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. 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. it also highlights which channels are explicitly included in the stress tests and which are not, and are consequently priorities for future work. third, sensitivity analysis can easily be carried out to assess the impact of altering behavioural assumptions – for example, what would happen if write - off rates on corporate exposures were higher than expected? fourth, the results can be compared to “ bottom - up ” stress tests calculated by individual firms, which have developed rapidly in recent years, but which may be less focussed on capturing macroeconomic and financial sector feedbacks. 8 the traditional approach to stress testing, nonetheless, suffers from some major limitations. most strikingly, the current treatment of key financial system interactions and feedback effects is often rudimentary. given that such effects are crucial in assessing the vulnerability to contagion and system - wide stress, that is a significant drawback. take the illustrative severe stress scenarios published in the bank of england financial stability report and shown above in chart b as a guide. these scenarios are constructed from risk transmission maps for each scenario based on the stylised model in chart c. in practice, however, there are important gaps, as can be seen from table 1, where the channels which have been explicitly quantified in the stress scenarios are shown. in particular, the potential amplification of the shock within the financial system through channels such as an endogenous fall in market liquidity as firms simultaneously seek to lower risk exposures ; dynamic hedging behaviour ( particularly of “ unbalanced ” options positions ) 3 ; and restrictions on lending ( a bank of england financial stability report july 2006 box 5, page 33. “ credit crunch ” or “ financial accelerator ” effect ), are not yet built in empirically. and the framework does not yet

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. indeed, in practice, banks often model the effect of even severe macroeconomic shocks as if they were occurring to the bank in isolation. they thus may assume that they have freedom to readjust their balance sheets and lending practices in the event of an adverse shock, without considering whether other banks may be trying to do the same thing and the effect that these behavioural responses may have cumulatively on market liquidity and on the economy as a whole. an important implication is that many firm - level stress tests may consequently underestimate the possible impact of adverse shocks. as i have highlighted, some of the potentially missing effects should be captured in the proposed suite of models. but the proposed enhanced “ top - down ” approach outlined above may still benefit from additional insights gained from closer dialogue and interaction with major financial firms on their likely reaction to episodes of stress. i consequently think there is merit in more formal comparison of “ top - down ” and “ bottom - up ” stress testing exercises, and of seeking ways of integrating the two into more formal “ systemic ” stress tests, where the authorities present an initial scenario to firms and then modify the scenario in the light of feedback on the potential response by firms in an iterative loop. this approach has recently been pioneered by the dutch central bank. 6 it potentially offers a useful way of improving knowledge of key system - wide interactions, and thus could provide a valuable supplement both to improved “ top - down ” approaches and to “ bottom - up ” stress tests which are naturally targeted more closely at the major risks facing individual firms given their balance sheets and positions. 16 to conclude, there is a major programme of inherently difficult and challenging modelling work ahead for the public authorities and for financial firms. but this is very important. development of a more coherent and consistent framework for the analysis of financial stability is a major prize. ultimately this should improve the understanding and pricing of risk and support better targeting of public policy, focused more closely on containing systemic risk and on the maintenance of the public good of systemic financial stability. de nederlandsche bank ( 2006 ), financial stability : is the dutch financial sector stress - resistant? quarterly bulletin, december.