Coherent Stress Testing : A Bayesian Approach to Scenario Analysis and Stress Testing

For the past several decades, financial crises have highlighted the need to assess the stability of the financial system.The current global financial crisis has demonstrated limitations in the purely statistical approaches which have heretofore been employed to assess the stability of financial institutions. During 2007 and 2008, several multiple-standard-deviation loss events, predicted to only occur once every several thousand years occurred in the space of 24 months. Clearly, the models in use were no longer functioning.In January 2009, during the depths of the financial crisis, the Basel Committee on Banking Supervision published its view that the bank stress-testing which had heretofore taken place was insufficient for a number of reasons. The views of the BIS were that the long period of historical stability preceding the crisis reduced likelihood that stress test was detecting severe shocks and systemic weaknesses. Furthermore, estimations of “severe” were dramatically underrated and neither correlation of shocks nor rational feedback effects were being taken into account. The effects of recent financial innovations were also being ignored