A New Heuristic Measure of Fragility and Tail Risks: Application to Stress Testing
IMF Working Papers, August 1, 2012
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- A New Heuristic Measure of Fragility and Tail Risks: Application to Stress Testing
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Bibliographic details
- Authors: Christian Schmieder, Tidiane Kinda, Nassim N. Taleb, Elena Loukoianova, Elie Canetti
- Published: August 1, 2012
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781475505665.001
Summary
- Presents a simple heuristic measure of tail risk.
- Applied to individual bank stress tests and to public debt.
- Frames stress testing as a first order test of potential negative outcomes in response to tail shocks.
- Argues that stress testing results can be misleading in the presence of model error and uncertainty in parameters and their estimation.
- Positions the heuristic as a second order stress test to detect nonlinearities in the tails that can lead to fragility.
- Shows how the measure can be used to assess the robustness of public debt forecasts.
- The heuristic can be used in a variety of situations to ascertain an ordinal ranking of fragility to tail risks.
Methodological contribution
- Introduces a simple, heuristic metric designed to capture tail risk and fragility beyond standard stress test outputs.
- Emphasizes detection of nonlinearities in tails that standard (first order) stress tests may miss.
- Designed to provide additional information on the robustness of stress tests under model error and parameter uncertainty.
Applications and use cases
- Individual bank stress testing (solvency stress testing context).
- Assessment of public debt forecast robustness.
- Ordinal ranking of fragility to tail risks across entities or scenarios.
Key findings and implications
- Standard stress testing can understate tail vulnerabilities when model error and parameter uncertainty are present.
- A second order heuristic test can reveal nonlinear tail behaviors that increase fragility.
- Applying the heuristic to public debt forecasts addresses an important issue for many countries.
Publication and metadata
- Authors: Christian Schmieder, Tidiane Kinda, Nassim N. Taleb, Elena Loukoianova, Elie Canetti
- Date: August 1, 2012
- Pages: 24
- Volume: 2012
- Issue: 216
- Series: Working Paper No. 2012/216
- DOI: https://doi.org/10.5089/9781475505665.001
- Stock No: WPIEA2012216
- ISBN: 9781475505665
- ISSN: 1018-5941
- Subjects: Banking, Credit, Financial sector policy and analysis, Money, National accounts, Personal income, Public debt, Solvency stress testing, Stress testing
- Keywords: bank, bank capitalization, basic procedure, contagion risk stress tests, Credit, debt, Forecasting, Global, inappropriate method, interconnectivity risk, Personal income, procedure, Solvency stress testing, Stability, standardized method, Stress Testing, tail risk, WP
IMF Working Papers. This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy.