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June 30, 2017

IMF published a working paper that develops a framework for facilitating the analysis of both the direct effects of macroeconomic shocks on the solvency of individual banks and feedback effects that allow for the amplification and propagation of shocks that can result from bank deleveraging and credit crunches. The framework allows for endogenous linkages between the real economy and the banking sector to better analyze the impact of macroeconomic shocks on the balance sheets of individual banks while allowing for feedback effects from banking-sector solvency shocks to the real economy.

The framework ensures consistency in the key relationships between macroeconomic and financial variables and bank balance sheets. This is accomplished by embedding a standard stress-testing framework based on data of individual banks in a semi-structural macroeconomic model. The framework has numerous applications that can strengthen stress testing and macro financial analysis. Moreover, it provides an avenue for many extensions that address the challenges of incorporating other second-round effects important for comprehensive systemic risk analysis, such as interactions between solvency, liquidity, and contagion risks. To this end, the paper presents some preliminary simulations of feedback effects arising from the link between the liquidity and solvency risk.

 

The paper argues that the link between solvency and liquidity can create non-linear effects from negative shocks and can enlarge macro-feedback effects. Avenues to strengthen the micro-prudential aspect of the framework are also discussed. While the stress-testing module developed here is very simple due to data constraints and the objective to make the framework operational with publicly available data, the stress-testing module can easily be extended to resemble an FSAP stress test based on supervisory data. All these extensions have been left for future work.

 

Related Link: Working Paper (PDF)

Keywords: International, Banking, IMF, Stress Testing, Macro-prudential Framework

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