John Taskinsoy 2022 SSRN Stress Testing Financial Systems February

Stress Testing Financial Systems: Macro and Micro Stress Tests, Basel Standards and Value-at-Risk
as Financial Stability Measures 

Dr. John Taskinsoy a
ABSTRACT
In the post-WWII (since the 1950s), there have been over 400 banking, currency, and sovereign debt
crises, which translates to about 10 crises per annum; furthermore, the combined cost of the last five
crises since the late 1990s is in excess of $30 trillion, but when the cost of the COVID-19 (Great Global
Health Crisis) is factored in, collectively the biggest financial mayhem in the history of humanity could
be well over $50 trillion. This outcome serves a painful reminder that financial authorities (the Fed
and the ECB in particular), the supervisory community (BCBS, EBA, BIS, etc.), and the multilateral
organizations (IMF, World Bank, IIF, OECD, etc.) have grossly failed to strengthen the global financial
system by preventing the recurrence of banking and financial crises, mitigating massive costs to the
world economies, and safeguarding the global financial stability. Consequently, various risk detection
tools alongside capital adequacy and liquidity measures under Basel I, Basel II, FSAP, and individual
banks’ inadequate microprudential stress tests contributed to further instability rather than stability
in the global financial system. For the past four decades, a high-magnitude crisis has occurred in every
decade, i.e. US stock market crash in 1987, Asian crisis in 1997-98, subprime crisis and the subsequent
global financial crisis in 2007-08, and great global health crisis (COVID-19) in 2020-21. The economic
and societal impact of the latter has not been effectively calculated (i.e. circa 6 million lives have been
perished, countless societies have been jolted from their roots, and millions of displaced people), but
it would not come as a total shock if the cost of COVID-19 globally comes between $20 and $50 trillion.
This is not the first time a disease outbreak has ravaged humanity, and certainly it will not be the last.
Keywords: Value-at-Risk; Stress Testing; Financial Stability; Microprudential; Macroprudential

JEL classification: O31, G12, E42, C40, Q32, Q54, H23
 This research did not receive any specific grant from funding agencies in the public, commercial, or not-for-profit sectors.
a Corresponding author email address: johntaskinsoy@gmail.com
Faculty of Economics & Business – Universiti Malaysia Sarawak (Unimas), 94300 Kota Samarahan, Sarawak, Malaysia.
1
1.0 Introduction
In the pre-Basel world (at least within G-101) dating back to the late 1980s (1988), internationally
active banks were believed to operate in an unsafe and unsound manner; furthermore, large banks
had a constant propensity to circumvent banking regulation and supervision through inventing such
loopholes as skirting, race to the bottom, de facto versus de jure and cherry picking.2 Despite the
augmented financial havoc in the 1980s, large internationally active banks engaged in greater risk-
taking which, as predicted by a chorus of economists, caused massive regulatory arbitrage. Against
this backdrop, overly leveraged banks across G-10 had inadequate quality capital plus insufficient
levels of capital buffers to absorb potential losses in the event of a financial distress.
Financial intermediation by trusted-third parties (i.e. banks, non-bank institutions, and credit card
companies, etc.) is at the epicenter of any economy; therefore, a series of disintermediation would
cause disruptions to the entire financial system. Following the lost decade of the 1970s (Yom Kippur
War3 in 1973, OPEC4 oil crisis5 in 1974-78, forced liquidation of Germany’s Cologne-based Bankhaus
Herstatt in 19746, and balance of payments crises during the 1970s and 1980s), several multilateral
organizations such as Basel Committee on Banking Supervision7 (“Basel Committee”), World Bank,
International Monetary Fund (“IMF”), and Organization for Economic Co-operation and Development
OECD) have developed risk-measurement frameworks to ensure global financial stability.
Before the Basel Committee released “International Convergence of Capital Measurement and Capital
Standards” (commonly known as Basel I) in July 1988 (BCBS, 1988), capital adequacy measurements
and capital standards of banks within G-10 were both disparate and varied, making it extremely
challenging for regulators and supervisors to assess capital adequacy of the banking sectors across
G-10. Although the Basel Committee had envisaged that the Basel I standard in the long-run would
make the global banking system more resilient, but Basel I faced skepticism and was subject to
substantial criticism due to its arbitrary risk categories (OECD and non-OECD origination) and
arbitrary risk buckets (0%, 10%, 20%, 50%, and 100%, see Table 1). Ferguson (2003), former Federal
1 Belgium, Canada, France, Germany, Italy, Japan, Netherlands, Sweden, Switzerland, the UK, and the United States.
2 Each of these methods involved expanding bank operations into countries where banking regulation/supervision is weak
or relocating to countries where banks are subject to less rigorous capital and liquidity requirements.
3 This was a follow-up retaliation by the Egyptian and Syrian forces to win back territory lost to Israel during the Arab-
Israeli war in 1967. Each side claimed victories but in reality the Yom Kippur war was a disaster for Syria.
4 OPEC: Organization of the Petroleum Exporting Countries
5 OPEC sharply raised oil prices during 1973-74 to show its strong disapproval of the U.S. aid to Israel during the war. By
March 1974, the price of oil rose from $3/barrel to $12/barrel. The price of gold rose from $44/ounce in 1972 to $185 in
1975 (see Kindleberger & Alibar, 2005 for the reasons behind the huge spike).
6 The sudden bankruptcy of a small privately-owned Bankhaus Herstatt in June 1974 is a famous as well as a shocking
incident that clearly illustrated the settlement risk in foreign exchange payments, plus ignored regulatory issues.
7 The Basel Committee on Banking Supervision (BCBS) is a committee of banking supervisory authorities established in
1974 by the governors of the central banks of G-10.
2
Reserve Vice Chairman, elaborated in a speech that “Basel I Accord is too simplistic to adequately
address the activities of the most complex banking institutions”.
Table 1: Arbitrary risk categories and risk weights under Basel I

Cash claims on OECD governments and loans either collateralized or and
1. 0%
guaranteed by them, claims on non-government domestic entities.
Claims on multilateral development banks incorporated within OECD and loans
2. 20% guaranteed by such entities, cash in collection, claims on OECD banks and short-
term loans (less than one year).
Fully secured mortgage loans on residential properties either occupied by the
3. 50%
borrower or rented out.
Claims on private sector, non-OECD banks (maturity of over one year),
4. 100% commercial firms owned by public entities, non-OECD governments, real estate,
and equity issued by banks.
Source: BCBS (1988)
Table 2: Revised risk weights and credit assessments under Basel II
Option 1: Sovereigns
AAA A+ BBB+ BB+ Below

Credit Assessment Unrated
to AA- to A- to BBB- to B- B-
Risk Weight 20% 50% 100% 100% 150% 100%
Option 2: Banks & Corporations
AAA A+ BBB+ BB+ Below

Credit Assessment Unrated
to AA- to A- to BBB- to B- B-
Risk Weight 20% 50% 50% 100% 150% 50%
Short-term Risk
20% 20% 20% 50% 150% 20%
Weight
Corporate 20% 50% 100% 100% 150% 100%
ECA Risk Scores 0-1 2 3 4-6 7
Risk Weights 0% 20% 50% 100% 150%
Source: BCBS (2004)
The apparent flaw of Basel I was that it primarily focused on credit risk while ignoring other risk
types such as the supervisory review process and market discipline. To correct overly criticized flaws
of Basel I and to increase its sensitiveness to risk (Table 2), the Basel Committee published a new
revised framework in June 2004, fully implemented by the end of 2006; “International Convergence
of Capital Measurement and Capital Standards: A Revised Framework” (BCBS, 2004). Contrary to
expectations, Basel II further augmented procyclicality and turned the too-big-to-fail banks into
bigger-and harder-to-fail banks, plus Basel II rules resulted in the creation another bank type called
3
shadow banking that gave large banks incentives to move risky assets off their balance sheets. But the
worst repercussions of Basel II was that it made banks heavily rely on credit ratings provided by the
external credit assessment institutions (ECAIs). This last point made banks feel the least urgency to
allocate funds to strengthen their existing risk-management frameworks or develop far better ones.
The home-grown Asian crisis of 1997-98 together with several instability-inflicting macro events8
throughout the 1990s prompted the IMF and World Bank in 1999 to launch a joint Financial Sector
Assessment Program (FSAP). The utmost goal of an FSAP (stress testing is an integral component) is
twofold; to achieve global financial stability by ways of identifying and mitigating “...financial sector
vulnerabilities and their macroeconomic stability implications”; and to foster “the development of the
financial sector and its contribution to economic growth” (IMF and World Bank, 2003; 2005). As part
of the IMF’s country surveillance program known as Article IV Consultation, the FSAP was created “to
help countries enhance their resilience to crises and foster growth by promoting financial stability
and financial sector diversity” (see Blaschke et al., 2001; IMF, 2004; IEO, 2006).
Source: Author; Taskinsoy (2018c)

Figure 1: IMF financial sector assessment program
8 A short list of most significant modern crises that took place in the 1990s; US savings and loan (S&L) crisis (1986 – 1995);
high yield tumble (1990); Japanese stock market (Nikkei) crash (1990); Swedish financial crisis (1990-94); Gulf crisis
(1991-92); ERM crisis (1992); US interest rate crisis (1994); Mexican economic crisis (1994 – Tequila crisis); Latin
America crisis (1995); Russian financial crisis (1996); Asian crisis (1997); and Brazil crisis (1999).
4
Stress testing as a forward-looking process is an integral component of all FSAP assessments, which
is designed to gauge various risk exposures arising from micro and macro events under extreme but
plausible market conditions and analyze their adverse impact on financial stability.9 Since the review
in 2003, FSAPs covered in the 2005 review used stress tests that were sophisticated containing more
scenario and contagion analyses than single factor sensitivity analysis (Table 3).
Table 3: Selected features of stress tests in FSAPs
2000 – 2002 2003 – 2004

Scenario analysis 64 94
Contagion analysis 11 35
Insurance sector covered 25 35
Source: IFM and World Bank (2005)
Notwithstanding positive contributions of FSAPs to financial sector stability and non-financial sector
developments, a number of issues and lessons were learned from assessments. As such, rapid credit
growth by the private sector in developing and emerging market economies was not supported by
adequate credit risk management frameworks; moreover, the credit expansion into sub-prime loans
together with lax regulation and weak banking supervision led to asset-price bubble, deterioration in
credit quality, and ultimately resulted in costly financial crises. Dollarization was also a main issue in
many countries where the financial intermediation was dollarized, undermining the ability of central
banks to manage national currencies which further weakened financial conditions underpinned by
currency mismatches, unhedged dollar or euro denominated exposures, increased indebtedness by
both private businesses and households. Ever since the FSAP’s inception in 1999, it had been heavily
criticized for its voluntary participation aspect10, and the outbreak of the 2008 global financial crisis
(GFC) amplified the dosage of criticism. In 2009, the IMF integrated the FSAP into its broader country
surveillance program known as the Article IV consultation (Figure 2); however, the IMF’s landmark
decision came in 2010 (after the GFC), making it mandatory for systemically important banks (SIBs)
in 25 jurisdictions (increased to 29 in 2013) to undergo FSAPs every five years (IMF, 2014).11
Stress testing in banking was an arcane topic before the late 1990s. However, the use of value-at-risk
(VaR) models became mainstay when the Basel Committee required internationally active banks to
9 In addition to stress testing (top-down and bottom-up), the analytical toolkit of the FSAP includes; systematic analysis of
Financial Stability Indicators (FSIs); assessments of standards and codes; and assessments of financial policy and
institutional framework (see IMF & World Bank, 2003; 2005).
10 The IMF has established the following prioritization criteria to select member-countries to undergo an FSAP; (i) systemic
importance of the country; (ii) macroeconomic or financial vulnerabilities; (iii) major reform programs; (iv) monetary
policy regimes and features of the exchange rate that contribute to financial instability.
11 Since 2009, 144 member countries have requested and undergone FSAPs, majority of them multiple times. In recent years,
the IMF has been conducting 14–16 FSAPs per year at an annual cost of US$13–15 million (see IMF, 2014). With the
current rate, it would take about two years to complete FSAPs in 25 jurisdictions.
5
employ VaR models internally to calculate capital adequacy and capital buffers for market risk and
counterparty credit risk (BCBS, 1996a; b). Unfortunately, VaR is not a standalone tool due to inherent
imperfections12, therefore the numerical outputs of VaR under extreme but plausible market events
must be validated by stress testing13 or other analytical tools14 (see Fallon, 1996; Benninga & Wiener,
1998; Hendricks, 1996; Jorion, 2001; Kupiec, 1995; Lopez & Walter, 2000). The IMF defines stress
testing as “a range of techniques used to assess a vulnerability of a portfolio to major changes in the
macroeconomic environment or to exceptional, but plausible events” (Blaschke et al., 2001).
Source: Author; Pruski (2012)

Figure 2: IMF financial sector assessment program (FSAP)
12 The accuracy of VaR outputs depends previously set variances and covariance; virtually all VaR models focus on downside
risks, ignoring liquidity and systemic risks; the conditional normal distribution of returns is a prerequisite (ineffective in
heterogeneous distributions with many outliers or negative returns); linearity is a requirement, but the payoff of an
option is not linear; stationarity and non-stationarity may cause a breakdown in VaR computations.
13 Prior to the Asian crisis of 1997-98, the Basel Committee internally developed backtesting to confirm the accuracy of VaR
outputs. However, the Basel Committee was not settled on one method. Backtesting was later replaced by stress testing
due to its deficiencies and imperfect signals it generated (see BCBS, 1996b; Campbell, 2005).
14 GARCH, IGARCH, EGARCH, and the quasi-maximum likelihood GARCH (or QML GARCH) can be used as alternative models.
6
Source: Author; Taskinsoy (2018b)
Figure 3: A conceptual macroprudential stress testing framework
Notes: NPL: Non-performing loan; PD: Probability of default; LGD: Loss-given default; EPD: Exposure at default
7
Shortly after the GFC of 2008, various uses of stress tests were under close scrutiny; valuable lessons
from numerous analyses have highlighted that stress testing is not a standalone tool but it can be
indispensable when used as a complement to different VaR models. The US Federal Reserve (Fed)
initiated the Supervisory Capital Assessment Program (SCAP) in 2009 (see Fed, 2009a, b), the huge
success of which had spurred the adoption and implementation of macro stress testing as a crisis
management tool (see Figure 3 and 4), designed and conducted by central banks and the supervisory
authority to assess the resilience of the financial system as a whole plus to develop supervisory
assessments of capital adequacy and capital buffers at systemically important banks (SIBs).
Source: Adopted from Sorge (2004)

