Factor Model for Stress-testing with a Contingent Claims Model of the Chilean Banking System
IMF Working Papers, April 1, 2008
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Bibliographic details
- Authors: Dale F. Gray, James P Walsh
- Published: April 1, 2008
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781451869507.001
Summary
- Paper derives risk indicators for the major Chilean banks based on contingent claims analysis, an extension of Black-Scholes-Merton option-pricing theory.
- Risk indicators are clearly tied to macroeconomic and financial developments in Chile and outside, but bank responses are highly heterogeneous.
- Principal component analysis is applied to reduce the number of variables linked to the banks' risk to a tractable number.
- Vector autoregressions of risk indicators with the most significant factors show strong ties from financial markets and regional developments.
- Impulse response functions from these factors are derived to allow for scenario testing.
- Scenarios illustrate how the magnitude and persistence of responses of bank credit risk can vary across banks in the system.
Methodology and Models
- Contingent claims analysis (extension of Black-Scholes-Merton option-pricing theory) used to derive bank-level risk indicators.
- Principal component analysis used for dimensionality reduction of bank risk variables.
- Vector autoregressions employed on risk indicators with the most significant factors.
- Impulse response functions derived from the factor VARs to enable scenario testing.
Key Findings
- Risk indicators link closely to macroeconomic and financial developments domestically and internationally.
- Bank responses to shocks are heterogeneous across major Chilean banks.
- Financial markets and regional developments are strong drivers of the most significant factors affecting bank risk.
- Scenario analysis demonstrates variation in both magnitude and persistence of credit risk responses across banks.
Policy-Relevant Applications and Scenario Testing
- The derived impulse response functions and scenarios provide a framework for stress-testing bank credit risk under alternative shocks.
- The approach allows assessment of heterogeneous bank vulnerabilities within the Chilean banking system.
- Policymakers and supervisors can use factor-driven scenarios to evaluate differential bank responses and potential systemic implications.