## Amplification modelling

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**Canonical URL:** [Amplification modelling](https://www.imf.org/-/media/files/news/seminars/mcm-lse-danielsson_session3.pdf)

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### Stress testing and crisis frequency
- The average OECD country suffers a systemic crisis once every 42 years (Laeven and Valencia database).
- The UK once every 17 years, the next one is due in 2024.
- The 42-year estimate is an overestimate because it includes relatively non-extreme events, like October 1987 and August/September 1998.
- A more reasonable frequency is once every 78 years (2007-1929).
- A stress test scenario should be calibrated to that frequency.

### Risk is endogenous
- Classification of risk as exogenous or endogenous (Danielsson–Shin (2002)):
  - exogenous: shocks to the financial system arrive from outside the system, like with an asteroid.
  - endogenous: financial risk is created by the interaction of market participants.
- Quoted perspective: “The received wisdom is that risk increases in recessions and falls in booms. In contrast, it may be more helpful to think of risk as increasing during upswings, as financial imbalances build up, and materialising in recessions.” — Andrew Crockett, then head of the BIS, 2000.

### The two faces of risk
- Market participants are guided by many models and rules (e.g., capital, mark–to–market, leverage) that often dictate short–termism.
- Prices don’t follow random walks in adverse states of nature — they become partially predictable.
- The financial system is not invariant under observation; we cycle between virtuous and vicious feedbacks.
- Distinction:
  - perceived risk — risk reported by most risk forecast models.
  - actual risk — hidden but ever present.

### Endogenous bubble and dynamics
- Conceptual depiction: perceived risk and actual risk diverge during a build-up of prices (endogenous bubble), with perceived risk falling as prices rise while actual risk increases.
- Hidden triggers can lead to indicators flashing, improvised responses, Macroprudential (MacroPru) implementation, but actual risk may continue to build, producing cyclical recurrence.

### The 42 year cycle of systemic risk (conceptual cycle)
- Sequence of stages described:
  - actual risk builds up
  - hidden trigger
  - perceived risk indicators flash
  - improvised responses
  - MacroPru implemented
  - actual risk builds up again
- Emphasis on persistence: MacroPru implementation may not prevent renewed build-up of actual risk and the return of the cycle.

### Implications for stress test design — Triggers and amplifiers
- There is an infinite number of triggers and a very small number of amplification mechanisms.
- Unknown unknowns matter; stress tests preparing only for known risks are insufficient.
- Illustrative contrasts:
  - The US stock market suffers a $200 billion loss and nobody is concerned.
  - The US has a $200 billion loss in subprime mortgages, and a global crisis ensues.
- Stress test design needs to be based on hidden amplification mechanisms.

### When decisions are made
- Timing matters: market volatility and systemic-stress indicators influence when risk-taking decisions are made (chart reference to SP−500 annual volatility and ECB Systemic Stress Composite Indicator across 1990–2016).

### How volatility affects risk-taking and crises
- Danielsson, Valenzuela and Zer (2016) “Learning from History: Volatility and Financial Crises” — key findings:
  - Economic agents perceive a low risk environment as a signal to increase risk-taking, which can eventually lead to a crisis.
  - Volatility does not predict crises.
  - Volatility below its trend significantly increases both:
    - future risk-taking (credit-to-GDP)
    - and the probability of banking crises half a decade or longer into the future.

### Government accounting and crisis resolution
- Gandrud and Hallerberg (2016) “Keeping Costs in the Shadows: The Resolution of Financial Crisis and the Rules of the Game” — key points:
  - Government accounting rules vary considerably across countries.
  - A particular intervention might be classified as an expense on the central bank balance sheet in one country but not another.
  - Consequently, a particular action might be called a bailout in one country but not in another.
  - Government accounting rules determine how governments choose to intervene.
  - A stress test should take government accounting differences into account.

### The potential for procyclical macroprudential policy
- VoxEU.org (2016) Jon Danielsson, Robert Macrae, Dimitri Tsomocos, Jean-Pierre Zigrand — arguments and risks:
  - Minsky argument and homogenization of the financial system.
  - Most current indicators of systemic risk only identify perceived risk.
  - Danger of reacting with some time lag to indicators that themselves are measured with a time lag.
  - When macroprudential policy is known to the market, banks will schedule risk-taking around indicators, stress tests and expected policy reaction.
  - Authorities should be willing to reduce aggregate risk-taking and leverage during booms and increase it in times of stress.
- Common objections that call for a procyclical policy response include:
  - “Banks are failing because they already extended too much credit”
  - “Surely bank capital needs injections rather than allowing the banks capital to absorb losses”
  - “Helping the City to increase lending now leads to even bigger moral hazard”
  - “Macropru is discredited because it was supposed to have prevented this credit event in the first place, why should it do better this time?”

### Types of data for macroprudential modeling
- Accounting data:
  - Infrequent, backward looking, measurement errors.
- Market data:
  - Reflects ex–post outcomes, not the ex–ante environment when decisions were taken years earlier.
- Flow data:
  - Highly aggregate and measured with lags.
  - Efforts to measure asset manager flows between asset classes and regions.
- Supervisory level data:
  - Probably contain most needed information.
  - May not be processed, or inconsistently recorded.
  - Often not available for macropru modeling.
  - Even then geographically restricted.

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_Source: https://www.imf.org/-/media/files/news/seminars/mcm-lse-danielsson_session3.pdf_