Enhanced Stress Testing and Financial Stability

To date, regulatory bank stress testing in the United States has focused on ensuring the banking system is resilient to losses in one or a few stress scenarios that involve macro-economic weakness, but it is unclear how far this resilience extends beyond the stress scenarios considered. In addition, a theory of which stress-scenarios should be chosen to achieve systemic-risk reduction objectives has not yet been developed. To improve stress testing practices, this paper proposes a framework for modeling systemic risk. The framework is used to identify areas where current stress-testing practices can be improved. Based on the framework, the paper proposes a new approach for systemic risk stress-testing and recapitalization policy that ensure the banking system is robust to a wide set of shocks, but minimizes the costs of achieving robustness through better sharing of risk. In addition, the systemic risk framework is used to examine how risks should be shared among banks to achieve systemic risk reduction.