the other hand, stress testing now has enhanced roles for crisis management and financial sector oversight. In order to better shoulder these new roles, the stress testing framework should be improved, incorporating systemic risk perspectives. This article proposes best practice principles for such a framework, building on the lessons from the crisis. The test should be designed appropriately, including a clear understanding of the scope and objectives, knowledge of the key individual financial institutions in the system, their business models and main channels of risk transmission, and right decision on the test's perimeter and coverage. However, there will be limitations, regardless of refinements and improvements. One should therefore always be cautious about using test results in isolation: a well-rounded risk assessment should use stress tests with other tools to broaden the understanding of vulnerabilities.
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Keywords: best practice; financial crisis; macroprudential; stress testing; systemic risk

Document Type: Research Article

Publication date: January 1, 2014

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  • Journal of Risk Management in Financial Institutions is the essential professional and research journal for all those involved in the management of risk at retail and investment banks, investment managers, broker-dealers, hedge funds, exchanges, central banks, financial regulators and depositories, as well as service providers, advisers, researchers and academics. Guided by expert Editors and an eminent Editorial Board, each quarterly 100-page issue does not publish advertising but rather in-depth articles, reviews and applied research by leading professionals and researchers in the field on six key inter-related areas: strategic and business risk, financial risk, including traditional/exotic credit, market and liquidity risks, operational risk, regulatory and legal risks, systemic risk, and sovereign risk.

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