Designing Scenarios for Macro Stress Testing (Financial System Report, April 2016)
April 22, 2016
Financial System and Bank Examination Department
Bank of Japan
In the Financial System Report, two macro stress test scenarios are presented: (1) a "tail event scenario" that assumes an extremely severe set of financial and economic conditions approximately equivalent to the Lehman shock in every semiannual report, in order to assess the stability of the financial system through fixed-point observations; (2) a "tailored event scenario" in which the vulnerability of the financial system is assessed according to macroprudential concerns, with its focus changing over time. In the April 2016 issue of the Report, the tailored event scenario features a rise in Japanese banks' foreign currency funding costs.
This paper delves into the approach employed in specifying the quantitative relationships among variables during the process of developing the stress scenarios. In recent years, financial institutions have been placing increasing emphasis on stress testing as a tool to capture and analyze varied and complex risks and their effects on profitability and financial strength, as part of a risk management framework. Stress testing plays an important role in a risk appetite framework that governs financial institutions' risk management and risk taking behavior, based on their business strategies. In conducting stress testing on a financial institution, it is critical to develop an appropriate scenario that applies suitably severe stress corresponding to its risk profile. Other important elements of a well-designed scenario include the appropriate calibration of macro-economic and financial variables, firm-level financial data, and a sound understanding of their linkages. The Bank of Japan hopes that this paper will contribute to the enhancement of stress testing among financial institutions. The Bank of Japan discloses the detailed scenarios and test results, in order to enhance communication with financial institutions.
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