Figure 4: Macro stress testing overview
Although the Committee of European Banking Supervisors (CEBS) followed the footsteps of the Fed’s
SCAP, but the first two EU-wide stress tests were bungled up; in stark contrast to the SCAP, the EU
version of the stress tests were perceived as uninformative due to a partial disclosure of the results
by the Committee of European Banking Supervisors (CEBS, 2010a; b); consequently, stress conditions
became further intensified across Europe and the upshot of that was a severe credit crunch, which
ultimately resulted in the European sovereign debt crisis (2010-12). The SCAP’s results indicated a
cumulative capital shortfall of $185 billion by the 10 of 19 BHCs15; after taking into account capital
raising actions, the net final figure was only $75 billion. Although the CEBS (2009-10) did not publish
any capital shortfall data of its stress tests, the results of the 2011 EU-wide stress test conducted by
the CEBS’ successor European Banking Authority (EBA) indicated an overall capital shortfall of €26.8
15 Each BHC had a combined total assets of $100 billion or more at year-end 2008. These 19 BHCs (SIBs) have controlled
nearly 70% or two-thirds of all assets in the U.S. banking system and collectively owned more than 50% of every loan
type generated in the banking sector (this was consistent with banking systems of other advanced nations).
8
billion; similarly, after each bank’s new capital raising actions were completed, the capital shortfall
was reduced to €2.5 billion.16 Despite SCAP’s success, the US Federal Reserve decided to replace it
with two new stress tests; Comprehensive Capital Analysis and Review (CCAR) and Dodd-Frank Act
Stress Testing (DFAST). In overall, stress testing (both micro and macro) has provided financial and
societal benefits; as such, a wide spectrum of different views were reconciled for a common goal,
building and sustaining a resilient global financial system with the ability as well as the capacity to
withstand shocks even under most severe recessions or depression like stress conditions.
Since 2011, the Fed has conducted two separate stress tests each year, CCAR (BHCs with consolidated
assets of $50 billion or more) and DFAST (small community banks). In the stress tests between 2013
and 2018 (Table 4 and 5), BHCs had to pass both quantitative (i.e. Common Equity Tier 1 – CET1 of
5%) and qualitative measures; the latter was decided after the Fed’s own assessment. Table 2
illustrates which BHC’s capital plans received conditional non-objection or objection by the Fed based
on quantitative or qualitative grounds. In January 2017, the Fed decided not to issue qualitative
objections for banks with less than $250 billion in assets. However, the US Congress passed a
regulatory relief bill in 2018 which raised the threshold from $50 billion to $250 billion.
The GFC of 2008 as the worst financial havoc in human history serves a painful reminder that financial
authorities (i.e. the Fed and the ECB in particular), the supervisory community (BCBS, EBA, and BIS),
and the multilateral organizations (IMF, World Bank) have gravely failed to prevent the recurrence
of banking and financial crises, to mitigate massive costs to the world economies, and to safeguard
the global financial stability. Consequently, various risk detection tools alongside capital adequacy
measures under Basel I, Basel II, FSAP, and individual banks’ microprudential stress tests contributed
to further instability rather than stability in the global financial system. For instance, microprudential
stress tests of banks absent from rigorous scenarios painted a rosy picture before the dot.com crisis
in 2001, mortgage debacle in 2006, and the GFC in 2008; additionally, surveys of large banks’ stress
testing practices conducted by the Committee on the Global Financial System (CGFS, 2000; 2005) on
did not flag any issues. Even before the ink was dry on the Basel II agreement (i.e. due to the GFC of
2008, it was not fully implemented), the Basel Committee introduced a set of more stringent capital
and liquidity rules in December 2010 (referred to as Basel III), which were enacted into law within
the European Union through the Capital Requirements Directive IV (CRD); however internationally,
the first draft of the rules was released to banks in mid-2011 (BCBS, 2010a, b, c).
16 The evolution of stress testing in Europe: Financial Services Authority (UK) released Consultation Paper “Stress and
Scenario Testing” (CP 08/24) in December 2008 and Policy Statement 09/20 “Stress and Scenario Testing Feedback” (CP
08/24) in December 2009 (Bank of England (BOA) began conducting annual stress test in 2009 onward). After CEBS failed
in its first two stress tests, the EBA began to design and conduct annual EU-wide stress test (2010 – present).
9
Table 4: Federal Reserve CET1 estimates in the severely adverse scenario
2013 2014 2015 2016 2017 2018
Bank Holding Companies (BHCs)
DFAST CCAR DFAST CCAR DFAST CCAR DFAST CCAR DFAST CCAR DFAST CCAR
Ally Financial Inc. 1.5 1.8 6.3 6.3 7.9 7.1 6.1 5.2 6.5 5.2 6.8 5.5
American Express Company 11.3 5.0 14.0 8.4 15.5 8.2 12.3 6.6 10.6 5.0 7.8 4.4
Banc West Corporation ---- ---- ---- ---- ---- ---- 8.6 9.0 9.1 6.1 ---- ----
Bank of America Corporation 6.9 6.0 6.0 5.0 7.4 6.8 8.1 7.1 8.9 6.8 7.9 5.4
The Bank of New York Mellon Corp. 15.9 13.2 16.1 12.7 16.0 11.4 11.2 8.4 11.2 9.1 9.0 8.3
Barclays US LLC ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- 9.6 9.6
BB&T Corporation 9.4 7.8 8.4 8.1 8.1 7.1 6.9 6.1 7.9 6.3 7.9 6.0
BBVA Compass Bancshares, Inc. ---- ---- 8.5 8.1 6.3 6.3 6.5 6.4 7.7 7.4 7.6 7.2
BMO Financial Corporation ---- ---- 7.6 7.6 9.0 9.0 5.9 5.9 8.0 8.0 8.3 8.3
BNP Paribas USA, Inc. ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- 7.9 7.9
Capital One Financial Corporation 7.4 6.7 7.8 5.6 9.5 7.0 8.2 6.4 7.0 5.6 5.7 4.6
CIT Group Inc. ---- ---- ---- ---- ---- ---- ---- ---- 12.9 5.4 ---- ----
Citigroup Inc. 8.9 8.2 7.2 6.5 8.2 7.1 9.2 7.7 9.7 8.0 7.2 5.6
RBS Citizens Financial Group, Inc. ---- ---- ---- 9.0 10.7 9.8 8.8 7.7 7.7 6.5 6.8 5.4
Comerica Incorporated ---- ---- 8.6 7.8 9.0 7.9 8.3 6.8 9.4 7.5 ---- ----
Deutsche Bank Trust Corporation ---- ---- ---- ---- 34.7 34.7 30.1 30.1 60.2 58.0 ---- ----
Credit Suisse Holdings (USA), Inc. ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- 17.6 17.2
DB USA Corporation ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- 12.2 12.2
Discover Financial Services ---- ---- 13,7 8.7 15.3 10.4 12.4 8.7 10.4 6.9 8.9 5.8
Fifth Third Bancorp 8.6 7.5 8.4 7.5 7.9 6.9 6.8 5.9 8.0 6.3 7.5 5.5
The Goldman Sachs Group, Inc. 8.2 5.3 9.2 5.7 9.9 5.8 10.2 7.6 8.4 6.0 5.6 4.6
HSBC North America Holding, Inc. ---- ---- 6.6 6.6 8.9 8.9 9.1 7.0 12.9 8.9 8.1 7.8
Huntington Bancshares Inc. ---- ---- 7.4 6.0 9.0 7.9 5.0 5.6 7.0 6.0 8.1 5.8
JP Morgan Chase & Company 6.8 5.6 6.7 5.5 6.5 5.0 8.3 6.8 9.1 6.9 7.2 4.9
KeyCorp 8.0 6.8 9.3 8.0 9.9 8.5 6.4 6.4 6.8 5.5 6.8 4.6
M&T Bank Corporation ---- ---- 6.2 6.7 7.3 6.9 6.9 4.6 7.9 6.2 7.5 4.0
Morgan Stanley 6.4 5.6 7.6 ---- 8.8 5.9 10.0 7.7 9.4 7.9 7.3 5.0
MUFG Americas Holdings Corp. ---- ---- ---- 5.9 8.0 8.0 10.1 10.2 12.5 11.5 12.2 10.4
Northern Trust Corporation ---- ---- 11.7 10.0 12.4 10.8 9.6 8.7 10.9 9.1 11.7 9.4
The PNC Financial Services Group, Inc. 8.7 8.6 9.0 8.1 9.5 8.0 7.6 6.1 8.0 6.3 6.4 5.3
RBC USA Holdco Corporation ---- ---- ---- ---- ---- ---- ---- ---- ---- 11.2 11.2
Regions Financial Corporation 7.5 7.0 9.0 8.2 8.3 6.8 7.3 6.2 8.2 6.0 8.1 5.2
Santander Holdings USA, Inc. ---- ---- 7.3 7.9 9.4 9.4 11.8 11.9 12.4 12.8 15.2 14.8
State Street Corporation 13.0 9.7 14.7 11.4 14.3 10.8 9.6 6.6 7.4 6.0 5.3 4.0
SunTrust Banks, Inc. 7.3 6.9 9.0 8.0 8.2 7.3 7.5 6.4 7.1 5.4 6.6 4.7
TD Group US Holdings LLC ---- ---- ---- ---- ---- ---- 8.4 8.7 11.3 11.3 11.2 10.6
UBS America Holding LLC ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- 16.4 16.2
U.S. Bancorp 8.3 6.6 8.3 6.6 8.6 7.3 7.5 6.2 7.6 6.3 7.5 6.0
Wells Fargo & Company 7.0 5.9 8.2 6.1 7.6 6.2 7.2 6.1 8.6 7.4 8.6 6.5
Zions Bancorporation ---- ---- 3.6 4.4 5.1 5.1 6.6 6.0 8.5 6.6 ---- ----
Source: Federal Reserve
10
Table 5: Federal Reserve’s actions on capital plans in CCARs 2013-2018
Year Objection to capital plan CET1 % Federal Reserve Comment
Ally’s capital plan was rejected because it failed to meet

the threshold CET1 of 5%. BB&T’s capital plan was
Ally Financial Inc. 1.8
objected by the Fed on qualitative grounds even though
2013
the bank’s CET1 ratio was well above the hurdle CET1
BB&T Corporation 7.8
of 5%. Two BHCs were asked to remediate weaknesses
and resubmit a new capital plan to the Fed.
Citigroup Inc. 6.5 Zion’s capital plan received quantitative objection as it

HSBC North America Holdings Inc. 6.6 failed to meet CET1 of 5%. Other 4 BHCs were objected
2014 RBS Citizens Financial Group, Inc. 9.0 based on qualitative grounds and asked to resubmit a
Santander Holdings USA, Inc. 7.9 new capital plan (failure to do so would lead to the Fed’s
Zions Bancorporation 4.4 objection to capital plans/capital distributions).
All three BHCs received qualitative objection to their

Deutsche Bank Trust Corporation 34.7 capital plans. Despite Deutsch Bank’s very high CET1
Santander Holdings USA, Inc. 9.4 ratio, the Fed’s analysis indicated major deficiencies
2015
Bank of America Corporation 6.8 across the bank in risk identification and measurement.
(conditional non-objection) Bank of America was asked to remediate the observed
deficiencies and resubmit their new capital plans.
All three BHCs received qualitative objection to their

Deutsche Bank Trust Corporation 30.1 capital plans. Deutsch Bank Trust made improvements
Santander Holdings USA, Inc. 11.9 but the bank still had unresolved supervisory issues.
2016
Morgan Stanley (conditional non- 7.7 Similarly, Santander made progress but had unresolved
objection) supervisory issues. Morgan Stanley was asked to
remediate some issues and resubmit a new capital plan.
Capital One Financial Corporation 5.6 No objection to capital BHCs’ plans based on qualitative
2017
(conditional non-objection) grounds. Capital One was asked to resubmit a new plan.
The Fed issued no qualitative objection according to the

DB USA Corporation 12.2 new regulatory bill passed in January 2017. The capital
The Goldman Sachs Group, Inc. 4.6 plan of DB USA was rejected, other three BHCs failed to
2018
State Street Corporation 4.0 meet minimum post-stress test capital ratios, and were
Morgan Stanley 5.0 asked to remediate issues observed by the Fed and
resubmit new capital plans to avoid objection.
Source: Federal Reserve
Basel III is a significant improvement over Basel II in terms of capital definition and regulatory capital
minima along with capital buffers (Table 6). The vagueness of capital under Basel I and II was resolved
by clearly defining deductions from the Common Equity Tier 1 (CET1), Tier 2 capital was tightened
and the Tier 3 capital was removed permanently. The introduction of Basel III in December 2010 was
a reactionary response to the GFC; therefore, many banks have kept complaining about higher capital
ratios, capital charges, and a tighter liquidity regulation under Basel III. Carmassi and Micossi (2012)
assert that the international banking system will become more susceptible to shocks due to the
rigorous capital and tighter liquidity rules under Basel III, which may potentially reduce the amount
of capital for banks to invest while increasing banks’ leverage. Despite challenges, all jurisdictions
have pledged their commitment to Basel III adoption by January 2019. Over a decade has passed after
the GFC of 2008, and no financial crisis of a similar or higher magnitude has occurred.
11
The capital minima is markedly higher under Basel III (Table 6); for instance, CET1 a percent of RWA
(risk-weighted assets) increased from 3.5% in 2013 to 4.5% by 2015, and Tier 1 capital moves to 6%
from 4.5%. The total minimum regulatory capital (Tier 1 + Tier 2) is unchanged at 8% excluding
capital buffers and charges; once they are factored in, then the new capital minima potentially rise to
15.5% by 2019 (8% + 2.5% capital buffer + 2.5% G-SIB surcharge + 2.5% countercyclical buffer). The
capital conservation buffer initially starts at 0.625% in 2016 and rises by the same increment to reach
2.5% by 2019; however, the level of capital buffer may fluctuate depending on benign and stressed
economic conditions and the G-SIB surcharge (1% - 2.5%) is effective in 2019. Basel II had been
criticized extensively for its procyclical nature, to avoid it a countercyclical buffer is introduced, but
the range (0% to 2.5%) will be decided by national supervisory authorities (BCBS, 2010a, b).
Table 6: Basel III phase-in arrangements

Shading in grey indicates transition periods – all dates are as of January 1st
2013 2014 2015 2016 2017 2018 2019
Parallel run 2013 – 2017 Migration to

Leverage ratio
Disclosure starts 2015 Pillar 1 (2018)
Minimum CET1 ratio 3.5% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5%
Capital buffer 0.625% 1.25% 1.825% 2.5%

0 to
Countercyclical buffer Phase-in
2.5%
1.0 to
G-SIB surcharge Phase-in
2.5%
Minimum common
3.5% 4.0% 4.5% 5.125% 5.75% 6.375% 7.0%
equity + capital buffer
Phase-in deductions
20% 40% 60% 80% 100% 100%
from CET1
Minimum Tier 1 capital 4.5% 5.5% 6.0% 6.0% 6.0% 6.0% 6.0%
Minimum total capital 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0%
Minimum total capital

8.0% 8.0% 8.0% 8.625% 9.25% 9.875% 10.5%
+ conservation buffer
Capital instruments that

Phased out over 10-year horizon beginning 2013
no longer Tier 1 or Tier 2
Liquidity coverage ratio Observation

Introduce minimum standard by 2015
LCR ≥ 100 (short-term) Begins 2011
Net stable funding ratio Observation Introduce minimum

NSFR ≥ 100 (long-term) Begins 2011 Standard by 2018
Source: BCBS (2010a, b)

Notes: The minimum capital requirement increased significantly (4.5% Tier 1 + 2.5% capital buffers). Two new
liquidity standards (LCR > 100% and NSFR > 100%) and a leverage ratio (3%) have been introduced. Further, new
charges (2.5% G-SIB surcharge) and a 2.5% countercyclical buffer apply. When the minimum capital requirements,
capital buffers, and surcharges are added; banks may have as much as 13% capital charge.
12
2.0 Literature Review
A crisis (financial, economic, or currency) does not form instantaneously; on the contrary, it evolves
over time through an amalgam of interactions and linkages that are complex, multidimensional, and
in systemic nature. A high-magnitude financial crisis is a derivative of repeated and prolonged failures
by financial authorities to safeguard financial stability as a goal of public policy (Crockett, 1997a, b),
which along with monetary stability is at the epicenter of any normal-functioning financial system,
Borio (2003) calls it “twin stability” and trio stability includes political stability as well (Claessens &
Kose, 2013). There is no perfect substitute for banks in the capital markets; as an inextricable part of
a sustainable economic growth (i.e. banks allocate scarce resources from savers to investors who
enter into intertemporal contracts), banks must cope with a constant inventory of operational risks
such as imperfect market frictions, asymmetry of information and transaction costs (Arrow, 1964).
Before the 1950s, various insurance policies were used predominantly as a protection against natural
disasters and personal or work related accidents (Crockford, 1982; Ehrlich & Becker, 1972; Dionne &
Eeckhoudt, 1985). In fact, risk management in the business enterprise was arcane in the 1950s and
academic books on the subject only became available in the 1960s (Mehr & Hedges, 1963). The five
seminal papers were pivotal in the birth of options-based hedging vehicles; Markowitz’s (1952, 1959)
mean-variance criterion (i.e. diversification of risks and an ultimate portfolio selection reduced risk),
Modigliani-Miller’s (1958) irrelevance and arbitrage-reasoning (i.e. a firm’s market value is irrelevant
to its cost of capital, equity or debt financing), Sharpe’s (1964, 1990) Capital Asset Pricing Model –
CAPM (i.e. risk-based pricing), Black and Scholes’ (1973) option pricing formula (i.e. futures trading)
and the Merton’s (1973, 1974) pricing of corporate debt (i.e. arbitrage-based pricing models). Since
the 1980s, futures trading and foreign exchange (FX) grew at a record pace surpassing daily volumes
of stock and bond markets combined; interestingly, Warren Buffet, a billionaire, described derivatives
as “weapons of mass destruction” (see Adams & Wyatt, 1987; Cornell, 1981; Diebold, 2012; Frankel
& Froot, 1990; Hsieh, 1989; Glassman, 1987; Lyons, 1988; Jorion & Stoughton, 1989).17
With the Great Depression of the 1930s, adding adjectives such as “Great” to describe unprecedented
events became a tradition; similarly, the global financial crisis of 2008 has been denoted as “Great
Recession,” “Great Contraction,” or “Great Financial Catastrophe” which manifested itself on the basis
of a confluence of nocuous developments and events in the 1990s and early 2000s (Blinder & Yellen,
2001 called it “The Fabulous Decade”); excessive debt hangover by the private sector and households;
greater and negligent risk-taking (debt hangover); the dotcom bust and the ensuing dollar glut (Fed’s
expansive monetary policy, historically low interest rates, and a lax credit environment); financial
17 For a longer perspective and detailed discussions on this topic and other related topics, interested readers are welcome
to check out Taskinsoy (2012; 2013; 2018; 2019; 2020; 2021; 2022).
13
innovation (adjustable mortgage rates – AMRs, predatory lending by non-bank mortgage lenders, and
expansion into sub-prime lending); global imbalances (Bernanke, 2007; Blanchard & Milesi-Ferretti,
2009); and securitization and re-securitization of debt and derivatives, i.e. mortgage-backed security
(MBS), credit default swap CDS), and collateralized debt obligation (CDO), Blinder (2013) called this
trio a “perfect storm” (see Bernanke, 2012; BIS, 2011a; Birdsall, 2012; Boyd & Heitz, 2012; Caballero,
2010; Claessens et al., 2010; Crotty, 2009; Iwaisako, 2010; Meltzer, 2013; Miller, 1991).
A study by the U.S. Government Accountability Office (GAO) has revealed that the GFC cost the U.S.
economy over $20 trillion. In July 2010, then President Obama18 signed the Dodd-Frank Wall Street
Reform and Consumer Protection Act, acknowledging that the GFC of 2008 – the most unprecedented
financial mayhem in US history (and the world) – tossed the US economy into severe recession which
was a near financial meltdown. There has been a plethora of cost estimates for the GFC (projections
are constantly updated due to the fact that some the crisis’ effects are still lingering or unfolding). For
instance, the IMF estimated the cost at $11.9 trillion, $10.2 trillion of which in the U.S. and $1.7 trillion
in developing countries.19 U.S. Senator Dorgan indicated that the recent global crisis’ cost to American
tax papers could exceed well over $12 trillion; as such, $7.8 trillion for the Federal Reserve bailout
commitment of; $2 trillion for the FDIC of; and $2.7 trillion for the Treasury.20 According to Atkinson
et al (2013), the range of direct and indirect cost is between $6 and $14 trillion, while Boyd and Heitz
(2012) contend that the GFC’s aggregate cost can be less than $7.3 trillion, but the highest estimate
came from Beachy (2012) who believed the cost figure would be close to $20 trillion.
2.1 Basel Standards Failed to Strengthen the Global Financial System
Prior to the establishment of the Basel Committee on Banking Supervision in 1974 and the release of
its first banking standard in 1988 (Basel I), banking sectors in Europe were fragmented with highly
segmented and regulated national markets (ECB, 2002). The process of creating a single common
market as the EU was inaugurated with the 1957 Treaty of Rome, and a series of related actions taken
by the European Commission and the Councils of Ministers was divided into five distinct periods;
deregulation of entry into domestic markets (1957-73), harmonization of regulations (1973-83), the
1992 directives21, creation of a single currency (1992), and the Financial Services Action Plan (2001-
05). During 1970 - 1980, due to severe restrictions on cross-border activities by banks (i.e. services
and capital flows), large banks had propensity to circumvent regulations by inventing loopholes.
18 See remarks by the President Obama, available at http:// www.whitehouse.gov/the-press-office/remarks-president-

