System-wide stress testing & systemic risk

The financial crisis of 2007-2009, which brought the entire system at the brink of collapse, renewed efforts to guard against financial instability. A key pillar of the post-crisis regulatory toolkit is "stress testing". Stress tests provide a forward-looking examination of firms’ potential losses during severely ad- verse conditions. And enable timely action to recapitalise those firms who experience capital shortfalls in such crisis scenarios. Today’s regulatory stress tests do not heed the key lesson of the financial crisis: amplifications in the networked financial system must be taken into account to be able to assess systemic risk. Because of this, these tests are unable to assess systemic risk and ergo to address it – defeating their raison d’ˆetre.
The overarching research question in this thesis is whether new building blocks – expressing the heterogeneity of institutions, contracts, markets, constraints and behaviour in the interconnected financial system – can be supplied for system-wide stress tests to better capture the endogenous amplification of shocks in order to improve the assessment of systemic risk and the evaluation of prudential policies to address financial fragility.
The cornerstone of my thesis is the development of a generic network-based method, comprised of these five building blocks (i.e. institutions, contracts, markets, constraints and behaviour), for system-wide stress testing – which has gained traction from leading central banks, including the Bank of England and the European Central Bank. Using this method, I implement two data-driven models to address some of the most salient financial stability questions of today. First, we ask how the regulatory buffer size and its usability under Basel III affect systemic risk? We find that financial resilience decreases if regulatory buffers are seen to be less usable by banks. If regulatory buffers are not treated as usable, then regulatory buffers de facto act as capital requirements. In such case, if an adverse shock threatens an institution to breach its capital buffers constraints, it is forced to delever, which tends to have a destabilising effect on the financial markets. We show that the size of usable regulatory buffers that is required to maintain stability is underestimated if the interaction between exposure loss contagion, funding contagion, overlapping portfolio contagion and margin call contagion is not taken into account. Second, we inquire what the systemic implications are of the bail-in design to resolve systemically important banks? First of all, we find that the bail-in design tremendously matters for whether bail-ins can be credibly executed in system-wide financial crises and cases of large systemically impor- tant bank failures, without significantly exacerbating financial distress. Our results demonstrate that an early bail-in, strong recapitalisation and fair distribution of equity compensation by means of debt-to-equity conversion rates makes bail-in a feasible option on the table for idiosyncratic cases of bank failure and limits – but not eliminates – contagion in cases of system-wide distress. We further show that excluding run-prone, short-term debt from the application of the bail-in tool, increasing the requirements on loss absorbing debt and providing investors with certainty about the bail-in design lowers contagion in system-wide crises to manageable levels. Our findings highlight that while well-designed bail-ins could be credibly administered in system-wide crises, it is not clear that the current bail-in design is in the regime of stability. Altogether, the methods and findings of this thesis emphasise the promise that system-wide stress tests hold for regulators to efficaciously assess systemic risk and calibrate prudential policies constituting the financial architecture.

Keywords: stress testing
systemic risk
networks
mathematics
finance