An MVAR framework to capture extreme events in macro-prudential stress tests

Paolo Guarda, Abdelaziz Rouabah and John Theal

No 1464, Working Paper Series from European Central Bank

Abstract: Severe financial turbulences are driven by high impact and low probability events that are the characteristic hallmarks of systemic financial stress. These unlikely adverse events arise from the extreme tail of a probability distribution and are therefore very poorly captured by traditional econometric models that rely on the assumption of normality. In order to address the problem of extreme tail events, we adopt a mixture vector autoregressive (MVAR) model framework that allows for a multi-modal distribution of the residuals. A comparison between the respective results of a VAR and MVAR approach suggests that the mixture of distributions allows for a better assessment of the effect that adverse shocks have on counterparty credit risk, the real economy and banks' capital requirements. Consequently, we argue that the MVAR provides a more accurate assessment of risk since it captures the fat tail events often observed in time series of default probabilities. JEL Classification: C15, E44, G01, G21

Keywords: counterparty risk; Luxembourg banking sector; MVAR; stress testing; tier 1 capital ratio (search for similar items in EconPapers)
Date: 2012-08
New Economics Papers: this item is included in nep-ban, nep-cba and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3) Track citations by RSS feed

Downloads: (external link)
https://www.ecb.europa.eu//pub/pdf/scpwps/ecbwp1464.pdf (application/pdf)

Related works:
Working Paper: An MVAR Framework to Capture Extreme Events in Macroprudential Stress Tests (2011)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:ecb:ecbwps:20121464

Access Statistics for this paper

More papers in Working Paper Series from European Central Bank 60640 Frankfurt am Main, Germany. Contact information at EDIRC.
Bibliographic data for series maintained by Official Publications ().