A macro stress testing model with feedback effects
Stress testing is a tool to analyse the resilience of a financial system under extreme shocks. In contrast to single-bank stress testing models, macro stress testing models attempt to analyse risk for the system as a whole by taking into account feedback – i.e. the transmission of risks – within the system or between the financial system and the real economy. This paper develops a simple model of macro stress testing, incorporating two types of feedback - one between credit and interest rate risks and another between the banking system and the real economy. The model is tested using hypothetical banking sector data. The results from the exercise highlight the importance of incorporating feedback effects for the assessment of total risks to the system, and of recognising more than one type of feedback effect in a model for a robust assessment of risks to financial stability.