Working Paper: NBER ID: w13607
Authors: Dale F. Gray; Robert C. Merton; Zvi Bodie
Abstract: This paper proposes a new approach to improve the way central banks can analyze and manage the financial risks of a national economy. It is based on the modern theory and practice of contingent claims analysis (CCA), which is successfully used today at the level of individual banks by managers, investors, and regulators. The basic analytical tool is the risk-adjusted balance sheet, which shows the sensitivity of the enterprise's assets and liabilities to external "shocks." At the national level, the sectors of an economy are viewed as interconnected portfolios of assets, liabilities, and guarantees -- some explicit and others implicit. Traditional approaches have difficulty analyzing how risks can accumulate gradually and then suddenly erupt in a full-blown crisis. The CCA approach is well-suited to capturing such "non-linearities" and to quantifying the effects of asset-liability mismatches within and across institutions. Risk-adjusted CCA balance sheets facilitate simulations and stress testing to evaluate the potential impact of policies to manage systemic risk.
Keywords: macrofinancial risk; financial stability; contingent claims analysis
JEL Codes: E44; G0
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| CCA framework (G52) | improved analysis of financial risks (G17) |
| CCA framework (G52) | risk-adjusted balance sheet (G32) |
| risk-adjusted balance sheet (G32) | sensitivity of assets and liabilities to external shocks (E44) |
| CCA framework (G52) | quantification of asset-liability mismatches (G32) |
| traditional models (C20) | failure to capture gradual accumulation of risks (G33) |
| CCA framework (G52) | improved risk management outcomes (G11) |
| CCA framework (G52) | simulations and stress testing (C15) |
| simulations and stress testing (C15) | evaluate potential impact of policies (D78) |
| CCA framework (G52) | capture nonlinearities in risk transmission (C22) |