signing-dodd-frank-wall-street-reform-and-consumerprotection-act.
19 https://www.telegraph.co.uk/finance/newsbysector/banksandfinance/5995810/IMF-puts-total-cost-of-crisis
20 See 156 Cong. Rec. S 2684 (daily ed. Apr. 27, 2010)
21 Which refers to single banking license, home country control, mutual recognition, and freedom of cross-border services
and capital flow (for more detail, see ECB, 2002).

14
Although the harmonization of disparate national banking regulations began in 197722, the European
banking markets still remained fragmented due disagreements between sovereign states on elements
of the integration framework (i.e. host vs. home country control, freedom of cross-border services
and capital flows, mutual recognition, and banking supervision). These aforementioned issues were
addressed in the Second Banking Directive23 along with a White Paper published by the European
Commission in 1985, and the 1992 Maastricht Treaty on European Union confirmed the Single Market
Program; this way, the harmonization of national banking markets (1983-92) was completed, which
implied that the member states of the European Economic Area (EEA) accepted the Maastricht Treaty
and the European banking legislation. Finally, for an ultimate single financial market, the Financial
Services Action Plan (FSAP) laid out four objectives to be used by the EU states to develop legislative
and non-legislative frameworks (for details and a longer discussion, see ECB, 2002).
While the European Council (EC) together with the European System of Central Banks (ESCB) and the
financial authority of each member state in the European Economic Area (EEA) took part in creating
a single financial market with a single currency (i.e. harmonizing both capital adequacy and capital
standards), the Basel Committee24 (as the primary global standard setter) envisioned to achieve the
goal of prudential regulation in international banking markets.25 Because the Basel Committee is not
a supranational authority, it reports to the Group of Governors and Heads of Supervision (GHOS)
which is in charge of governance and oversight. The Basel Committee issued its first paper (directive)
in 1975 known as the Concordat which set out the guidelines for sharing supervisory responsibility
between host and home country supervisory authorities; in May 1983, the Concordat was revised and
re-issued as “Principles for the supervision of banks' foreign establishments”. The Latin American debt
crisis in the early 1980s prompted the Basel Committee to work on a common capital measurement
(i.e. capital adequacy) system referred to as the Basel Capital Accord (or in short, Basel I) which was
released to banks in July 1988. Basel I rules were not carved in stone, they were designed to evolve
through consultative processes; owing to adverse developments in the macroeconomic environment,
the Basel Committee has made some amendments to Basel I; in November 199126, in April 199527,
and in January 199628 (fully effective by the end of 1997); the latter amendment made the use of VaR
models mainstay in measuring banks’ market risk capital requirements (BCBS, 1996a, b).
22 The Directive 77/780/EEC on “The Coordination of Laws, Regulations and Administrative Provisions Relating to the
Taking up and Pursuit of Credit Institutions”.
23 Directive 89/646/EEC
24 The Basel Committee on Banking Supervision (BCBS) was established in 1974 by the central bank Governors of G-10, but
the first meeting took place in February 1975. The membership includes 45 institutions from 28 jurisdictions.
25 See BCBS charter at https://www.bis.org/bcbs/charter.htm
26 “Inclusion of general provisions/general loan-loss reserves in capital”, https://www.bis.org/publ/bcbs09.htm
27 “Treatment of potential exposure for off-balance-sheet items”, https://www.bis.org/publ/bcbs18.htm
28 “Incorporate market risks”, https://www.bis.org/publ/bcbs119.htm
15
Source: Author; BCBS (1988, 2004, 2010)
Figure 5: Basel I, Basel II, and Basel III requirements
16
The underlying objectives of Basel I were twofold: “to strengthen the soundness and stability of the
international banking system” and “to reduce competitive inequalities” (BCBS, 1988).Also, Basel I had
the objective of achieving a level of playing field by requiring all banks within G-10 to comply with
the one-size-fits-all capital adequacy rules (Figure 5). Even though Basel I was a major milestone, the
serious drawback (flaw) was its primary focus on credit risk while ignoring other important risk types
such as securitization risk, market risk, liquidity risk (funding freeze), and pipeline risk. Ferguson
(2003) elaborated in a speech that “Basel I Accord is too simplistic to adequately address the activities
of our most complex banking institutions”. Many economists and experts believe Basel I encouraged
greater risk-taking, caused significant distortions in cross-border lending, and resulted in massive
capital arbitrage (see BCBS, 2004; Elizalde, 2007; Rodríguez, 2002).
Basel I enabled banks to hoard more capital via disintermediation, which caused a credit squeeze (or
crunch) in the 1990s. To prevent this from occurring again, the Basel Committee released the 1996
amendment (BCBS, 1996a, b) which required banks to use VaR models for internal risk measurement
purposes and to calculate capital adequacy at 8% of risk-weighted assets (RWAs); Jackson et al. (1999)
view the total capital requirement 8% of RWAs (Figure 6) is a form of another regulatory taxation imposed
on banks. Blundell-Wignall et al. (2014) suggest that Basel I created incentives for gaming the system, this
enabled banks to move higher-risk assets between on-balance and off-balance sheets via securitization; this
in turn created a new bank type called shadow banking. Another deficiency of Basel I was that Securitization
was used as a technique to disperse risk; conversely, this enabled the inherent risks from complex securitized
instruments (i.e. CDO, MBS, and CDS) to be deeply entrenched in the whole financial system, making it
extremely challenging for the financial authorities to assess whether or not each bank in the financial system
had both adequate capital and sufficient capital buffers to absorb losses in an acute stress.
Source: Author
Figure 6: Capital adequacy ratio under Basel I
Each installment of the Basel standards was a reactionary response to adverse developments; for
instance, Basel I was introduced following the Latin American debt crisis in the 1980s, and the
systemic Asian crisis in the late 1990s prompted the Basel Committee to overhaul Basel I, the outcome
was a revised framework commonly known as Basel II (BCBS, 2004). Despite Basel II’s increased
17
sensitivity to risks (but CAR remained unchanged, see Figures 7 and 8) and the hype generated by the
Basel Committee, Basel II failed to strengthen global banking resilience; quite the opposite, Basel II
rules raised procyclicality and turned too-big-to-fail banks into bigger-and harder-to-fail banks.
Source: Author
Figure 7: Capital adequacy ratio under Basel II
Source: Author; BCBS (2004)

Figure 8: Pillar structure of Basel II
Unfortunately, Basel II ushered greater risk-taking, i.e. enabling banks to move riskier assets off their
balance sheets made them excessively leveraged; therefore, the global financial system was not safer
18
nor was it more resilient than before. Basel II made banks overly rely on ratings provided by external
credit assessment institutions (ECAIs) for even decisions on dividend payouts, audit frequency, and
deposit rates; consequently, both large and systemically important banks (SIBs) had the least urgency
to strengthen their existing risk-management frameworks or develop far better ones.
Same as Basel I, Basel II’s more sensitive rules to risk failed to prevent the recurrence of financial and
economic crises. The database29 built by Laeven and Valencia (2008) and the updated version (2012)
illustrates that over the past four decades, there have been 147 banking crises, 218 currency crises
and 66 sovereign debt crises, which translates to about 11 crises per annum between 1970 and 2011.
Reinhart and Rogoff (2009) study indicates that there have been three major waves of crises; the
1980s (the Latin American debt crises), crises occurred in three clusters in the 1990s (transition
economies, Mexican Tequila (peso) crisis-1994, and Asian crisis-1997), and the 2000s (credit crises);
Reinhart and Rogoff have also concluded that credit boom-bust cycles (e.g., Dell’Ariccia et al., 2012)
were at the core of 45 episodes of the 147 banking crises (see Tables 7 and 8 for outcomes).
Table 7: Crises outcomes in the united states and in the Euro area
Output Increase in Monetary Fiscal Liquidity Peak

Country Fiscal costs
loss debt expansion costs support NPLs
% of
% of financial deposits, % of total
In percent of (%) GDP
system assets foreign loans
liabilities
Euro area 23.0 19.9 8.3 3.9 1.7 13.3 3.8
The U.S. 31.0 23.6 7.9 4.5 2.1 4.7 3.9
Source: Leaven and Valencia (2012), slightly modified by the author
Table 8: The Asian crisis cost outcomes among the ASEAN-5 countries
Output Increase in Monetary Fiscal Peak Liquidity Peak

Country
loss debt expansion costs Liquidity support NPLs
Central bank claims and % of total

In percent of (%) GDP
liquidity support by Treasury loans
Indonesia 69.0 67.6 4.5 56.8 23.1 17.2 32.5

Malaysia 31.4 0.2 4.0 16.4 9.7 8.8 4.0
Philippines 0.0 44.8 8.4 13.2 19.4 1.5 20.0
Singapore n/a n/a n/a n/a n/a n/a n/a
Thailand 109.3 42.1 3.9 43.8 5.1 4.4 33.0
Source: Leaven and Valencia (2012), modified by the author
29 Exception of rare conformances, crises do occur in waves; for instance, when Laeven and Valencia (2008, 2012) have
analyzed the frequency of starting month of banking crises, they have found that September has the highest frequency
(averaging 25 crises), the rest of the months as follow; January (4), February (1 or 2), March (2 or 3), April (2), May (1),
June (1), July (4), August (7), October (1), November (6), and December (7).
19
Basel II was criticized for amplifying cyclical lending, this in turn reduced capital inflows to emerging
market economies and developing countries. Saurina and Trucharte (2007) emphasized that Basel II
rules increased procyclicality substantially, exacerbated boom-bust cycles, and led to deleveraging;
as a result, contagion and counterparty risk triggered a noticeable surge in defaults. Gordy (2003)
argued that a single global risk factor of Basel II to capture firm defaults increased the likelihood of
large capital shortfalls. Blundell-Wignall et al (2014) assert that Basel II raises procyclicality. The
Basel Committee acknowledged that the inherent deficiencies (flaws) of Basel II and its spinoff of
heavy reliance on ratings given by the ECAIs played a crisis-intensifier role during the GFC of 2008.
The use of external ratings created three adverse incentives for banks; (1) banks felt no real urgency
to develop their own internal risk-assessment frameworks; (2) ECAIs misused the rating process to
issue artificially-inflated ratings to clients from whom they earned lucrative service fees; (3) banks’
overreliance on ECAIs resulted in a cliff effect in capital requirements (BCBS, 2004).
The propagation of high-magnitude financial crises since the late 1990s, but particularly the GFC of
2008 made the adoption and implementation of Basel III a central focus in the new millennium. Basel
III promotes banking resilience through higher capital and liquidity requirements (see Table 9),
which apply to both domestic and internationally active banks. A series of measures has been
introduced under Basel III to correct all fundamental deficiencies of the antecedent Basel standards
(Basel I and II). Going forward, assessments of credit and market risks are no longer based on
simplistic historical statistical correlations; therefore, Basel III is designed to address mark-to-market
counterparty credit risk, credit valuation adjustments and wrong-way risk (BCBS, 2010a, b).
Table 9: Individual bank minimum capital conservation standards
Minimum capital conservation ratios (expressed as a

Common equity Tier 1 (CET1)
percentage of earnings)
4.5% - 5.125% 100

5.125% - 5.75% 80
5.75% - 6.375% 60
6.375% - 7.0% 40
> 7.0% 0
Source: BCBS (2010)

Notes: Calculations of capital;
Common equity Tier 1 capital
Common equity Tier 1 (CET1) = ≥ 4.5%
CR RWA + MR RWA + OR RWA
Tier 1 capital
Tier 1 capital ratio = ≥ 6.0%
Total capital
Capital Adequacy Ratio (CAR) = ≥ 8.0%
20
Because some of the Basel III rules are too general and not designed for financial sectors of developing
and emerging market economies (EMEs) in mind, the central banks of some countries have decided
to conduct quantitative impact studies (QIS) to determine whether some elements of Basel III (i.e. G-
SIB surcharge or LR) need to be modified, partially implemented or cancelled altogether as required
by the nature and needs of their country-specific. Carmassi and Micossi (2012) suggest that banks
have become a lot more susceptible to macro shocks due to insufficient capital and excessive leverage.
On the other hand, regardless of much improved rules under Basel III, Haldane (2011) argues that
Basel III is still open to gaming, therefore it would be unable to prevent systemic shocks.
The Basel Committee has improved the definition of capital significantly under Basel III, which was
vague both in Basel I&II; each deduction from CET1 is clearly defined, Tier 2 capital is tightened (five-
year maturity without redemption prior to expiration), and Tier 3 capital is removed permanently.
As illustrated in Table 6 and 9, the regulatory capital is markedly higher under Basel III; for instance,
CET1 as a percent of RWA increases from 3.5% in 2013 to 4.5% by 2015, and Tier 1 capital moves to
6% from 4.5% over the same period (neither capital ratio increases further until 2019 when all the
rules become fully effective). The total minimum capital (Tier 1 + Tier 2) is kept unchanged at 8%
excluding buffers and charges, but once they are factored in, then the new total may potentially
increase to 15.5% by 2019 (8% + 2.5% capital buffer + 2.5% G-SIB surcharge + 2.5% countercyclical
buffer). The capital conservation buffer initially starts at 0.625% in 2016 and rises by the same
increment to reach 2.5% by 2019; however, the level of capital buffer may fluctuate during benign
and malignant economic times and G-SIB surcharge (1% to 2.5%) is effective in 2019. To improve the
procyclical nature of Basel II, a countercyclical buffer is introduced, but the range (0% to 2.5%) will
be decided by the national supervisory authority of each country (BCBS, 2010a).
The Basel Committee introduced a Credit Valuation Adjustment (CVA) risk capital charge to address
mark-to-market losses. Before and leading up to the GFC of 2008, over-the-counter (OTC) derivatives
markets were outside of the traditional banking and subject to hardly any regulation; the exponential
growth of derivatives since the 1990s along with increased interconnectedness due to fast-paced
globalization has accelerated the buildup of systemic risk that amplified the crisis’ aggregate loss. To
strengthen market infrastructures, regulate OTC derivatives markets, and mitigate the buildup of
systemic risk, the Basel Committee is supporting initiatives that will establish the Committee on
Payments and Settlement Systems (CPSS), the International Organization of Securities Commissions
(IOSCO), and central counterparties (CCPs). The overreliance on external ratings by the ECAIs under
Basel II caused “cliff effects” in capital requirements; to eliminate them, banks are required to perform
their own assessments of externally rated securitization exposures.
21
Hoenig (2013) argues that the Basel III capital does not reflect the reality since it is nothing but an
illusion and Norton (2013) contends that 3% LR is sufficient for the too-big-to-fail BHCs; according
to a research by the FDIC (which has been criticizing the Basel III risk-weighting approach), this figure
has to be doubled (at least 6%) so that the largest SIBs can properly address “...trading book risk
weighting variations...” and “...underpricing of risks”, which are associated with too-big-to-fail BHCs
(Blundell-Wignall & Atkinson, 2010). The aggregate results of the 2011 Basel III monitoring exercise
(BCBS, 2012) indicates that the 212 participating banks (103 group 1 banks with Tier 1 capital of €3
billion, remaining 109 banks are group 2) would have an overall capital shortfall of €47.4 billion for
minimum CET1 of 4.5% (€38.8 billion by group 1) and €518 billion for a CET1 target of 7% (€485.6
billion by group 1). In terms of capital shortfalls, Blundell-Wignall et al (2014) find the results no
surprise because the negative aspect of IRB approach (e.g., banks estimate risk weights of assets using
their internal models) of Basel II is transferred to Basel III; furthermore, they assert that LCR > 100
and NSFR > 100 will potentially face the same dilemma as they “mimic” the capital adequacy.
Leverage ratio = Tier 1 capital / Total exposure ≥ 3%
Net Stable Funding Ratio (NSFR) = Available stable funding / required stable funding ≥ 100
Liquidity Coverage Ratio (LCR) = HQLAs / Net liquidity outflows over 30-day period ≥ 100
2.2 Economic Costs and Benefits of the New Basel III Regulation
For the past three decades, regulatory capital minima imposed on banks has increased progressively
and substantially. Although Modigliani and Miller (1958) argue that a firm’s market value is irrelevant
to its average cost of capital, whether it is financed through equity or debt. However, opponents argue
that the real world is imperfect with costs and frictions, thus the gearing matters. In the real world,
not only markets are imperfect surrounded by distortions that favor debt financing over equity
financing (i.e. tax shield), but investors with varying risk tolerance have asymmetry of information
and do not have an equal access to capital markets. The Basel Committee acknowledges that the cost
of Basel III implementation could be initially high for most banks, but in the long-run, economists and
experts believe the economic benefits (i.e. reduced probability of financial crises) of higher capital
and tighter liquidity under Basel III will outweigh economic costs.
The Basel Committee has assessed the economic impact of the Basel III reform (Table 10 for various
studies), and the results suggest that for every percentage point increase in the capital ratio results
in a 0.09% reduction in GDP from the baseline. In the same scenario, the impact of 1% increase in the
liquidity requirement causes a 0.08% decline (BIS, 2011b). These results are closely in line with the
22
findings of the Long-term Economic Impact (LEI) group (BCBS, 2010b) and the Macroeconomic
Assessment Group (MAG, 2010). High-magnitude (i.e. GFC) financial crises occur once every 20 or 25
years, so the probability of a crisis to occur is between 4% and 5%; in their analyses, BIS (2011b)
used 5%, Reinhart and Rogoff (2009) used 5.2%, and Laeven and Valencia (2008) employed 4.2%.
The Basel Committee’s analysis of the long-term impact of Basel III on output indicates that if Basel
III yields 1% reduction in the annual probability of a banking crisis, the expected benefit is 0.6% of
GDP; if the effect is temporary, then the benefit is 0.2% of GDP (BCBS, 2010b). The Basel Committee
has performed another study to compare benefits and costs of the Basel III rules, the underlying
message of the analysis is that higher liquidity and capital standards produce positive net benefits.
The following factors lead to a larger estimate of net benefits: reduced procyclicality through
countercyclical capital buffer; a premium paid by risk-averse investors for an expected banking crisis;
banks’ ability to absorb losses (higher capital and liquidity) will mitigate the severity of crises; and
increased non-bank intermediation will help reduce the overall cost (BCBS, 2010b).
Table 10: Net economic benefits due to regulatory tightening under Basel III
CET1 benefit Net

