A generic stress testing framework with related economic shocks and possible regulatory intervention

Dror Parnes and Michael Jacobs Jr.

Abstract

In this study, we develop and demonstrate a universal framework for supervisory stress tests of financial institutions that considers the probable dependencies among macroeconomic shocks and possible regulatory intervention. The proposed differential equations model can assess the combined influence of related shocks in various markets and economic attributes on banks’ excess capital beyond minimum regulatory ratios. The suggested model allows policy makers to implement sensitivity analyses, which reveal how an examined bank’s excess capital would react to diverse economic shocks with a wide range of varying intensities. Our model can further assess the likely impact of regulatory intervention at different magnitudes and at various points in time. It can therefore help regulators to select the optimal intervention in different economic settings.