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New Framework for Measuring and Managing Macrofinancial Risk and Financial Stability

  • Dale F. Gray;
  • Robert C. Merton
  • Zvi Bodie

This paper proposes a new approach to improve the way central banks can analyze and manage the financial risks of a national economy. It is based on the modern theory and practice of contingent claims analysis (CCA), which is successfully used today at the level of individual banks by managers, investors, and regulators. The basic analytical tool is the risk-adjusted balance sheet, which shows the sensitivity of the enterprise’s assets and liabilities to external “shocks.” At the national level, the sectors of an economy are viewed as interconnected portfolios of assets, liabilities, and guarantees—some explicit and others implicit. Traditional approaches have difficulty analyzing how risks can accumulate gradually and then suddenly erupt in a full-blown crisis. The CCA approach is well-suited to capturing such “non-linearities” and to quantifying the effects of asset-liability mismatches within and across institutions. Risk-adjusted CCA balance sheets facilitate simulations and stress testing to evaluate the potential impact of policies to manage systemic risk.

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Paper provided by Central Bank of Chile in its series Working Papers Central Bank of Chile with number 541.

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Date of creation: Dec 2009
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Handle: RePEc:chb:bcchwp:541
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  1. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-70, May.
  2. Bernanke, Ben S. & Gertler, Mark & Gilchrist, Simon, 1999. "The financial accelerator in a quantitative business cycle framework," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 21, pages 1341-1393 Elsevier.
  3. Black, Fischer & Cox, John C, 1976. "Valuing Corporate Securities: Some Effects of Bond Indenture Provisions," Journal of Finance, American Finance Association, vol. 31(2), pages 351-67, May.
  4. Dimitrios P Tsomocos & Gunnar Bardsen, 2006. "Evaluation of macroeconomic models for financial stability analysis," Economics Series Working Papers 2006-FE-01, University of Oxford, Department of Economics.
  5. Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, vol. 4(1), pages 141-183, Spring.
  6. Mario Draghi & Francesco Giavazzi & Robert C. Merton, 2003. "Transparency, Risk Management and International Financial Fragility," NBER Working Papers 9806, National Bureau of Economic Research, Inc.
  7. Yingbin Xiao & Dale F. Gray & Cheng Hoon Lim & Michael T. Gapen, 2004. "The Contingent Claims Approach to Corporate Vulnerability Analysis: Estimating Default Risk and Economy-Wide Risk Transfer," IMF Working Papers 04/121, International Monetary Fund.
  8. Dimitrios P Tsomocos, 2004. "A Time Series Analysis of Financial Fragility in the UK Banking System," Economics Series Working Papers 2004-FE-18, University of Oxford, Department of Economics.
  9. Ivan Alves, 2005. "Sectoral fragility: factors and dynamics," BIS Papers chapters, in: Bank for International Settlements (ed.), Investigating the relationship between the financial and real economy, volume 22, pages 450-80 Bank for International Settlements.
  10. Tsomocos, Dimitrios P., 2003. "Equilibrium analysis, banking and financial instability," Journal of Mathematical Economics, Elsevier, vol. 39(5-6), pages 619-655, July.
  11. Jan Willem van den End & Mostafa Tabbae, 2005. "Measuring Financial Stability: Applying the MfRisk Model to the Netherlands," DNB Working Papers 030, Netherlands Central Bank, Research Department.
  12. Marco Sorge, 2004. "Stress-testing financial systems: an overview of current methodologies," BIS Working Papers 165, Bank for International Settlements.
  13. Robert C. Merton & Zvi Bodie, 1992. "On the Management of Financial Guarantees," Financial Management, Financial Management Association, vol. 21(4), Winter.
  14. Charles Goodhart & Pojanart Sunirand & Dimitrios Tsomocos, 2006. "A model to analyse financial fragility," Economic Theory, Springer, vol. 27(1), pages 107-142, 01.
  15. M. Hashem Pesaran & Til Schuermann & Scott M. Weiner, 2001. "Modelling regional interdependencies using a global error-correcting macroeconometric model," 10th International Conference on Panel Data, Berlin, July 5-6, 2002 B4-1, International Conferences on Panel Data.
  16. Zvi Bodie, 2006. "On asset-liability matching and federal deposit and pension insurance," Review, Federal Reserve Bank of St. Louis, issue Jul, pages 323-330.
  17. Charles Goodhart & Pojanart Sunirand & Dimitrios P. Tsomocos, 2004. "A model to analyse financial fragility: applications," LSE Research Online Documents on Economics 24680, London School of Economics and Political Science, LSE Library.
  18. Longstaff, Francis A & Schwartz, Eduardo S, 1995. " A Simple Approach to Valuing Risky Fixed and Floating Rate Debt," Journal of Finance, American Finance Association, vol. 50(3), pages 789-819, July.
  19. Dale F. Gray & Robert C. Merton & Zvi Bodie, 2006. "A New Framework for Analyzing and Managing Macrofinancial Risks of an Economy," NBER Working Papers 12637, National Bureau of Economic Research, Inc.
  20. repec:imf:imfwpa:06/80 is not listed on IDEAS
  21. Dale F. Gray & Elena Loukoianova & Samuel W. Malone & Cheng Hoon Lim, 2008. "A Risk-Based Debt Sustainability Framework: Incorporating Balance Sheets and Uncertainty," IMF Working Papers 08/40, International Monetary Fund.
  22. repec:imf:imfwpa:05/155 is not listed on IDEAS
  23. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
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