Macroprudential stress tests have been employed by regulators in the United States and Europe to assess and address the solvency condition of financial firms in adverse macroeco-nomic scenarios. Financial institutions are required to maintain a capital cushion against such events and stress tests are designed to assess if it is adequate. If it is not, then the capital shortfall is the additional capital needed. We compare the capital shortfall measured by regulatory stress tests, to that of a benchmark methodology — the “V-Lab stress test” — that employs only publicly available market data. We find that when capital shortfalls are measured relative to risk-weighted assets, the ranking of financial institutions is very different from the V-Lab stress test, whereas when measured relative to total assets, the results are quite similar. We show that the risk measures used in risk-weighted assets are cross-sectionally uncorrelated with market measures of risk as they do not account for the “risk that risk will change. ” Furthermore, the firms that appeared to be best capitalized relative to risk-weighted assets were no better than the rest when the European economy deteriorated into the sovereign debt crisis in 2011.

This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate. Financial network analysis is used to provide firm level bottom-up holistic visualizations of interconnections of financial obligations in global OTC derivatives markets. This helps to identify Systemically Important Financial Intermediaries (SIFIs), analyse the nature of contagion propagation, and also monitor and design ways of increasing robustness in the network. Based on 2009 FDIC and individually collected firm level data covering gross notional, gross positive (negative) fair value and the netted derivatives assets and liabilities for 202 financial firms which includes 20 SIFIs, the bilateral flows are empirically calibrated to reflect data-based constraints. This produces a tiered network with a distinct highly clustered central core of 12 SIFIs that account for 78 percent of all bilateral exposures and a large number of financial intermediaries (FIs) on the periphery. The topology of the network results in the “Too-Interconnected-To-Fail ” (TITF) phenomenon in that the failure of any member of the central tier will bring

Financial innovations often respond to regulation by sidestepping regulatory restrictions that would otherwise limit activities in which people wish to engage. Securitization of loans (e.g., credit card receivables, or subprime residential mortgages) is often portrayed, correctly, as having arisen in part as a means of “arbitraging ” regulatory capital requirements by booking assets off the balance sheets of regulated banks. Originators of the loans were able to maintain lower equity capital against those loans than they otherwise would have needed to maintain if the loans had been placed on their balance sheets. 1 Capital regulation of securitization invited this form of off-balance-sheet regulatory arbitrage, and did so quite consciously. Several of the capital requirement rules for the treatment of securitized assets originated by banks, and for the debts issued by those conduits and held or guaranteed by banks, were specifically and consciously designed to permit banks to allocate less capital against their risks

The macroeconomic theories and models favored by academics, as well as those used more commonly by policymakers, effectively rule out by assumption economic and financial crises of the sort we are living through. (In particular, the longer-run dangers posed by the rapid expansion of credit and resulting private-sector balance-sheet developments are almost wholly ignored.) As a result, the current crisis was neither anticipated nor prepared for, and the crisis was also less well managed than it might have been. At the level of macroeconomic theory and modeling, this experience suggests that basic Keynesian insights need to be complemented by some insights from the Austrian school as well as those of Minsky. (Demand factors are important, but so too are supply-side and financial considerations.) Such a synthesis provides a reasonable explanation of the crisis and points to some of the difficulties likely to be faced in emerging from it. As for the policy implications in current circumstances, it needs to be better recognized that policies with positive short-run effects can have negative effects over a longer time period. If, as a result, fiscal expansion and monetary expansion have now reached their limits in some countries, supply-side policies must be given greater emphasis. (These would include measures to encourage investment, both private and public, as well as other structural measures to raise the potential growth rate of the economy.) Such measures, along with more decisive efforts to reduce the “headwinds ” of over-indebtedness, should with time provide the foundations for a sustainable economic recovery.

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The former BIS chief economist argues that the global economic crisis should prompt a rethinking of macroeconomic analysis Simply improving our macroeconomic analytical frameworks will likely not be sufficient to avoid future crises. Nevertheless, a reevaluation is necessary. There are many dead ends from which to escape, but there are also many promising strands of thought to be pursued. Everyone is painfully aware that we are in the middle of a major global economic and financial crisis. During a visit to the London School of Economics late last year, Queen Elizabeth ll asked why no economists had forecast the crisis. But indeed some had sounded warnings. A more interesting question is why no one, including

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The financial crisis, that began to unfold in the summer of 2007 in the United States and led to the worst economic downturn after the Great Depression, with huge direct and indirect costs to public finances, brought to the fore great weaknesses in the system of financial surveillance worldwide. Macroeconomic imbalances were major underlying factors of the crisis, together with the a-critical celebration of the “invisible hand ” and of markets ’ efficiency, rationality and self-corrective properties. The need was, therefore, recognized to bring together a better understanding and adjustment of macroeconomic and financial issues. In particular, financial surveillance should be better designed and implemented around sustainable macroeconomic developments. The Global Financial System (GFS) is an essential infrastructure to support the global economy, a central network to achieve the economy’s potential at world level. The GFS is a worldwide integrated dynamic innovative network of interactive components: intermediaries, securities (products), markets,

Abstract: The Squam Lake Report is a volume by economists for economists. It offers the fruits of the labors of 15 top economists who met at Squam Lake, New Hampshire, to discuss financial reform. While somewhat disjointed, and avoiding many important issues, the book is nonetheless a tour du force. Its many recommendations derive from two basic principles: that reformers need to think systemically, and that third-party costs stemming from systemic risk need to be internalized. And its approach is just what you would expect from a group of academic economists. It asks (and answers) questions like: Where did incentives go wrong? What were the sources of market failure? How can we better protect society against negative externalities?

NOTE: This Working Paper should not be reported as representing the views of the European Central Bank (ECB). The views expressed are those of the authors and do not necessarily reflect those of the ECB. Macroprudential Research Network This paper presents research conducted within the Macroprudential Research Network (MaRs). The network is composed of economists from the European System of Central Banks (ESCB), i.e. the 27 national central banks of the European Union (EU) and the European Central Bank. The objective of MaRs is to develop core conceptual frameworks, models and/or tools supporting macro-prudential supervision in the EU. The research is carried out in three work streams: 1) Macro-financial models linking financial stability and the performance of the economy; 2) Early warning systems and systemic risk indicators; 3) Assessing contagion risks.