The Calibration of Shocks

Another key question to address in implementing a system-focused stress test is how big are the shocks? Stress testing involves discovering the effect of exceptional but plausible events; therefore, the scenarios considered should be beyond the normal range of experi­ence. Scenarios can be based on historical data (e. g., using the largest observed changes or extreme values over a specified period), or they can be hypothetical and may involve large movements thought to be plausible. Historical scenarios can be more intuitive because they were actually observed, but hypothetical scenarios may be more realistic, especially if the financial structure has changed significantly (e. g., with deregulation, liberalization, or changes in monetary policy operating procedures). Experiences of other countries can be a useful guide as well.

Although the object of stress testing is not to apply shocks until all major financial institutions fail, it is exceptional outcomes that precipitate financial instability.7 Thus, when one is assessing the vulnerability of financial systems, it is important to consider a range of movements that is wide enough to capture such outcomes. For example, a simple sensitivity test can be calibrated according to the largest change in a risk factor over the past 10 years. It is important to bear in mind that the relevant empirical measure for sce­narios is the joint probability of all factors moving simultaneously, which may be difficult to assess empirically. Because it is often difficult to attach a probability to hypothetical scenarios, some judgment is involved. However, this judgment can be guided by historical experience. In some circumstances, small changes in key variables may be sufficient to precipitate

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