Indonesia Malaysia Philippines Singapore Thailand Average
RWA cost benefit
(Net benefit as % of GDP after 4-year implementation) % %

benefit 0.51 0.47 0.49 0.44 0.53 0.49
1 0.16
cost 0.34 0.32 0.35 0.29 0.36 0.33
benefit 0.82 0.78 0.72 0.63 0.75 0.74
2 0.31
cost 0.46 0.40 0.49 0.34 0.48 0.43
benefit 1.13 1.03 0.94 0.79 1.07 0.99
3 0.45
cost 0.58 0.50 0.60 0.42 0.62 0.54
benefit 1.45 1.34 1.19 1.03 1.38 1.28
4 0.62
cost 0.69 0.62 0.73 0.51 0.75 0.66
benefit 1.64 1.53 1.44 1.26 1.66 1.51
5 0.68
cost 0.85 0.76 0.90 0.68 0.92 0.82
benefit 1.82 1.70 1.74 1.54 1.89 1.74
6 0.76
cost 1.01 0.90 1.04 0.85 1.08 0.98
Source: Taskinsoy (2020d)
As illustrated in Table 10, the main results of the net benefits analysis by Taskinsoy (2020d) show
that both costs and benefits due to regulatory tightening increase in proportion to the increments of
increases in the regulatory capital and liquidity. After a four-year implementation, decline in steady
state output due to a 1 pp rise in the CET1 was 0.33% on average and the benefit in terms of a gain in
output during the same period was 0.49%; as a result, the net benefit was 0.16% (0.04% per annum).
The annual net benefit nearly doubled (0.08%) for a 2 pp rise in the CET1 ratio; however, net benefits
declined substantially when a 25% liquidity requirement was added in addition to a 1 pp rise in the
23
Table 11: Studies on impact of regulatory tightening of Basel III on steady state output
Study Method Reduction in Steady State Output
1 pp rise in capital ratios

Taskinsoy (2018b) 0.33% across ASEAN-5
After a 4-year implementation
25% liquidity requirement

50% liquidity requirement

1 pp rise in capital ratios 0.6% in total

BCBS (2010b)
Plus liquidity standards 0.08% annually for 8 years
0.22% after eight years

MAG (2010) 1 pp rise in capital ratios
0.13% after twelve years
MAG (2010) 25%, 50% liquidity requirement 0.08%, 0.15% respectively
1 pp rise in capital ratios 0.09% (another 0.08% arises from

Angelini et al. (2011)
No liquidity requirement meeting the NSFR requirement)
2 pp rise in the TCE ratio 0.24% (Euro area), 0.29% (US), 0.29%
No liquidity requirement (Italy and UK)
Plus 25% liquidity requirement (Italy and UK)
Plus 25% liquidity requirement (Italy and UK)
0.19% (US), 0.30% (Euro area), and

Slovik and Cournède (2011) 0.11% (Japan); 0.23% across three
OECD economies
0.93% (US), 2.10% (Euro area), and

100 bps rise in lending rates
Slovik and Cournède (2011) 1.33% (Japan), 1.45% across three
OECD economies
1, 4, 10 pp rise in capital ratios

Oxford Economics (2013) 0.14%, 0.60%, 1.4% respectively
2 pp rise in Tier 1, total capital 0.60% (U.S.), 0.60% (Europe), and

IIF (2011)
No monetary policy response 0.80% (Japan) in 2011-2015
2 pp rise in Tier 1, total capital 0.10% (U.S.), 0.40% (Europe), and

IIF (2011)
No monetary policy response 0.30% (Japan) in 2012-2019

Miles et al. (2012) 0.15% in the UK
Large M-M effect is assumed
8 pp shock to credit standards 0.5%

Lown & Morgan (2004)
No long-term rates in the VAR 0.3%
0.75% in the U.S. after one year

Swiston (2008) 20 pp tightening in lending
1.25% in the U.S. after two years
Note: MM refers to Modigliani & Miller (1958); pp denotes percentage point; bps denotes basis points.
This table is of great importance because it gives the reader the opportunity to view the findings of the most recently
published studies in one place and to have a chance to compare them with the findings of the analyses undertaken
in this thesis. A more proper for this table is actually the Literature Review, but without this table, it would be
difficult to determine whether the findings of this thesis are in line with other studies.
24
CET1 ratio, there was a bigger loss in steady state output (0.39%) which reduced the net benefit to
0.10%. A 50% liquidity requirement caused a further reduction in the net benefit which was reduced
to 0.02% after deducting the 0.47% cost. The results of the analysis showed that there was a positive
correlation, almost a linear relationship between regulatory tightening and economic performance
underpinned by reduced probability of crisis and NSFR > 100. Both costs and benefits increased in
proportion to rising capital and liquidity levels. The net benefit peaked at 6 pp increase in the CET1
ratio, at which level, the average cost impact of Basel III on output was 0.98% and benefit was 1.74%;
bringing the final net benefit figure to 0.76%. These estimates may not reflect the actual events.
The impact of a one percentage point increase in the TCE ratio of risk weighted assets combined with
liquidity (LCR and NSFR) tightening on bank lending, regulatory capital, and lending spreads tend to
vary significantly, this was contributed by the selection of a modelling approach and assumptions
employed by different studies. The MAG (2010) assessed the macroeconomic impact of the regulatory
tightening under Basel III and measured the cost that banks would have to incur making the transition
to rigorous capital and liquidity standards (Table 12). In the analyses, the impact of a 1 pp rise in the
TCE ratio and the deviation from the baseline scenario is assessed over a four-year implementation.
The main results of the analyses indicated that economies would face transitional costs arising from
regulatory tightening, but the negative impact would be alleviated in the long-term. The main findings
of the study showed the US Federal Reserve’s FRB/US model resulted in the largest impact.
Table 12: Varying impact of Basel III due to modelling approach
ECB ECB Federal Reserve

MCM Model CMR Model FRB/US Model
Without monetary policy
Increase in spreads only -0.08% -0.29% -0.79%
Increase in spreads due to changes

-0.19% --- -0.89%
in lending standards
With monetary policy -0.16% -0.25% -0.31% to -0.36%
Source: MAG (2010)

MCM model: Multi-country model with endogenous policy; CMR model: Medium-to-large DSGE model; FRB/US
model with endogenous monetary policy.
The cost impact of Basel III capital and liquidity regulation differed depending on what modelling approach was
employed. The approach used by the Federal Reserve resulted in the largest impact.
Slovik and Cournède (2011) analyzed the cost impact of Basel III on output loss across the three main
OECD economies using adjusted semi-elasticities of the OECD New Global Model. The results of their
25
analysis highlight that banks holding insufficient levels of capital will likely become more prone to
crises affecting respective GDP growth negatively. Albertazzi and Marchetti (2010), in their analysis
of Italy’s banking sector during 2007-2009, found evidence that low capital adequacy with insufficient
capital buffers led to a contraction in the credit supply ensuing the collapse of Lehman Brothers.
2.3 Value-at-Risk (VaR) Failed to Strengthen the Global Financial System
The recurrence of financial crises30 is a true testimony to the fact that all parties part of the global
financial system have failed wretchedly to ensure financial stability; additionally, economic models,
theories, and tools (i.e. VaR) that became available failed to make true assessments of the severity
and extents of financial crises in the 2000s. If past history is instructive, it should not come as a
surprise that boom-and-bust cycles are natural manifestations of a free-capitalist economy31, thus
they are mostly anticipated and expected. What is insane is that the parties (i.e. political leaders,
governments, standard-setters, central banks, multilateral institutions, economists, academia, and
risk managers) seem to have not learned any valuable lessons over the course of crises how to make
their impact (severest implications) milder. The previous financial crises of 1929, 1987, 1997, and
2007 can provide a simpler explanation; after all, each event faced similar forces such as; greater risk-
taking by investors and banks; excessive on-and off-balance sheet leverage; inadequate liquidity
(both in quality and quantity); significant cross-border and shadow-banking operations (arbitrage);
asset liability mismatch (short-term borrowed funds used for long-term projects); cases of severe
procyclical deleveraging; insufficient capital buffers held by banks to absorb losses from credit
defaults; and investor herd mentality (intensified financial losses due to contagion).
There has been an abundance of economic theories32, academic papers, and ample prudential as well
as regulatory standards created by renowned global organizations such as World Bank, International
30 Financial crises are usually inevitable outcomes of banking panics, in most part, facilitated by stock market crashes,
bursting of bubbles (e.g. the Internet, housing), sovereign defaults leading to sovereignty debt crisis (2009-12 in euro
area), and currency crises (Asian crisis of 1997-98 was a perfect example for contagion and systemic risk).
31 Simplistic risk sensitiveness of Basel I and a regulatory flaw under Basel II conversely encouraged internationally active
banks to engage in cross-border and shadow banking activities which fostered economic booms in Asia and Latin America
through massive capital flows. A sudden reversal of capital flows combined plus repeated attacks on currencies caused
Asian crisis. Invention of the Internet and successful commercialization of the web-enabled technologies created the
Internet boom (1997), and about three years later, the Internet bubble deflated (2000-01). Mortgage-backed securities
(MBS) and collateralized debt obligations (CDO) played a key role in formation of housing bubble in the U.S. MBS and CDO
saw major declines as subprime mortgages began to default facilitated by lax lending conditions and banks’ aggressive
push on innovative refinancing and consumer loans enabling barrowers with subprime ratings to qualify for mortgage
loans which later led to the subprime crisis in 2006.
32 Among a long list of theories, here are just a few: Maynard Keynes (1936), “The General Theory of Employment, Interest
and Money”, argues that during economic downturn, governments will have to run larger deficits in order to keep people
employed; Hyman P. Minsky (1986), “Stabilizing an Unstable Economy”, argues financial fragility as an obvious
component and expected outcome of excessive risk taking; therefore, the level of fragility increases as the level of risk
taking significantly goes up; Marxist theories (Karl Marx sees recessions and depressions as normal unavoidable
occurrences in capitalism); and for Austrian theories (see Hayek & Rothbard, 1963).
26
Monetary Fund (IMF), Basel Committee on Banking Supervision (BCBS), Organization for Economic
Co-operation and Development (OECD), and Institute of International Finance (IIF) offering ways
(theories, models, tools, processes, and systems) how to prevent future financial crises from striking.
Conversely, repeated financial crises since the 1980s have proved three things; 1) more regulation
through macroprudential reforms (e.g. Basel I, II, III) not only did not prevent financial crises from
striking, but also they failed to make crises’ severe effects milder; 2) the new breed of financial crises,
especially in the new millennium (2000s), tend to be more frequent, longer-lasting, and costly; and
3) the current global financial system is extremely vulnerable to exogenous shocks arising from acute
stress, plus humans possess no ability or power to predict times and extents of crises beforehand.
Although majority of modern-time financial crises had taken place in the 19th33 and 20th34 centuries,
financial and economic crises however can be traced back as early as the 3rd century when the Roman
Empire nearly collapsed due to economic depression. England’s default in 1340 consequence of its
massively mounting war debt from the Hundred Years' War with France could be cited as one of the
earliest sovereign debt crises (Reinhart & Rogoff, 2009). However, for the sake of this thesis along
with crises are concerned, a closer attention will be paid to the term “golden decade” (Haldane, 2009)
which defines a period of unprecedented growth in many facets of life (technology, financial markets,
company profits, employment, living standards, and earnings). It may be just a mere coincidence but
the end of a golden decade, with the exception of the Wall Street Crash of 1929 and the subsequent
Great Depression epoch (1930-39), also corresponds with the times of major financial or economic
crises (the last two mammoth crises originated in the U.S.).
The severe consequences arising from financial and economic crises are not particularly hard to
imagine; fast deterioration in living standards (widening gap of wealth inequality); record levels of
unemployment; jolted societies from their roots and displaced people; a general mood of pessimism
(diminished hopes); and greater financial instability coupled with significant uncertainty about future
prospects. Investors in the new millennium have agonizingly witnessed how new strain of financial
crises with massive disruptive power left behind a financial dismay and spillover effects (contagion)
33 There had been as many as 13 major financial and economic crises in the 19 th century, majority of which were caused by
bank failures except the panic of 1893 (collapse of the railroad in the U.S.) and the panic of 1896 (a drop in silver reserves
resulted in a severe depression in the U.S.). Six of these crises originated in the U.S. and five of them in Britain (see
Kindleberger & Aliber, 2005; Laeven & Valencia, 2008).
34 Unlike the 19th century, about 20 major crises in the 20 th century were caused by different types of factors such as; stock
market crashes (Wall Street crashes of 1901, 1929, and 1987; Shanghai in 1910); speculative attacks on currencies (Asian
crisis in 1997, attacks on European Exchange Rate Mechanism in 1992-93, Mexican peso in 1994-95, and Brazilian real in
1998-99); assets bubbles (Japan in the 1990s), and sovereign debt defaults (Mexico in 1982, Russia in 1998). By the 21st
century, the nature and severity of financial crises not only have become more complex and costly, but also longer lasting.
Again, the three mammoth crises of the new millennium had the US origin; bursting of the Internet bubble in 2000-01,
mortgage debacle of 2006 (bubble formed during 2004-06 and burst in 2006), and the 2008 global financial crisis.
27
on the broader economy. In that respect, Blinder (2013) called the 2008 global financial crisis a
“perfect storm” and Bernanke (2005) characterized it as “a global financial meltdown”.
Since the 1980s, globalization (internationalization of finance and cross-border activities) has been
on a fast lane fueled by a wishful thinking that financial markets would develop necessary structures
and systems through self-regulation without the need for strong governance (Nissanke, 2010), this
idealistic view began to show severe side effects in the 1990s and 2000s; as such, Asian crisis of 1997-
98, dotcom crisis of 2001-02, mortgage (subprime) debacle of 2007-08, global financial crisis of 2008
and sovereign debt crisis of 2009-12. The 1987 US stock market crash was probably the early example
of a severe systemic shock sending chills through the spine of the global financial system where even
the basic market functioning became totally incapacitated. The crash was significant in many fronts,
but most importantly, it was an eye-opening single event that clearly showed how modern trading
systems were immensely fragile under extreme but plausible scenarios.
Source: Adapted from Carlson (2006)

