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Stress Tests - A New Modeling Paradigm & a Pragmatic Approach

I have been reviewing the papers from a recent conference;-

The ESRB at 1

SUERF/Deutsche Bundesbank/IMFS Conference

& I think there is a crystallisation of a theme at that conference reflected in one particular presentation which articulates a narrative that we have been developing here on asymptotix in regard to Stress testing over the last 2 or 3 years.

IMF Global Financial Stability Report - September 2011: Europe bank's exposure to the eurozone debt crisis increased to €300bn

 

Europe bank's exposure to the eurozone debt crisis has increased to €300bn (£263bn).

Cumulative spillovers from high spread euro area sovereigns to the EU banking system - 300 bn euros

The epicenter of sovereign risk has been Greece, which generated the first of four waves of spillover to European banks. The analysis suggests that, first, spillovers on European bank exposures to the Greek sovereign have amounted to almost €60 billion (Figure 1.17). Second, as sovereign risks spread to other governments, the spillovers to banks have mounted. If the sovereign stresses in Ireland and Portugal are included, the total spillover rises to €80 billion. Third, the governments in Belgium, Italy, and Spain have also come under market pressure; incorporating credit risks from these sovereigns into the analysis further raises the total estimated spillover, to about €200 billion. Fourth, bank asset prices in the high-spread euro area have fallen in concert with sovereign stresses, leading to a rise in the credit risk of interbank exposures; including those exposures increases the total estimated spillover to €300 billion overall. Although these numbers are based on market assessments of credit risk, which may reflect a degree of overshooting, the underlying problems that they highlight are real.

New asymptotix paper: Quantitative Easing and the Yield on the Ten Year Gilt

asymptotix QE10Y

this intro page updated / edited 7th July 2012
(the paper probably needs a re-write & update too)

At the beginning of asymptotix, explaining our philosphy here, I said;-

Back in the day; the Monetarist / Keynesian debate, bursting out in the US when Reagan was elected, the Keynesians (e.g. Cowles Commission) could attack monetarists by saying that monetarists had no theory [the monetarists were 'Logical Positivists']. The monetarist response (Chicago School and Berkeley) was that the Keynesians did not understand science and particularly did not understand data.

A Developing issue in Macro-Econometric Modeling: Stress Testing

There is a developing issue in Macro-Econometric Modeling right now. It has been burning for about a year; we at asymptotix have some practical engagement with it which is reflected in our essay called 'Crowding Out 2'. That essay and its related comments simply document our experience at the client coal-face where we naively found ourselves addressing in a commercial engagement a great intellectual challenge of our time, probably way ahead of the academic curve. At a much more global and higher media oriented level this issue is documented in what is known as the Krugman / Ferguson debate or put more crudely (cf Niall Ferguson) the Keynesians versus the Monetarists (or more strictly the Classicists or Neo-Classicists).

The Lunatix are on the Grass: A new Bretton Woods proposition for Europe

viaduct morlaix asymptotixSUMMARY 

We are where we are, capital has transitioned to the state, we need public institutions which can properly manage us through this second phase sovereign debt crisis and develop a roadmap for free markets beyond a properly constituted European "Bretton Woods" style "Public Debt Bank" (its not for me to coin the name); philosophically in line with Keynes' thinking.

The term macroprudential - origins and evolution

In the wake of the recent financial crisis, the term “macroprudential” has become a true buzzword. A core element of international efforts to strengthen the financial system is to enhance the macroprudential orientation of regulatory and supervisory frameworks. Yet the term was little used before the crisis, and its meaning remains obscure. This special feature traces the term’s origins to the late 1970s, in the context of work on international bank lending carried out under the aegis of the Euro-currency Standing Committee at the BIS. It then describes its changing fortunes until its recent rise to prominence.

ISSUES IN MODEL RISK

 

the elephant in the data centre

(see below)

 

ECB Financial Stability Review June 2009: Eurozone banks face $283bn writedowns

Eurozone banks face additional losses of more than $283bn this year and next as continental Europe’s severe recession intensifies strains on its financial sector, the European Central Bank has warned.

The fates of the eurozone economy and its banks have become increasingly interlinked, the ECB reported on Monday in its latest “financial stability review” with banks losses expected to be focused on their loan exposures. Risks to the stability of the financial sector remained high, it said, while “uncertainty prevails” over the shock-absorbing capacity of the banking system.

The Point About Stress Tests

 

This morning I could be back at school or University, reading this; "City traders are braced for turmoil in UK financial sector stocks this week, when the Federal Reserve releases results of health checks on 19 US banks on Thursday. At least two big banks are believed to have failed the "stress tests"." from here: the Herald.

 

Macroeconomic Models of the Euro area at the European Central Bank

 

see intro text box : August 2012 : point of order : August 2012;   " the '@ the ECB' predicate in the title is more than a little redundant & 'wears' as time goes on but I am stuck with it; the ECB does move with the times, particularly after the Trichet speech in Clare College, Christmas 2009 & one can even begin to see DG ECFIN lumber towards modernity also; the historical lesson below still retains relevance however .. "

 

I noticed an inocuous looking little text box on the enormous European Central Bank (ECB) website, it describes four approaches to macroeconomic modeling going on at the European Central Bank, the first thing that strikes one is just how elderly the methodological underpinning is.

That does not by defintion mean that the approach in this modelling is weak or flawed or anything like that at all but it may entail that when a commercial financial institution is looking for a methodological guide for stress testing or asset valuation, these methodologically elderly models may not be the best blueprint for them. This is particulalry so currently where what could be described as a 'Logical Positivist' approach needs to be adopted in Stress Testing and Asset Valuation problems. By this I mean the 'partial equilibrium' or purely statistical methods deployed simply to quantify risk or economic capital or fair value. In this context I thought it might be useful to look briefly at the 4 macroeconomic models referenced on the ECB site and summarise what these models are doing and what their objective is.

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