Dynamical Macro-Prudential Stress Testing Using Network Theory

Abstract

The increasing frequency and scope of financial crises have made global financial stability one of the major concerns of economic policy and decision makers. This has led to the understanding that financial and banking supervision has to be thought of as a systemic task, focusing on the interdependent relations among the institutions. Using network theory, we develop a dynamic model that uses a bipartite network of banks and their assets to analyze the system’s sensitivity to external shocks in individual asset classes and to evaluate the presence of features underlying the system that could lead to contagion. As a case study, we apply the model to stress test the Venezuelan banking system from 1998 to 2013. The introduced model was able to capture monthly changes in the structure of the system and the sensitivity of bank portfolios to different external shock scenarios and to identify systemic vulnerabilities and their time evolution. The model provides new tools for policy makers and supervision agencies to use for macroprudential dynamical stress testing.