Figure 9: Stock market indicators leading to the 1987 crash
Innovation in different forms had played a facilitating role in the making of the 1987 US stock market
crash; financial (derivatives, futures and options markets); technological (program trading as in
“portfolio insurance and “index arbitrage”, the designated order turnaround (DOT) system, and short
sales); and legislative (beneficial tax treatment for mergers and mortgage). All of these unique
developments and the resultant innovative financial instruments had attracted new investors (e.g.
pension funds) which provided significant gains for equity markets in spite of notable deterioration
in the macroeconomic outlook (Winkler & Herman, 1987). Carlson (2006) pointed out that margin
calls during the severe episode of the 1987 crisis created a panic situation adversely affecting liquidity
and market functioning, plus program trading with huge daily volumes intensified market losses.
28
A new portfolio risk measurement approach called value-at-risk (VaR) became popular In the 1990s
among financial and non-financial firms. VaR is not a new model, at least in theory; it has been around
for half a century since Baumol (1963) introduced the concept in the early 1960s. However two key
decisions were pivotal in VaR’s widespread adoption; first, JP Morgan created a benchmark open
architecture called RiskMetrics and provided public access to the compiled database on the variances
and covariance across different asset classes (JP Morgan, 1996); second, VaR became the mainstay
when the Basel Committee decided to allow banks to use VaR (at 99% confidence interval for 10 days)
internally while computing the capital adequacy and the capital requirements (see BCBS, 1996a for
market risk). VaR is calculated as shown below;
VaR = portfolio Value ∗ σ ∗ α ∗ √δt (e.g. Jorion, 1996;2001)
Where, 𝜎 denotes the daily volatility of the portfolio value, 𝛼 is the confidence level at which the
possibility of a loss is measured, 𝛿 is the time interval measured in days.
Following the 1987 US stock market crash, then Chairman of JP Morgan asked his famous question
“how much can we lose on our trading portfolio by tomorrow’s close?” which became the basis for VaR.
One advantage of VaR is that it aggregates portfolio related losses in a single number, arising from
volatility triggered by changes in interest rates, equity prices, or commodity prices. VaR answers the
question of the largest potential loss over a specified time horizon t at a given confidence interval p.
The largest value at risk can be written as 1 - p; meaning, the VaR on an asset is $1 million for a day
at 99% confidence, i.e. there is only 1% probability that the portfolio’s asset value will drop more than
$1 million in any given day (99% of the times the portfolio’s value will drop less than $1 million).
Despite a widespread use of VaR models, the systemic Asian crisis of 1997 still took place. Manganelli
and Engle (2001) claim that the common structures of all VaR models are fundamentally designed to
do three things; (i) mark to market the portfolio, (ii) estimate the distribution of portfolio returns,
and (iii) calculate the VaR of a portfolio or the entire bank. The accuracy of VaR outputs depends on
previously set variance and covariance, without them the results are meaningless. All VaR models
focus on downside risks, ignoring liquidity and systemic risks which played a crisis-intensifier role in
the last three US origin high-magnitude financial crises. For all VaR models, the conditional normal
distribution of returns is a prerequisite (weak in heterogeneous distributions with many outliers or
negative returns); linearity is a requirement, but the payoff of an option is not linear; stationarity is
another requirement, and non-stationarity may cause a breakdown in VaR calculations (Benninga &
Wiener, 1998; Hendricks, 1996; Kupiec, 1995; Lopez & Walter, 2000). Fallon (1996) defines VaR as a
“one-sided confidence interval on portfolio losses.” VaR failed to strengthen the global financial
system because it is not a standalone tool to measure vulnerabilities within the banking sector, VaR
29
numeric outcomes are less reliable under extreme but plausible scenarios, which must be validated
by another analytical tool such as GARCH, IGARCH, EGARCH, and stress testing.
The tractability of VaR calculations depends on several statistical assumptions; first is the common
stationarity requirement, which states that the possibility of 1% fluctuation in returns is the same for
bond, equity, and commodity at any point in time; second is the non-negativity requirement; with the
exception of forwards, futures, and swaps, financial assets cannot attain negative values; third and
probably the most important one is the distributional assumption, which stipulates that rates of
returns follow a normal distribution with a mean (μ=0) and standard deviation (σ=1). For a longer
perspective, see Jorion (2001), Kupiec (1995), and Lopez and Walter (2000).
Benninga and Wiener (1998) believe that VaR is rather a simple concept, but estimating asset return
distribution parameters and calculating position sizes of portfolios during its implementation pose
challenges. Thus, they claim that the lognormal distribution is better for many asset prices (subject
to the non-negativity requirement) than the normal distribution required by VaR. Dominguez and
Alfonso (2004) apply stress tests to the quantitative risk estimates obtained from Parametric VaR,
historical, and Monte Carlo simulations. The family of parametric models of volatility, starting with
ARCH – autoregressive conditional heteroscedasticity was introduced by Engle (1982); variations
appeared later that include GARCH, EGARCH, and IGARCH. Generalized ARCH (GARCH),
proposed by Bollerslev (1986), assumes the portfolio volatility as σ2t = α + β(R t − μ)2 + γσ2t−1 ,
where α, β, γ are constants and γ is the confidence interval, usually set to 0.94 or 0.97. Exponential
Garch (EGARCH) was proposed by Nelson (1991).
Dominguez and Alfonso (2004) evaluate how well VaR methodologies respond to stress testing
exercise based on historical scenarios. On the other hand, Berkowitz and O’Brien (2001) indicate that
banks’ VaR forecasts were less robust compared to the reduced-form based on the GARCH model
which is better than the bank VaR models for detecting and capturing banks’ P&L volatility. Hendricks
(1996) argues that VaR’s “extreme outcomes occur more often and are larger than predicted by the
normal distribution” and “the size of market movements is not constant over time.” VaR models are
complemented by stress testing, the results of which are informative to central banks. By focusing on
tail risks, stress testing quantifies banks’ vulnerabilities to various risk exposures and projects
potential losses under extreme but plausible scenarios. Moreover, stress tests assess banks’ capital
positions in terms of quality and quantity of high liquid assets to withstand shocks in the event of an
acute stress for at least a period of 30 days; further, stress testing results can be used by executives
within the bank as inputs to make investment and operational decisions.
30
2.4 Stress Testing Failed to Strengthen the Global Financial System
Although stress testing was an arcane topic in the finance field before the late 1990s, nevertheless
various stress tests have been used in other disciplines such as pharmaceutical (forced degradation),
software (load testing), civil engineering (torture testing), material design (compression, bending,
tension, elasticity tests), building and construction (tensile stress, strength, structural testing), and
component manufacturing (impact, toughness, notch testing). The word “stress” connotes a negative
impression, but stress tests conducted by banks (i.e. microprudential stress testing for internal risk
management purposes) and regulatory supervisors (i.e. system-wide macro stress testing) assess
banks and broader financial system can withstand shocks under highly adverse market conditions.
In the previous VaR section, it was mentioned that VaR is not a standalone tool to measure certain
risk exposures under extremely but plausible scenarios and VaR numeric outcomes must be validated
by other analytical tools such as GARCH, IGARCH, EGARCH, and stress testing. In this section, the same
can be said for stress testing which is indispensable but not failsafe as a standalone tool and must be
used as a complement to VaR or stressed VaR. Contemporaneous financial crises since the 1980s have
unmistakably proved that stress testing is not a supervisory early-warning tool to calculate the
probability and timing of the next future crisis; to think of it as one would be ill-advised (Borio et al.,
2012). However, stress tests as part of a bank’s comprehensive risk management framework can aid
bank executives in the decision-making process and central banks in monetary policy decisions.
The typology of stress testing is categorized along two dimensions; microprudential (BU: bottom-up,
by banks for internal risk management and by supervisors for “Pillar II Solvency” under Basel II and
III, see Figure 10), macroprudential (top-down TD) and BU by supervisors for stability, and FSAP for
surveillance,), and macroprudential (BU, only by central banks as a crisis management tool since
2009). There is also separate liquidity stress testing, which is less advanced and not linked to banking
solvency, it determines whether banks and markets have sufficient liquidity. The Basel Committee
had observed that important risks (securitization, short-term funding, liquidity, interbank contagion
and counterparty default) were not detected and covered sufficiently in most stress tests prior to the
GFC of 2008, plus the scenarios used in these weak stress tests were not rigorous enough. The stress
testing literature attest that microprudential stress tests conducted by banks and the supervisory
community failed to strengthen the resilience of the global financial system (BCBS, 2009a).
Banks day-to-day operations revolve around a constant inventory of risks which evolve, mutate, and
transform; therefore, it is crucial for banks to assess their position in terms of risk detection and risk
management. According to the Basel Committee, “stress test is commonly described as the evaluation
31
Source: Taskinsoy (2018b)
Figure 10: Overview of Micro and Macroprudential Stress Testing Framework
Notes: Baseline scenario is not a stress scenario, which is used for adjustment purposes prior to adverse and severely adverse scenarios.
PD: Probability of default; LGD: Loss given default; EPD: EAD: Exposure at default.
32
of a bank’s financial position under a severe but plausible scenario to assist in decision making within
the bank” (BCBS, 2009a). The Basel Committee believes that adequately designed micro and macro
stress tests with rigorous adverse scenarios will “…improve banking sectors’ ability to absorb shocks
arising from an acute financial and economic stress” (BCBS, 2010a). Although the stress testing
literature exemplifies a plethora of descriptions, an extensive survey is found in CGFS (2000, 2001),
the Basel Committee emphasizes that “what constitutes a good stress test is, however, not universally
clear” (BCBS, 2013a). Fender et al. (2001) explain that stress testing is “a risk management tool that
measures a firm’s exposure to extreme movements in asset prices”. The CGFS highlights that stress
tests quantify banks’ risks under highly adverse market conditions, but they do not determine the
likelihood of their occurrences (CGFS, 2000). The IMF defines stress test as “…a range of techniques
used to assess a vulnerability of a portfolio to major changes in the macroeconomic environment or
to exceptional, but plausible events” (Blaschke et al., 2001). The Basel Committee states that the
upshot of stress testing is “…the evaluation of a bank’s financial position under a severe but plausible
scenario to assist in decision making within the bank” (BCBS, 2009a).
Table 13: Stylized Categorization of Stress Tests
Typology Aim & Use Pros Cons
Microprudential Banks own stress tests for internal risk Internally developed Narrow focused, portfolio
Individual banks management purposes. Sensitivity and models measure capital or a single risk factor. Risk
scenario analyses are conducted to adequacy and liquidity. measurement methods
Bottom-up (BU) identify and gauge risk exposures. Assess bank resilience. vary among banks.
Microprudential Supervisory stress testing collects data Improved governance Resource intensive, costly.
Supervisors from banks to assess their soundness and transparency. An Banks are forced to change
and to ensure that each bank meets integral part of bank lending/capital planning
Top-down (TD) capital minima and sufficient liquidity. oversight. Routinized. behavior. More complex.
Macroprudential Forward-looking capital planning to Planned distribution of Qualitative objection until

Central banks ensure that banks have adequate capital. System-wide, Jan. 2017. Predictable and
capital and sufficient liquidity under consistently applied routinized. Costly and time
Top-down (TD) highly unlikely market conditions. multiple scenarios. consuming, and complex.
Macroprudential Help countries enhance resilience to Cost is shared by IMF Voluntary, and misleading
IMF’s FSAP shocks, foster growth by promoting and World Bank. It is results. Loss of credibility,
financial stability and financial sector voluntary, systematic a scuff on the unblemished
BU & TD diversity. Consistently applied. and consistent. reputation. Resource drain.
Source: Taskinsoy (2019e); European Banking Authority (EBA, 2014)

Notes: Stress testing began as microprudential conducted by banks for own risk management purposes, but today the
typology of stress testing was expanded to include two more which are mandatory for banks to participate and all
three stress tests may be conducted simultaneously; microprudential stress test conducted by supervisors and
macroprudential stress test as a crisis management tool conducted by central banks only.
To insure that stress testing programs are properly embedded in banks’ more comprehensive risk-
management frameworks, the Basel Committee has introduced the “Principles for sound stress
testing practices and supervision” in May 2009. Out of twenty one principles, fifteen concern
33
individual banks’ stress testing programs and are divided into three focus areas: use of stress testing
and integration in risk governance (6 principle); stress testing methodology and scenario selection
(4 principles); and specific area of focus (5 principles). Principles for supervisors (6 principles) make
regular and comprehensive assessments, enforce corrective actions, challenge the scope and severity
of banks’ stress test scenarios, examine banks’ stress test results as part of the supervisory review
process under Pillar 2 of Basel II, and identify systemic vulnerabilities (BCBS, 2009a). Since the late
1990s, banking systems across the world have become increasingly intricate, therefore enhanced risk
detection/measurement tools plus advanced supervision techniques have become necessary. In that
regard, macro stress testing has become a central focus to address the crisis-perpetrating issues such
as inadequate financial sector capitalization and constrained access to short-term funding.
Primary objective of microprudential BU stress tests is to ensure that banks, especially systemically
important banks (SIB), have both adequate capital and sufficient capital buffers not only to withstand
shocks under extreme but plausible market events but continue lending to households and businesses
even during the worst episode of acute stress (Fed, 2018). Although scenario analysis (i.e. historical
or hypothetical) is rather new, sensitivity analysis is well established within banks. Hirtle et al. (2014)
point out that the development of stress tests began around the same time as financial risk modeling
when analysts had contemplated pessimistic or worst-case outcomes before investing. In a scenario
analysis (a simulation technique), banks take into account multiple risk factors either from actual past
events (i.e. historical) such as Great Depression, or a future event (i.e. hypothetical) that has not yet
occurred but could be a plausible threat. A key advantage of historical scenarios is that data on
observed risk factors and their drivers could be obtained; as in disadvantage, past events (i.e. Great
Depression of 1930s) may not be relevant in today’s extraordinarily intricate financial systems.
Because hypothetical scenario analysis is an exercise of asking a series of “what-if” questions and then
simulate their effects, it gives banks the advantage of exposing threats that no bank executive thought
about before; the disadvantage is that the results may be manipulated due to interpretation.
At the back of ever more financial turmoil in the 2000s, large banks were required to put in place
rigorous stress testing programs under Basel II and Basel III (BCBS, 2004; 2009a; 2010a). Alongside
stress testing market risk and credit risk (via using the advanced and foundation internal ratings-
based (IRB) approaches), banks are regulator-mandated to stress test their credit portfolios in the
banking and trading books as well as their liquidity positions (BCBS, 2004). Adequately designed
stress testing programs containing extreme but plausible scenarios are argued to provide a better
decision-making process for banks and supervisors; “stress testing alerts the bank management to
34
adverse unexpected outcomes related to a variety of risks and provides an indication of how much
capital might be needed to absorb losses should large shocks occur” (BCBS, 2009a).
The recurrence of financial crises in the new millennium have unmistakably proved that individual
banks’ micro stress tests conducted for internal risk management purposes had serious deficiencies
(inherent flaws). Not only they had narrow scope, but were both inadequate (not bank-wide) and
insufficient (light scenarios generated results by design) to prevent a high-magnitude financial crisis
similar to that of the GFC of 2008. International Institute of Finance (IIF) argues that “during the
market turbulence, the magnitude of losses at many firms made it clear that their stress testing
methodologies needed refinement – stress testing was not consistently applied, too rigidly defined,
or inadequately developed (IIF, 2008). The domineering lesson of the latest global financial meltdown
during 2007-08 revealed that banks gravely failed to differentiate common risk dynamics of the
modern finance between structured products and bonds; further, micro stress tests conducted by
banks and the supervisory authorities failed to capture key risks such as pipeline, securitization,
short-term funding liquidity, interbank contagion and counterparty default (BCBS, 2009).
The Committee on the Global Financial System (CGFS) investigated the use of stress testing through
424 stress tests performed by 43 large internationally active banks and securities firms from ten
countries (CGFS, 2000; 2001; 2005). The overall conclusion of the CGFS survey revealed that stress
testing was an important as well as a valuable tool to gauge and manage risks (CGFS, 2000). Most
frequently used stress testing technique among these institutions in 2000 was the simple sensitivity
test to measure the adverse impact of changes in a single risk factor on portfolios or business units.
The second popular stress testing technique used was a scenario analysis (i.e. historical or/and
hypothetical) to measure risk exposures under extreme but plausible market conditions.
Stress testing, especially macro stress testing employed by central banks as a crisis management tool,
does not supplant other approaches (Morgan et al., 2010). Although the FSAP’s primary objective is
“the identification and mitigation of financial sector vulnerabilities and their macroeconomic stability
implications” and “fostering development of the financial sector and its contribution to economic
growth” (World Bank, 2006), both micro and macro stress testing programs prior to the GFC failed to
ensure global financial stability. Despite growing concerns, the majority of staffs both from the IMF
and the World Bank proclaim that FSAPs have led to positive changes in financial and non-financial
sectors (IMF & World Bank, 2003). Nevertheless, repeated misleading results (IMF, 2008) not only
caused loss of credibility and trust, but left a long-lasting scuff on the unblemished reputation of the
IMF and World Bank. An extensive review of the program’s processes (IMF & World Bank, 2005a; b)
35
was initiated after overhauling of banking systems (i.e. Irish bank system) and collapsing banks (i.e.
Dexia) shortly after passing FSAPs and EU-wide stress tests in 2010 and 2011.
Macroprudential Stress Testing by Central Banks: A Crisis Management Tool
The earlier bank-wide (microprudential) stress tests failed to detect risks; moreover, deficiencies
coupled with the inherent flaws of stress tests caused banks to overreact to the GFC’s unfolding events
(BCBS, 2009a; b). Starting with the Fed’s SCAP in 2009, macroprudential stress tests (BU) are used as
a crisis management tool to ensure financial stability. There is also liquidity stress testing but it is still
in infancy and not linked to bank-solvency. In the aftermath of the GFC of 2008, both adoption and
implementation of Basel III and regular macro stress testing by large and systemically important
banks (SIBs) have become a central focus, but not without enormous costs and challenges.
One of the shortcomings of micro stress testing was that it was entirely portfolio focused and narrow
in scope; furthermore, the health of the financial system as a whole or the buildup of systemic risk
was never a concern. On the other hand, macro stress testing (used by supervisors and central banks)
is broad in scope (Tables 15 and 16), system focused (i.e. health of an entire financial system is more
important than individual banks), and systemic risk in check, and is used as a crisis management tool
by central banks only. The widely perceived success of the SCAP (Fed, 2009a, b; see Table 14) spurred
worldwide implementations, but the success rate was varied and disparate across the globe. For
instance, in stark contrast to the U.S. experience, Europe bungled with its first two macro stress tests
designed and conducted by the CEBS (2010) and the successor EBA (2011), the EU-wide stress tests
instead contributed to financial instability rather than restoring investor confidence as it was the case
in the U.S. (Blinder, 2013 for steps taken to restore confidence; FCIC, 2011 for causes; Dewatripont et
al., 2010 for valuable lessons learned; and Nissanke, 2010 for impact on EMEs).
Among many others, Greenlaw et al. (2012) point out that macroprudential stress testing programs
still focus on microprudential aspects. Regardless of micro or macro, Borio et al. (2011) argue that
stress testing must have four common elements; (1) risk exposures that are pertinent to stress; (2)
parameters of the scenario (exogenous) that send plausible shocks to risk exposures; (3) a model that
simulates shocks at different levels to analyze and monitor propagation of various stress points
through the system; (4) measurement of the outcome. Bernanke (2013) points out that macro stress
tests provide three benefits; i) adds a “forward-looking” aspect to capital ratios; ii) takes care of “tail
risks”; and iii) ensures adequate level of capital (quality and quantity) along with sufficient capital
buffers at each SIB to absorb losses and keep lending under extreme but plausible market conditions.
36
Table 14: Supervisory capital assessment program (SCAP)
Federal Reserve estimates in the supervisory severely adverse scenario
$ Billions % of loans
At December 31, 2008

