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Non-Linearities, Model Uncertainty, and Macro Stress Testing

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Author Info

  • Miroslav Misina
  • David Tessier

Abstract

A distinguishing feature of macro stress testing exercises is the use of macroeconomic models in scenario design and implementation. It is widely agreed that scenarios should be based on "rare but plausible" events that have either resulted in vulnerabilities in the past or could do so in the future. This requirement, however, raises a number of difficult statistical and methodological problems. Economic models, as well as the statistical models of the relationships among economic variables, generally focus on capturing the average rather than the extreme behaviour, and frequently rely on the assumption of linearity. In this paper we show that these models are particularly ill-suited for stress-testing as they do not adequately capture past behaviour in extreme events, nor do they generate plausible responses to shocks under stress. Whereas one might argue that the use of these models is still preferable to no having no models, since they at least impose the consistency restrictions on the paths generated under the scenario, failing to deal with a large extent of uncertainty of these paths may lead to results that are non-informative, and potentially misleading. The paper illustrates both of these problems by a series of examples, but our conclusions have broader implications for the types of models that would be useful in these exercises.

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Bibliographic Info

Paper provided by Bank of Canada in its series Working Papers with number 08-30.

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Length: 34 pages
Date of creation: 2008
Date of revision:
Handle: RePEc:bca:bocawp:08-30

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Keywords: Financial stability;

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References

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  1. Òscar Jordà, 2005. "Estimation and Inference of Impulse Responses by Local Projections," American Economic Review, American Economic Association, vol. 95(1), pages 161-182, March.
  2. Jorge A. Chan-Lau, 2006. "Fundamentals-Based Estimation of Default Probabilities: A Survey," IMF Working Papers 06/149, International Monetary Fund.
  3. Miroslav Misina & David Tessier & Shubhasis Dey, 2006. "Stress Testing the Corporate Loans Portfolio of the Canadian Banking Sector," Working Papers 06-47, Bank of Canada.
  4. Virolainen , Kimmo, 2004. "Macro stress testing with a macroeconomic credit risk model for Finland," Research Discussion Papers 18/2004, Bank of Finland.
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Cited by:
  1. Rodrigo Alfaro A. & Rodrigo Cifuentes S., 2009. "FinanciaL Stability, Monetary Policy and Central Banking: an Overview," Journal Economía Chilena (The Chilean Economy), Central Bank of Chile, vol. 12(2), pages 5-10, August.
  2. Gabriele Galati & Richhild Moessner, 2011. "Macroprudential policy - a literature review," BIS Working Papers 337, Bank for International Settlements.
  3. Ricardo Schechtman & Wagner Piazza Gaglianone, 2011. "Macro Stress Testing of Credit Risk Focused on the Tails," Working Papers Series 241, Central Bank of Brazil, Research Department.
  4. Miroslav Misina & Greg Tkacz, 2009. "Credit, Asset Prices, and Financial Stress," International Journal of Central Banking, International Journal of Central Banking, vol. 5(4), pages 95-122, December.
  5. Antonella Foglia, 2009. "Stress Testing Credit Risk: A Survey of Authorities' Aproaches," International Journal of Central Banking, International Journal of Central Banking, vol. 5(3), pages 9-45, September.
  6. Guarda, Paolo & Rouabah, Abdelaziz & Theal, John, 2012. "An MVAR framework to capture extreme events in macro-prudential stress tests," Working Paper Series 1464, European Central Bank.

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