Working Paper: CEPR ID: DP13604
Authors: Richard Berner; Stephen G. Cecchetti; Kermit Schoenholtz
Abstract: Stress tests applied to individual institutions are an important tool for evaluating financial resilience. However, financial systems are typically complex, heterogeneous and rapidly changing, raising questions about the adequacy of conventional tests. In this paper, we interpret the current stress test practice from a network perspective, highlighting central counterparties (CCPs) as an example of a critical network hub. Networks that include CCPs involve deep and broad interconnections, making stress testing a challenging task. We propose supplementing both private and supervisory CCP stress tests with a high-frequency indicator constructed from a market-based estimate of the conditional capital shortfall (SRISK) of the CCP’s clearing members. Applying our measure to two large CCPs, we analyze how they can transmit and amplify shocks across borders, conditional on the exhaustion of prefunded resources. Our results highlight how the network created by central clearing can act as an important transmission mechanism for shocks emanating from Europe.
Keywords: stress testing; financial network; central counterparties; CCP; financial stability; SRISK; financial regulation; resolution
JEL Codes: G18; G23; G28; G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| central counterparties (CCPs) (E58) | financial shocks (F65) |
| prefunded resources of a CCP (G23) | potential for further stress (Y50) |
| systemic shock (P50) | widespread financial instability (F65) |
| initial failure from a large aggregate shock (E32) | widespread financial instability (F65) |
| failure of CCPs (P11) | broader collapse of financial network (F65) |
| interconnectedness of financial networks (F65) | complicates assessment of resilience (E71) |
| central counterparties (CCPs) (E58) | transmission mechanisms for financial shocks (F65) |