Working Paper: NBER ID: w25686
Authors: Richard B. Berner; Stephen G. Cecchetti; Kermit L. 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 analyze 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; central counterparties; financial networks; systemic risk
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) | systemic risk (E44) |
| interconnectedness of CCPs (F60) | vulnerabilities (K24) |
| prefunded resources exhausted (H55) | vulnerabilities (K24) |
| capital levels of the CMs (E44) | CCPs' contribution to systemic risk (F65) |
| significant decline in global equity prices (G10) | substantial capital shortfall for CMs (G32) |
| simultaneous stress on CCPs (D74) | overlapping clearing members (G24) |
| CMs' capital shortfalls (F65) | exacerbate stress during market turmoil (G41) |
| interconnectedness of CCPs (F60) | systemic vulnerabilities (P34) |