Working Paper: CEPR ID: DP17145
Authors: Cecilia Parlatore; Thomas Philippon
Abstract: We develop a tractable framework to study the optimal design of stress scenarios. A principal wants to manage the unknown risk exposures of a set of agents. She asks the agents to report their losses under hypothetical scenarios before mandating actions to mitigate the exposures. We show how to apply a Kalman filter to solve the learning problem and we characterize the scenario design as a function of the risk environment, the principal's preferences, and the available remedial actions. We apply our results to banking stress tests. We show how the principal learns from estimated losses under different scenarios and across different banks. Optimal capital requirements are set to cover losses under an adverse scenario while targeted interventions depend on the covariance between residual exposure uncertainty and physical risks.
Keywords: stress test; information; bank regulation; filtering; learning
JEL Codes: G2; D82; D83
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| prior beliefs (P) (D80) | stress scenarios (S) (C62) |
| stress scenarios (S) (C62) | reported losses (Y) (G22) |
| reported losses (Y) (G22) | posterior beliefs about risk exposures (X) (D81) |
| posterior beliefs about risk exposures (X) (D81) | optimal capital requirements (C) (D25) |
| covariance between residual exposure uncertainty (U) and physical risks (R) (D81) | interventions (I) (I12) |
| prior beliefs (P) (D80) | posterior beliefs about risk exposures (X) (D81) |
| stress scenarios (S) (C62) | posterior beliefs about risk exposures (X) (D81) |