Stress Testing Financial Systems: A Macro Perspective

The recent financial crisis has perpetuated the need for a greater emphasis on stress testing the financial system. A greater level of preparedness is required on the part of institutions that form a part of this system. This makes the task of analyzing stress testing at the macro level an interesting exercise. This paper has three objectives. First, it provides an overview of macro stress testing. This section deals with issues of scope, design, specification and aggregation. Second, it focuses on two main methodologies used for stress testing analysis- the piecewise and integrated approach. While the former focuses on evaluating vulnerability to single risk factors, the latter combines the sensitivity to multiple risk factors into a single estimate of expected losses. Finally, it looks at the methodological challenges of inter-bank linkages, feedback effects and endogenous parameter instability etc.