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Models of Financial Stability and their Application in Stress Tests

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  • Christoph Aymanns
  • J. Doyne Farmer
  • Alissa M. Keinniejenhuis
  • Thom Wetzer

Abstract

This paper reviews the literature on heterogeneous agent models of financial stability and their application in stress tests. We open with the observation that the financial system is a complex system, which heterogeneous agent models are well-suited to analyze. The paper then proceeds in two parts. In the first part, we discuss the fundamental drivers of systemic risk in financial systems, and set out how our understanding of them can be informed by heterogeneous agent models. We focus on models of systemic risk resulting from leverage constraints and models of financial contagion due to interconnectedness. In the second part of this review, we discuss how the conceptual insights from leverage and contagion models can be combined to model and understand systemic risk more broadly and to build robust and data-driven stress tests.

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  • Christoph Aymanns & J. Doyne Farmer & Alissa M. Keinniejenhuis & Thom Wetzer, 2017. "Models of Financial Stability and their Application in Stress Tests," Working Papers on Finance 1805, University of St. Gallen, School of Finance.
    • Handle: RePEc:usg:sfwpfi:2018:05
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    2. Farmer, J. Doyne & Goodhart, C. A. E. & Kleinnijenhuis, Alissa M., 2021. "Systemic implications of the bail-in design," LSE Research Online Documents on Economics 111903, London School of Economics and Political Science, LSE Library.
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    4. Ramadiah, Amanah & Fricke, Daniel & Caccioli, Fabio, 2022. "Backtesting macroprudential stress tests," Journal of Economic Dynamics and Control, Elsevier, vol. 137(C).

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