Tier 1 capital 836.7
Tier 1 common capital 412.5
Risk-weighted assets 7,814.8
Loan losses (projected for 2009 and 2010 under more adverse) 599.2
First lien mortgages, domestic 102.3 8.8
Junior liens and HELOCs, domestic 83.2 13.8
Commercial and industrial 60.1 6.1
Commercial real estate, domestic 53.0 8.5
Credit cards 82.4 22.5
Securities (AFS and HTM) 35.2 -na-
Trading and counterparty 99.3 -na-
Other (1) 83.7 -na-
Memo: Purchasing accounting adjustments 64.3
Resources other than capital to absorb losses (2) 362.9
SCAP buffer added for more adverse scenario (SCAP buffer is defined as
additional Tier 1 common/contingent common)
Indicated SCAP buffer as of December 31, 2008 185.0

Less: Capital actions and effects of Q1 2009 results (3) (4) -110.4
SCAP buffer (5) 74.6
Source: The Federal Reserve (Fed, 2009b)

(1) Includes other consumer/non‐consumer loans and miscellaneous commitments and obligations.
(2) Includes pre‐provision net revenue less the change in the allowance for loan and lease losses.
(3) Capital actions include completed or contracted transactions since Q4 2008.
(4) Includes only capital actions and effects of Q1 2009 results for firms that need a SCAP buffer.
(5) There may be a need to establish an additional Tier 1 capital buffer, but this would be satisfied by the
additional Tier 1 Common capital buffer unless otherwise specified for a particular BHC.
Notes: The SCAP (2009) and its results were particularly of great importance since this was the first macro
stress testing used by the US Federal Reserve as a crisis management tool. The results were also significant to
central banks, supervisory authorities, bank executives, risk managers, and academia to understand the main
sources of financial losses, the majority of which resulted from mortgage-backed securities.
Macro stress testing as a crisis management tool is an attempt in the right direction to take care of the
four broad weaknesses (impediments of micro stress testing) highlighted by the Basel Committee: (i)
use of stress testing and integration in risk governance; (ii) stress testing methodologies; (iii) scenario
selection; and (iv) stress testing of specific risks and products (BCBS, 2009a). Macro stress testing as
a crisis management tool uses vastly complex (and usually proprietary) software programs, models,
and statistical applications run on very sophisticated computer systems; therefore, absence or limited
availability of infrastructure can cause a failure to identify or misidentify banks’ risk exposures.
37
Table 15: Crisis stress tests: macro-financial parameters scorecard
Parameter Application to Stress Tests
Variable Indicator US European Union Ireland Spain
SCAP CEBS CEBS EBA PCAR FSAP TD BU

2009 2009 2010 2011 2011 2012 2012 2012
Real GDP x x x x x x x x
Growth Real GNP x
Nominal GDP x x x
Unemployment x x x x x x x x
Employment
Employment x
CPI 2/ x x x x x
Price evolution HICP x x
GDP deflator x x x x
Private x
Consumption
Government x
Exports x
Trade Imports x
Balance of
x
payments
Investment x
Income and
investment Personal
x
disposable income
Real estate prices x x x x x x x x
Comm. property x x x x
Real estate
Resid. property x x x x x x x
Land x x
Up to 1 year 2/ x x x x x
Interest rate Up to 5 year 2/ x x
More than 5 years 2/ x x x x x
Relative to
Exchange rate 2/ x x x x x
U.S. dollar
Stock market Stock price index 2/ x x x x x
Credit to other Households x x x

resident Non-financial
sectors corporate x x x
Source: Ong & Pazarbasioglu (2013)

2/ Information not disclosed.
Notes: Macro-financial parameters used in stress tests are widely disparate. This scorecard shows what macro
parameters were used by the U.S., European Union, Spain, and Ireland.
38
Table 16: Crisis stress tests: risk factors scorecard
Risk Factor Application to Stress Tests
Risk Exposures US European Union Ireland Spain

accounting
Nature of
type
SCAP CEBS CEBS EBA PCAR FSAP TD BU
2009 2009 2010 2011 2011 2012 2012 2012
Residential mortgage x 1/ x x x x x x
First lien x
Second lien x
Commercial /
x
industrial loans
Corporate loans 1/ x x x x x x
RE developers x x x
SME loans x x x x
Credit Risk
CRE loans x x
...
Fin. inst. loans 1/ x x
Consumer loans
x 1/ x x x x x
(including credit cards)
Revolving loans x
Public works x x
Sovereign exposure
in available-for-sale x
(AfS) banking book
Other loans x
Sovereign portfolio x 1/ x x x x
Financial ins. portfolio x 1/ x x x x
Trading book
Other securities (MBS

x x
and other ABS)
Private equity holding x
Counterparty credit
exposures to OTC x
Market Risk
derivatives
Sovereign portfolio x x
book (AfS)
Banking
Financial ins. portfolio x x

x x
and other ABS)
Sovereign portfolio x
book (HtM)
Banking
Financial ins. portfolio x

x x
and other ABS)
Operational Risk x x
Separate liquidity test 2/ x x
Source: Ong & Pazarbasioglu (2013)

1/ Information not disclosed, HtM: Hold to maturity, AfS: Available for sale
2/ The EBA conducted a confidential thematic review of liquidity funding risks.
Notes: Deciding the right risk factors to stress test is very crucial, therefore choosing wrong risk factors will adversely
affect the outcome and may result in further losses. This scorecard shows the risk types stress tested by the U.S.,
European Union, Spain, and Ireland. Again, this is very important as a roadmap.
39
Ong and Pazarbasioglu (2013) have shown that the earlier EU-wide stress testing programs have
contrasted with the U.S. SCAP in terms of macro financial parameters used (Table 15) and risk factors
assumed (Table 16). Cardinali and Nordmark (2011), Ellahie (2012), and Petrella and Resti (2013)
suggest that the CEBS (2010a) stress test was uninformative; as a result, disclosure of the test results
caused a decline in equities. Beltratti (2011) argues that EBA (2011) stress test was informative in
terms of methodologies and scenarios. Stress testing literature exemplifies that public disclosure of
macro stress testing results along with methodologies and scenarios provides generalized benefits
just as adequate disclosures reduce opacity of banks (Gick & Pausch, 2012; Morgan et al., 2010). The
CEBS (2010a) EU-wide stress testing exercise suffered a huge puncturing blow when Ireland
requested financial assistance after the results were published; further, instability ascended in
markets when the systemically important Dexia (Belgium) and Bankia (Spain) required restructuring
shortly after passing the EBA 2011 stress test (EBA, 2011). Zandi and Zemcik (2014) feel that the EU
still faces integration issues due to national discrepancies, governance, and economic variations.
Source: Adapted from ECB (2013)

Notes: Bank solvency has become a central focus in recent years, and the thesis used this framework throughout
the analyses to understand and explain interactions as well as linkages between banks’ operations involving
exogenous and endogenous shocks.
Figure11: ECB bank solvency framework
40
As illustrated in Figure 11, the ECB solvency framework, similar to a stress testing framework, begins
with the scenario design (pillar 1) where funding shock resulting from credit and market risks are
considered. Macro factors and their impact on credit and market exposures (loan losses) as well as
profitability (ROA and ROE) are taken into account. The EU-wide stress tests conducted by both CEBS
and EBA were less credible because scenarios were arbitrary, capital definitions were different, and
no supplemental scenarios for large banks with high risk exposures. In the wake of stress testing
disappointments in the Euro area, the opponents argue that the EBA had catching-up to do to reach
the standards equivalent to the US Fed and the UK Prudential Regulatory Authority (Table 17).
Table 17: Stylized categorization of stress tests
Type Aim Use
Banks own stress Region‐wide

Banks’ risk micro‐ prudential
testing (risk,
Banks Risk management management and stress tests:
portfolio or
planning
institution)
Hybrid in methods
and aims; multiple
Micro‐ prudential Bank‐by‐bank Supervisory risk applications
stress tests (risk, information on analysis and
Supervisors
portfolio or risks and action, early
Either bottom
institution) vulnerabilities warning tools
up or top down
System‐wide Systemic Focus on

Aggregated
Macroprudential macro‐prudential stability, comparability
information on
authorities stress tests economic policy
systemic risks
(institution) implications
Source: European Banking Authority (EBA, 2014)

Notes: Stress testing began as microprudential conducted by banks for own risk management purposes,
but today the typology of stress testing was expanded to include two more which are mandatory for banks
to participate and all three stress tests may be conducted simultaneously; micro stress test conducted by
supervisors and macro stress test as a crisis management tool conducted by central banks only.
Since the CEBS 2010, EU governments took necessary steps to strengthen banks’ balance sheet; as a
result, the starting average core Tier 1 capital ratio (CT1R) of 90 banks in the exercise was 8.9% which
included €160 billion government backstop and €50 billion retained earnings. The results of the EBA
2011 EU-wide stress testing suggests that 20 banks would fall below the hurdle CT1R of 5% over the
two-year stress testing horizon, which would result in an overall capital shortfall of €26.8 billion (see
Table 18 for the 2014 EU-wide stress test results). However, when banks’ raising capital actions are
taken into account, only eight banks fail to meet the minimum CT1R of 5% and the capital shortfall is
reduced to €2.5 billion, but one of the concerning outcomes of the exercise is that 16 banks’ CT1Rs
are close to the border line between 5% and 6% (EBA, 2011). Since the use of macro stress testing
(2009), banks in the U.S. have had an easier time achieving recapitalization because publishing the
41
full results of the SCAP helped restore investor confidence, which in turn led to better equity returns.
Industry participants point out that publishing the results of macroprudential stress tests along with
methodologies and scenarios employed has provided generalized benefits.
Table 18: 2014 EU-wide stress test results for Q4 2013 - Q4 2016
European Banking Authority estimates in the adverse scenario
Tier 1 common ratio Number of failed banks

AQR Shortfall
Country/Region 2016 2016
Adjusted € million
2013 Baseline Adverse Total Baseline Adverse
All EU banks 11.1 11.6 8.5 123 14 24 24,189
Italy 9.5 9.3 6.1 15 8 9 9,413
Greece 9.9 8.0 2.0 4 2 3 8,721
Cyprus 4.4 9.5 -1.0 3 1 3 2,365
Portugal 11.1 10.1 5.9 3 0 1 1,137
Austria 10.5 10.6 7.4 6 1 1 865
Ireland 13.2 12.2 7.0 3 0 1 855
Belgium 14.0 11.9 7.2 5 0 2 540
Germany 12.8 12.8 9.1 24 1 1 228
Slovenia 15.9 14.4 6.1 3 0 2 65
France 11.3 11.8 9.0 11 1 1 0
Demark 14.2 15.4 11.7 4 0 0 0
Finland 16.4 17.6 12.0 1 0 0 0
Hungary 15.9 17.0 11.9 1 0 0 0
Latvia 9.8 10.5 7.7 1 0 0 0
Luxembourg 15.9 15.1 11.2 2 0 0 0
Malta 10.7 13.2 8.9 1 0 0 0
Netherlands 11.6 12.2 8.9 6 0 0 0
Norway 11.3 14.4 11.3 1 0 0 0
Poland 13.3 15.4 12.3 6 0 0 0
Spain 10.4 11.6 9.0 15 0 0 0
Sweden 15.3 16.9 13.7 4 0 0 0
United Kingdom 9.8 11.2 7.8 4 0 0 0
After capital raising --- --- --- 123 0 14 9,500
Source: European Banking Authority (EBA, 2014)

Notes: The SCAP by the Federal Reserve was followed by the EU’s own version of macro stress tests, but the
Committee of European Banking Supervisors (CEBS) and its successor the European Banking Authority (EBA)
bungled on their EU-wide stress tests. This table illustrates the main results of the 2014 EU-Wide Stress Test. The
aggregated capital shortfall of all EU banks, compared to those of the U.S., is relatively small.
3.0 Concluding Remarks
Banks, an inextricable part of any sustainable economic growth, have an endless propensity to adopt
financial innovation to better cope with imperfect market frictions, especially adverse effects arising
from asymmetric information and transaction costs. A banking system can provide signs of stability
or instability and be a good predictor of future growth, quality and quantity of regulatory capital plus
42
capital buffers, speed and degree of technological change. Disruptions to the normal functioning of a
financial system can adversely affect its allocation of real and scarce financial resources from savers
to investors who enter into intertemporal contracts through space and time amid uncertainties. A
banking system mainly involves five key tasks in financial intermediation; allocating resources from
savers to potential investors, trading and hedging activities, facilitating, and pooling of risks.
A banking operation and its investment activities revolve around a constant inventory of risks, which
must be detected, gauged and managed to ensure financial stability. Due to its multidimensional
nature, risk is never stagnant; therefore, it evolves, mutates and transforms. These characteristics of
risk and more make tem behave in unpredictable ways, which may not be detected or forecasted. This
situation puts banks at the fore to develop enhanced tools such as VaR and stress testing to assess
risks. However, stress testing and VaR models have been dissected under the microscope as the recent
global financial crisis (GFC) of 2008 revealed severe flaws. VaR has been blamed for being “blind to
true risk” under extreme but plausible scenarios; and stress testing has been ferociously battered for
being both inadequate and insufficient to cope with the intensity of the GFC.
In the post-WWII (since the 1950s), there have been over 400 banking, currency, and sovereign debt
crises, which translates to about 10 crises per annum; furthermore, the combined cost of the last five
crises since the late 1990s is in excess of $30 trillion, but when the cost of the COVID-19 (Great Global
Health Crisis) is factored in, collectively the biggest financial mayhem in the history of humanity could
be well over $50 trillion. This outcome serves a painful reminder that financial authorities (the Fed
and the ECB in particular), the supervisory community (BCBS, EBA, BIS, etc.), and the multilateral
organizations (IMF, World Bank, IIF, OECD, etc.) have grossly failed to strengthen the global financial
system by preventing the recurrence of banking and financial crises, mitigating massive costs to the
world economies, and safeguarding the global financial stability. Consequently, various risk detection
tools alongside capital adequacy and liquidity measures under Basel I, Basel II, FSAP, and individual
banks’ inadequate microprudential stress tests contributed to further instability rather than stability
in the global financial system. For the past four decades, a high-magnitude crisis has occurred in every
decade, i.e. US stock market crash in 1987, Asian crisis in 1997-98, subprime crisis and the subsequent
global financial crisis in 2007-08, and great global health crisis (COVID-19) in 2020-21. The economic
and societal impact of the latter has not been effectively calculated, but it would not come as a total
shock if the cost of COVID-19 globally comes between $20 and $50 trillion.
Unfortunately, outbreaks, epidemics, and pandemics are hidden but not unexpected costs of building
civilizations via globalization; throughout history , viruses have become increasingly frequent and
severely damaging ever since the humankind made the shift from the primitive Stone Age existence
43
to agrarian life about 10,000 years ago. Interconnectedness via globalization (one seamless world)
has forged trade hubs to connect with each other without strict rules, this has however inadvertently
amplified possibilities of communicable diseases, risks of contracting viruses, and costs of combating
COVID-19 like pandemics. Scientists, health officials along with environmentalists strongly warn that
rising civilizations and the resultant increased human activity is pushing the Earth’s eco system out
of balance; in turn, unthinkable impacts of global warming, if its acceleration is not curbed by 2030,
will cause a lot more severe pandemics to strike the humankind down.
When the global economy is exposed to a new great shock (i.e. COVID-19), comparisons between that
and the antecedents since WWI are inevitable. Despite coronavirus’ far greater costs than any event
since the onset of the 20th century, COVID-19 is not categorized as a financial crisis. While both the
2008 global financial crisis (Great Recession) and the Great Depression of the 1930s were fostered by
endogenous risks (i.e. monetary policy errors, funding freeze, heavy selloff in a herd mentality,
procyclical deleveraging, and fast-drying liquidity in markets, COVID-19 shock however is exogenous
to the global financial system as systemically important banks (SIBs) are not at the virus’ epicenter.
Therefore, trillions of dollars liquidity provided by the high-profile central banks (i.e. the Fed and the
ECB) is a wrong policy remedy because COVID-19 is a different crisis caused by a virus not caused by
illiquidity, but this is not to deduce that the farfetched financial implications of the virus shock will
not likely turn into a systemic global financial crisis with greater cost than the GFC of 2008.
References
Adams, P., & Wyatt, S. (1987). On the Pricing of European and American Foreign Currency Call
Options. Journal of International Money and Finance, 6:315-38.
Angelini, P., Clerc, L., Cúrdia, V., Gambacorta, L., Gerali, A., Locarno, A., Motto, R., Roeger, W., Van den
Heuvel, S. & Vlcekaolo, J. (2011). BASEL III: Long-term Impact on Economic Performance and
Fluctuations. Bank of International Settlement, Working Paper 338, February.
Arrow, K.J. (1964). The Role of Securities in the Optimal Allocation of Risk Bearing. Rev. Econ. Stud.,
Apr. 1964, (2), pp. 91–96.
Atkinson, T., Luttrell, D. & Rosenblum, H. (2013). How Bad Was It? The Costs and Consequences of the
2007-09 Financial Crisis. Staff Papers No. 20, Federal Reserve Bank of Dallas Federal Reserve
Board of Governors, July.
Baumol, W. (1963). An expected gain-confidence limit criterion for portfolio selection. Management
Science 10, pp. 174-182.
BCBS (Basel Committee on Banking Supervision) (1988). International Convergence of Capital
Measurement and Capital Standard. Basel, July.
BCBS (Basel Committee on Banking Supervision) (1996a). Amendment to the capital accord to
incorporate market risks. Basel, January.
44
BCBS (Basel Committee on Banking Supervision) (1996b). Supervisory framework for the use of
“backtesting” in conjunction with the internal models approach to market risk capital
requirements. Basel, January.
BCBS (Basel Committee on Banking Supervision) (2004). International Convergence of Capital
Measurement and Capital Standards: A Revised Framework. Basel, June.
BCBS (Basel Committee on Banking Supervision) (2009a). Principles for Sound Stress Testing
Practices and Supervision. Working Paper No. 155. Basel, May.
BCBS (Basel Committee on Banking Supervision) (2010a). Basel III: A Global Regulatory Framework
for More Resilient Banks and Banking Systems. Basel, December.
BCBS (Basel Committee on Banking Supervision) (2010b). An Assessment of the Long-Term Impact
of Stronger Capital and Liquidity Requirements. LEI Report, Basel.
BCBS (Basel Committee on Banking Supervision) (2010c). Results of the Comprehensive Quantitative
Impact Study. Basel, December.
BCBS (Basel Committee on Banking Supervision) (2012). Results of the Basel III monitoring exercise
as of June 30 2011. Basel, April.
Beachy, B. (2012). Financial Crisis Manual: Causes, Consequences, and Lessons of the Financial Crisis.
Global Development and Environment Institute Working Paper No. 12-06.
Beltratti, A. (2011). Do Stress Tests Carry Useful Information? Evidence from Europe. Bocconi
University.
Benninga, S. & Wiener, Z. (1998). Value at Risk. Mathematica in Education and Research, 7 (4), 1-7.
Berkowitz, J. & O’Brien, J. (2001). How Accurate Are Value-at-Risk Models at Commercial Banks?
Graduate School of Management, University of California, Irvine. Division of Research and
Statistics, Federal Reserve Board, July.
Bernanke, B.S. (2005). The Global Savings Glut and the U.S. Current Deficit. Sandridge Lecture,
Virginia Association of Economics, Richmond, Virginia.
Bernanke, B.S. (2007). Global Imbalances: Recent Developments and Prospects. Bundesbank lecture,
September 11.
Bernanke, B.S. (2012). Monetary Policy Since the Onset of the Crisis. Speech at the Federal Reserve
Bank of Kansas City Symposium, Jackson Hole, Wyo., August 31.
Bernanke, B.S. (2013). Stress testing banks – what have we learned? Speech at the maintaining
financial stability: Holding a tiger by the tail. Financial markets conference, sponsored by the
Federal Reserve Bank of Atlanta, April.
Birdsall, N. (2012). The Global Financial Crisis: The Beginning of the End of the ‘Development’
Agenda? CGD Policy Paper No. 003, Center for Global Development, Washington, D.C.
BIS (Bank for International Settlements) (2011a). Central Bank Governance and Financial Stability: A
Report by a Study Group. Basel: Bank for International Settlements. May.
BIS (Bank for International Settlements) (2011b). Basel III: Long-term Impact on Economic
Performance and Fluctuations. Working paper No 338, February.
Blanchard, O. & Milesi-Ferretti, G.M. (2009). Global Imbalances: In Midstream? IMF SPN/09/29,
(Washington: International Monetary Fund).
45
Blaschke, W., Jones, M. T., Majnoni, G. & Peria, S. M. (2001). Stress Testing of Financial Systems: An
Overview of Issues, Methodologies, and FSAP Experiences. IMF Working Paper WP/01/88.
Blinder, A.S. (2013). After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead.
The Penguin Press, USA, ISBN – 978-1-59420-530-9.
Blinder, A. & Yellen, J.L. (2001). The Fabulous Decade: Macroeconomic Lessons from the 1990s. New
York: Century Foundations Press.
Blundell-Wignall, A. & Atkinson, P. (2010). Thinking Beyond Basel III: Necessary Solutions for Capital
and Liquidity. OECD Journal: Financial Market Trends, 2010 (1), 1-23.
Blundell-Wignall, A., Atkinson, P.E., Roulet, C. (2014). Bank Business Models and the Basel System:
Complexity and Interconnectedness. OECD Journal: Financial Market Trends 2014, (2), 1-26.
Bollerslev, T. (1986). Generalized Autoregressive Conditional Heteroskedasticity. Journal of
Econometrics, 31, 307-327.
Borio, C. (2003). Towards a Macroprudential Framework for Financial Supervision and Regulation?
BIS Working Paper, No 128.
Borio, C., Drehmann, M. & Tsatsaronis, K. (2012). Stress-Testing Macro Stress Testing: Does it live up
to Expectations? BIS Working Paper No. 369, January.
Boyd, J.H., & Heitz, A. (2012). The Social Costs and Benefits of Too-Big-To-Fail Banks: A “Bounding”
Exercise. Department of Finance, University of Minnesota, February.
Caballero, R. (2010). The “Other” Imbalance and the Financial Crisis. NBER Working Paper No. 15636.
Cardinali, A. & Nordmark, J. (2011). How informative are bank stress tests? Bank opacity in the
European Union. Master's thesis, Lund University.
Carlson, M. (2006). A Brief History of the 1987 Stock Market Crash with a Discussion of the Federal
Reserve Response. Divisions of Research & Statistics and Monetary Affairs Federal Reserve
Board, Washington, D.C.
Carmassi, J. & Micossi, S. (2012). Time to Set Banking Regulation Right. CEPS Paperback, Brussels,
March.
CEBS (Committee of European Banking Supervisors) (2010a). Aggregate outcome of the 2010 EU-
wide stress test exercise. July.
CEBS (Committee of European Banking Supervisors) (2010b). Results of the comprehensive
quantitative impact study. December.
CGFS (Committee on the Global Financial System) (2000). Stress Testing by Large Financial
Institutions: Current Practice and Aggregation Issues. Report by a Working Group. BIS: Bank
for International Settlements, April.
CGFS (Committee on the Global Financial System) (2001). A survey of stress tests and current practice
at major financial institutions. Report by a Working Group. BIS, April.
CGFS (Committee on the Global Financial System) (2005). Stress Testing at Major Financial
Institutions: Survey Results and Practice. Report by a Working Group. BIS: Bank for
International Settlements, January.
Claessens, S., & Kose, M.A. (2013). Financial Crises: Explanations, Types, and Implications. IMF
Working Paper WP/13/28, Research Department, IMF: Washington D.C.
46
Claessens, S., Kose, M.A., & Terrones, M. (2010). The Global Financial Crisis: How Similar? How
Different? How Costly? Journal of Asian Economics, Vol. 21, No. 3, pp. 247-64.
Cornell, B. (1981). The Relationship between Volume and Price Variability in Futures Markets. Journal
of Futures Markets 1:303-16.
Crockett, A. (1997a). Why is Financial Stability a Goal of Public Policy? In maintaining financial
stability in a global economy, a symposium sponsored by the Federal Reserve Bank of Kansas
City, Jackson Hole, Wyoming.
Crockett, A. (1997b). The Theory and Practice of Financial Stability. Essays in International Finance,
203. International Finance Section, Department of Economics, Princeton University.
Crockford, G.N. (1982). The Bibliography and History of Risk Management: Some Preliminary
Observations. The Geneva Papers on Risk and Insurance 7, 169-179.
Crotty, J. (2009). Structural Causes of the Global Financial Crisis: A Critical Assessment of the ‘New
Financial Architecture’. Cambridge Journal of Economics 2009, 33, 563–580.
Dell’Ariccia, G., Igan, D., Laeven, L., & Tong, H. (2012). Policies for Macrofinancial Stability: How to
Deal with Credit Booms. IMF Staff Discussion Note No. 12/06.
Dewatripont, M., Rochet, J.C., & Tirole, J. (2010). Balancing the banks: global lessons from the financial
crisis. Princeton, NJ: Princeton University Press.
Diebold, F.X. (2012). 100+ Years of Financial Risk Measurement and Management. University of
Pennsylvania and NBER, April 29.
Dionne, G., & Eeckhoudt, L. (1985). Self-Insurance, Self-Protection and Increased Risk Aversion.
Economics Letters 17, 39-42.
Dominguez, J.M.F. & Alfonso, M.D.O. (2004). Applying Stress-Testing on Value at Risk (VaR)
Methodologies. Investment Management and Financial Innovations, 4/2004.
EBA (European Banking Authority) (2011). EU-Wide Stress Test Aggregate Report. European System
of Financial Supervision, July.
EBA (European Banking Authority) (2014). Results of 2014 EU-Wide Stress Test. Aggregate Results.
European System of Financial Supervision, October.
EBA (European Banking Authority) (2015). EU-Wide Stress Test 2016. Draft Methodological Note,
November.
ECB (European Central Bank). (2002). The Transformation of the European Financial System
(Editors: Vítor Gaspar, Philipp Hartmann, Olaf Sleijpen). Second ECB Central Banking
Conference. October 2002, Frankfurt, Germany
Ellahie, A. (2012). Capital Market Consequences of EU Bank Stress Tests. London Business School
Working Paper.
Elizalde, A. (2007). From Basel I to Basel II: An Analysis of the Three Pillars. CEMFI Working Paper
No. 0704, June.
Engle, R. (1982). Autoregressive Conditional Heteroscedasticity with Estimates of the Variance of
United Kingdom inflation. Econometrica 50, 987-1007.
Fallon, W. (1996). Calculating value-at-risk. Working Paper Series No. 96-49, Financial Institutions
Center. The Wharton School, University of Pennsylvania, January.
47
FCIC (Financial Crisis Inquiry Commission) (2011). The Financial Crisis Inquiry Report, Authorized
Edition: Final Report of the National Commission on the Causes of the Financial and Economic
Crisis in the United States. Financial Crisis Inquiry Commission, Public Affairs, ISBN – 978-1-
61039-041-5.
Fed (Board of Governors of the Federal Reserve System) (2009a). The supervisory capital assessment
program: Design and implementation, April 24.
Fed (Board of Governors of the Federal Reserve System) (2009b). The supervisory capital assessment
program: Overview of results, May 7.
Fed (Board of Governors of the Federal Reserve System) (2018). Dodd-Frank Act Stress Test 2018:
Supervisory Stress Test Methodology and Results, June.
Ferguson, R.W. (2003). Vice Chairman Federal Reserve Board, Testimony before the Subcommittee
on Domestic and International Monetary Policy, Trade, and Technology. Committee on
Financial Services, U.S. House of Representatives, February 27.
Frankel, J., & Froot, K. (1990). Exchange Rate Forecasting Techniques, Survey Data, and Implications
for the Foreign Exchange Market. Working Paper No. 3470, Cambridge, Mass.: National Bureau
of Economic Research.
Gick, W. & Pausch, T. (2012). Persuasion by Stress Testing: Optimal Disclosure of Supervisory
Information in the Banking Sector. SSRN.
Glassman, D. (1987). Exchange Rate Risk and Transaction Costs: Evidence from Bid-Ask Spreads.
Journal of International Money and Finance 6:479-90.
Gordy, M.B. (2003). A Risk-Factor Model Foundation for Ratings-Based Bank Capital Rules. Journal of
Financial Intermediation, 12 (3), 199-232.
Greenlaw, D., Kashyap, A.K., Schoenholtz, K.L., & Shin, H.S. (2012). Stressed out: Macroprudential
principles for stress testing. Chicago Booth Research Paper No. 12-08.
Haldane, A.G. (2009). Why Banks Failed the Stress Test (The basis for a speech given at the Marcus-
Evans Conference on Stress-Testing), 9-10 February.
Haldane, A.G. (2011). Capital Discipline. Speech to the American Economic Association, Denver, CO, 9
January.
Hendricks, D. (1996). Evaluation of Value-at-Risk Models Using Historical Data. Economic Policy
Review, Federal Reserve Bank of New York, April, 39-69.
Hirtle, B., Kovner, A. & McKay, E. (2014). Becoming More Alike? Comparing Bank and Federal Reserve
Stress Test results. Liberty Street Economics, Federal Reserve Bank of New York, July.
Hoenig, T. (2013). Basel III Capital: A Well-Intended Illusion (Speech Delivered to the International
Association of Deposit Insurers). Basel, April.
Hsieh, D. (1989). Modeling Heteroskedasticity in Daily Foreign Exchange Rates. Journal of Business
and Economic Statistics 7:307-17.
IEO (Independence Evaluation Office) (2006). Report on the Evaluation of the Financial Sector
Assessment Program. Washington, DC: IMF.
IIF (Institute of International Finance) (2008). Final Report of the IIF Committee on Market Best
Practices: Principles of Conduct and Best Practice Recommendations. Financial Services
Industry Response to the Market Turmoil of 2007-2008, July.
48
IIF (Institute of International Finance) (2011). The Cumulative Impact on the Global Economy of
Changes in the Financial Regulatory Framework. IIF: Washington.
IMF (International Monetary Fund) (2004). Are credit booms in emerging markets a concern? IMF
World Economic Outlook, Washington, D.C. April.
IMF (International Monetary Fund) (2014). Malaysia Financial Sector Assessment Program: Financial
Sector Performance, Vulnerabilities and Derivatives—Technical Note, IMF Country Report No.
14/98, April.
IMF & World Bank (2003). Financial Sector Assessment Program—Review, Lessons, and Issues Going
Forward. Prepared by the staffs of the World Bank and the International Monetary Fund,
February.
IMF & World Bank (2005a). Financial Sector Assessment Program—Review, Lessons, and Issues
Going Forward. Prepared by the Staffs of the International Monetary Fund and the World Bank,
February.
IMF & World Bank (2005b). Financial Sector Assessment: A Handbook. International Monetary Fund
and the World Bank.
Iwaisako, T. (2010). Global Financial Crisis, Hedge Funds, and the Shadow Banking System. Policy
Research Institute, Ministry of Finance, Japan, Public Policy Review, Vol. 6(3), March.
Jackson, P., Furfine, C., Groeneveld, H., Hancock, D., Jones, D., Perraudin, W., Radecki, L., Yoneyama, M.
(1999). Capital Requirements and Bank Behaviour: The Impact of the Basle Accord. Basle
Committee on Banking Supervision Working Papers No. 1, April.
Jorion, P. (2001). Value-at-risk: The New Benchmark for Controlling Market Risk. 2nd Edition,
Chicago: McGraw-Hill.
Jorion, P., & Stoughton, N. (1989). An Empirical Investigation of the Early Exercise of Foreign Currency
Options. Journal of Futures Markets 9:365-75.
JP Morgan (1996). RiskMetrics. Technical Document. 4th edition. New York.
Kindleberger, C.P., & Alibar, R.Z. (2005). Manias, Panics, and Crashes: A History of Financial Crises.
Fifth Edition, John Wiley & Sons, Inc., Hoboken, New Jersey.
Kupiec, P. (1995). Techniques for Verifying the Accuracy of Risk Measurement Models. Journal of
Derivatives, 3, 73-84.
Keynes, J.M. (1936). The General Theory of Employment, Interest and Money.
Laeven, L., & Valencia, F. (2008). Systemic Banking Crises: A New Database. IMF Working Papers
08/224, International Monetary Fund.
Laeven, L., & Valencia, F. (2012). Systemic Banking Crises Database: An Update. IMF Working Papers
12/163, June, IMF: International Monetary Fund.
Lopez, J. & Walter, C. (2000). Evaluating Covariance Matrix Forecasts in a Value-at-Risk Framework.
Manuscript, Federal Reserve Bank of San Francisco.
Lown, C. & Morgan, D. (2004). The Credit Cycle and the Business Cycle: New Findings Using the Loan
Officer Opinion Survey. Research Report from Stockholm Institute for Financial Research, 27,
September.
Lyons, R. (1988). Tests of the Foreign Exchange Risk Premium Using the Expected Second Moments
Implied By option Pricing. Journal of International Money and Finance 7:91-108.
49
MAG (Macroeconomic Assessment Group) (2010). Assessing the Macroeconomic Impact of the
Transition to Stronger Capital and Liquidity Requirements. Final Report, Basel Committee on
Banking Supervision, December.
Manganelli, S. & Engle, R. F. (2001). Value at Risk Models in Finance. Working Paper Series No. 75,
European Central Bank (ECB), August.
Markowitz, H.M. (1952). Portfolio Selection. Journal of Finance 7, pp. 77–91.
Markowitz, H.M. (1959). Portfolio Selection: Efficient Diversification of Investments. New York: John
Wiley & Sons.
Mehr, R.I., & Hedges, B.A. (1963). Risk Management in the Business Enterprise. Irwin, Homewood,
Illinois.
Meltzer, A.H. (2013). What's Wrong With the Federal Reserve: What Would Restore Independence?
Bus Econ 48, 96–103. https://doi.org/10.1057/be.2013.7.
Merton, R.C. (1973). Theory of Rational Option Pricing. The Bell Journal of Economics and
Management Science, 4 (1), 141-183.
Merton, R.C. (1974). On the Pricing of Corporate Debt: The Risk Structure of Interest Rates. Journal of
Finance, 29, pp.449:470.
Miles, D., Yang, J. & Marcheggiano, G. (2012). Optimal Bank Capital. The Economic Journal, 123 (567),
1-37.
Miller, M.H. (1991). Financial Innovation and Market Volatility. Blackwell Publishing.
Minsky, H.P. (1986). Stabilizing an Unstable Economy. Yale University Press.
Modigliani, F. & Miller, M.H. (1958). The Cost of Capital, Corporation Finance and the Theory of
Investment. American Economic Review, 48 (3), 261-297.
Morgan, D.P., Peristiani, S. & Savino, V. (2010). The Information Value of the Stress Test and Bank
Opacity. Federal Reserve Bank of New York Staff Reports No. 460.
Nelson, D. (1991). Conditional Heteroskedasticity in Asset Returns: A New Approach. Econometrics.
Nissanke, M. (2010). The global financial crisis and the developing world: Transmission channels and
fall-outs. Research and Statistics Branch, WP/06/2009, United Nations Industrial Development
Organization, Vienna.
OE (Oxford Economics) (2013). Analyzing the Impact of Bank Capital and Liquidity Regulations on US
Economic Growth (A report prepared for the Clearing House Association), April.
Ong, L.L. & Pazarbasioglu, C. (2013). Credibility and Crisis Stress Testing. IMF Working Paper No.
13/178 (Washington, D.C.: International Monetary Fund).
Petrella, G. & Resti, A. (2013). Supervisors as Information Producers: Do Stress Tests Reduce Bank
Opaqueness? Journal of Banking and Finance, 37 (12), 5406-5420.
Pruski, J. (2012). Financial Sector Assessment Program of the International Monetary Fund and the
World Bank. International Association of Deposit Insurers (IADI). Washington, June.
Reinhart, C.M. & Rogoff, K.S. (2009). Banking crises: An Equal Opportunity Menace. NBER Working
Paper, 14587.
Rodriguez, J. (2002). International Banking Regulation. Where’s the Market Discipline in Basel II?
Policy Analysis, the Cato Institute, No. 455.
50
Saurina, J., Trucharte, C. (2007). An Assessment of Basel II Procyclicality in Mortgage Portfolios.
Journal of Financial Services Research, 32 (1), 81–101.
Sharpe, W. (1964). Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk.
Journal of Finance 19:3, pp. 425–42.
Sharpe, W. (1990). Capital Asset Prices With and Without Negative Holdings. Nobel lecture. Stanford
University Graduate School of Business, Stanford, December.
Slovik, P. & Cournède, B. (2011). Macroeconomic Impact of Basel III. OECD Economics Department
Working Papers No. 844, OECD Publishing.
Sorge, M. (2004). Stress Testing Financial Systems: An Overview of Current Methodologies. BIS
Working Papers No. 165, December.
Swiston, A. (2008). A US Financial Conditions Index: Putting Credit Where Credit is Due”, IMF Working
Paper, No. WP/08/161.
Taskinsoy, J. (2012a). Relevancy of Corporate Financial Policies and the Profit Maximization View of
Islamic Banks. Journal of Social and Development Sciences, Vol. 3(6), pp. 184-193, June, ISSN
2221-1152.
Taskinsoy, J. (2012b). The Investment Rate of Return (IRR) to Tertiary Education in Turkey. Journal
of Education and Vocational Research, Vol. 3(5), pp. 154-164, May, ISSN 2221-2590.
Taskinsoy, J. (2012c). The Return of Investment on Tertiary Education in Malaysia. Journal of
Education and Vocational Research, Vol. 3(6), pp. 183-192, ISSN 2221-2590.
Taskinsoy, J. (2013a). Rigorous Capital Requirements under Basel III: Possible impact on Turkey’s
financial sector. Journal of WEI Business and Economics, Vol. 2(1), pp. 1-30, April.
Taskinsoy, J. (2013b). Basel III: Road to Resilient Banking, Impact on Turkey's Financial Sector. LAP
LAMBERT Academic Publishing, 237 pages, ISBN 13: 978-3-659-30696-9.
Taskinsoy, J. (2013c). Economic & Ecological Implications of Hydraulic Fracturing. West East Journal
of Social Sciences, Vol. 2(1), pp. 11-39, April.
Taskinsoy, J. (2018a). Bitcoin Mania: An End to the US Dollar’s Hegemony or another
Cryptocurrency Experiment Destined to Fail? (December 1, 2018). Available at SSRN:
https://ssrn.com/abstract=3311989 or http://dx.doi.org/10.2139/ssrn.3311989.
Taskinsoy, J. (2018b). Effects of Basel III Higher Capital and Liquidity Requirements on Banking
Sectors across the Main South East Asian Nations. International Journal of Scientific &
Engineering Research (IJSER), Vol. 9(4), pp. 214-37, April, ISSN 2229-5518.
Taskinsoy, J. (2018c). The Cost Impact of Basel III across ASEAN-5: Macro Stress Testing of Malaysia’s
Banking Sector. LAP LAMBERT Academic Publishing, 369 pages, ISBN-13 978-613-9-90012-1.
Taskinsoy, J. (2018d). A Macro Stress Testing Framework for Assessing Financial Stability: Evidence
from Malaysia. Journal of Accounting, Finance and Auditing Studies (JAFAS), Vol. 4(3), July, ISSN
2149-0996
Taskinsoy, J. (2019a). Ever More Financial Instability notwithstanding the Basel Standards and the
IMF’s Financial Sector Assessment Program (February 4, 2019). Available at SSRN:
Taskinsoy, J. (2019b). Turkish Lira – A Fiat Currency that Resembles the Volatility of
Cryptocurrencies: The Effects of Exchange Rate Volatility on Turkish Economy (February 15,
51
2019). Available at SSRN: https://ssrn.com/abstract=3335545 or
http://dx.doi.org/10.2139/ssrn.3335545.
Taskinsoy, J. (2019c). The Transition from Barter Trade to Impediments of the Dollar System: One
Nation, One Currency, One Monopoly (March 6, 2019). Available at SSRN:
https://ssrn.com/abstract=3348119 or http://dx.doi.org/10.2139/ssrn.3348119
Taskinsoy, J. (2019d). Stress Testing Made Easy: No More US Banks Stumbling and Facing Public
Embarrassment Due to the Federal Reserve’s Qualitative Objection (March 17, 2019). Available
at SSRN: https://ssrn.com/abstract=3354018 or http://dx.doi.org/10.2139/ssrn.3354018.
Taskinsoy, J. (2019e). Typology of Stress Testing: Microprudential vs. Macroprudential Stress Testing
of Risk Exposures (March 28, 2019). Available at SSRN: https://ssrn.com/abstract=3361528 or
Taskinsoy, J. (2019f). Pure Gold for Economic Freedom: A Supranational Medium of Exchange to
End American Monetary Hegemony as the World’s Main Reserve Currency (April 25, 2019).
Available at SSRN: https://ssrn.com/abstract=3377904 or
Taskinsoy, J. (2019g). Asian Miracle, Asian Tiger, or Asian Myth? Financial Sector and Risk Assessment
through FSAP Experience: Enhancing Bank Supervision in Thailand (May 9, 2019). Available at
SSRN: https://ssrn.com/abstract=3385337 or http://dx.doi.org/10.2139/ssrn.3385337.
Taskinsoy, J. (2019h). Higher Capital and Liquidity Regulations of Basel Standards Have Made Banks
and Banking Systems Become More Prone to Financial and Economic Crises (June 9, 2019).
Taskinsoy, J. (2019i). A Delicate Moment in Turkey’s Economic Transition: Can Turkey Survive
Mounting Economic Problems without the IMF’s Bailout Package? (June 22, 2019). Available at
Taskinsoy, J. (2019j). We Need No Dime from the IMF: Is This a Temporary Illusion or Can the Turkish
Economy Recover from the Current Recession without the IMF Loans? (July 9, 2019). Available
Taskinsoy, J. (2019k). Facebook’s Project Libra: Will Libra Sputter Out or Spur Central Banks to
Introduce Their Own Unique Cryptocurrency Projects? (July 20, 2019). Available at SSRN:
Taskinsoy, J. (2019l). Is Facebook’s Libra Project Already a Miscarriage? (August 15, 2019). Available
Taskinsoy, J. (2019m). Facebook’s Libra: Big Bang or Big Crunch? A Technical Perspective and
Challenges for Cryptocurrencies (August 29, 2019). Available at SSRN:
Taskinsoy, J. (2019n). Turkey’s Unravelling Economy Resembles the Ottoman Empire’s Financial
Collapse (September 29, 2019). Available at SSRN: https://ssrn.com/abstract=3461216 or
http://dx.doi.org/10.2139/ssrn.
Taskinsoy, J. (2019o). A Hiccup in Turkey’s Prolonged Credit Fueled Economic Transition: A
Comparative Analysis of Before and After the August Rout. Journal of Accounting, Finance and
Auditing Studies (JAFAS), Vol. 5(4), October, ISSN 2149-0996. Doi: 10.32602/jafas.2019.37.
52
Taskinsoy, J. (2019p). This Time Is Different: Facebook’s Libra Can Improve Both Financial Inclusion
and Global Financial Stability as a Viable Alternative Currency to the U.S. Dollar. Journal of
Accounting, Finance and Auditing Studies (JAFAS), Vol. 5(4), October, ISSN 2149-0996. Doi:
10.32602/jafas.2019.38.
Taskinsoy, J. (2019q). Blockchain: A Misunderstood Digital Revolution. Things You Need to Know
about Blockchain (October 8, 2019). Available at SSRN: https://ssrn.com/abstract=3466480 or
Taskinsoy, J. (2019r). Blockchain: Moving Beyond Bitcoin into a Digitalized World (October 17,
Taskinsoy, J. (2019s). Blockchain: An Unorthodox Solution to Reduce Global Warming (October 24,
Taskinsoy, J. (2019t). Bitcoin and Turkey: A Good Match or a Perfect Storm? (October 30, 2019).
http://dx.doi.org/10.2139/ssrn.3477849
Taskinsoy, J. (2019u). Facebook’s Libra: Why Does US Government Fear Price Stable
Cryptocurrency? (November 7, 2019). Available at SSRN: https://ssrn.com/abstract=3482441
or http://dx.doi.org/10.2139/ssrn.3482441.
Taskinsoy, J. (2019v). Global Cooling through Blockchain to Avoid Catastrophic Climate Changes by
2050 (November 29, 2019). Available at SSRN: https://ssrn.com/abstract=3495674 or
Taskinsoy, J. (2019w). The Global Competitiveness Index: A Comparative Analysis between Turkey
and G8 Nations (December 8, 2019). Available at SSRN: https://ssrn.com/abstract=3500542 or
Taskinsoy, J. (2019x). Bitcoin: The Longest Running Mania – Tulips of the 21st Century? (December
18, 2019). Available at SSRN: https://ssrn.com/abstract=3505953 or
Taskinsoy, J. (2019y). Widening Development Gaps between ASEAN-5 and Advanced Nations
(December 30, 2019). Available at SSRN: https://ssrn.com/abstract=3511482 or
Taskinsoy, J. (2020a). Malaysia: 'Crouching Tiger, Hidden Dragon' (January 19, 2020). Available at
Taskinsoy, J. (2020b). No Brainer, Tackle Climate Change by 2030 or Await the Doomsday by 2100
(February 5, 2020). Available at SSRN: https://ssrn.com/abstract=3532709 or
Taskinsoy, J. (2020c). From Primitive Barter to Inflationary Dollar: A Warless Economic Weapon of
Mass Destruction (February 21, 2020). Available at SSRN: https://ssrn.com/abstract=3542145
or http://dx.doi.org/10.2139/ssrn.3542145.
Taskinsoy, J. (2020d). Stress Testing: A Measure of Financial Stability across ASEAN-5 (February 25,
53
Taskinsoy, J. (2020e). Diminishing Dollar Hegemony: What Wars and Sanctions Failed to Accomplish,
COVID-19 Has (April 7, 2020). Available at SSRN: https://ssrn.com/abstract=3570910 or
Taskinsoy, J. (2020f). Old and New Methods of Risk Measurements for Financial Stability amid the
Great Outbreak (April 27, 2020). Available at SSRN: https://ssrn.com/abstract=3587150 or
Taskinsoy, J. (2020g). COVID-19: Is the Great Outbreak a Sign of What the Future Has Stowed for the
Human Race? (May 10, 2020). Available at SSRN: https://ssrn.com/abstract=3597434 or
Taskinsoy, J. (2020h). Cost Implications of the Great Lockdown due to the Novel Coronavirus
Outbreak (May 18, 2020). Available at SSRN: https://ssrn.com/abstract=3604573 or
Taskinsoy, J. (2020i). Coronavirus Pandemic: The U.S. Induced Great Panic of the 21st Century (May
26, 2020). Available at SSRN: https://ssrn.com/abstract=3610749 or
Taskinsoy, J. (2020j). COVID-19 Could Cause Bigger Cracks in Turkey’s Fragile Crisis Prone Economy
(May 28, 2020). Available at SSRN: https://ssrn.com/abstract=3613367 or
Taskinsoy, J. (2020k). Is Turkey Backsliding on Global Competitiveness and Democracy Amid Its EU
Bid in Limbo? (July 10, 2020). Available at SSRN: https://ssrn.com/abstract=3648210 or
Taskinsoy, J. (2020l). Diminishing American Power: The US - China Trade War, Sanctions, and
Coronavirus (August 20, 2020). Available at SSRN: https://ssrn.com/abstract=3677841 or
Taskinsoy, J. (2020m). The Great Pandemic of the 21st Century: The Stolen Lives (September 9,
Taskinsoy, J. (2020n). Bitcoin Could Be the First Cryptocurrency to Reach a Market Capitalization of
One Trillion Dollars (September 16, 2020). Available at SSRN:
Taskinsoy, J. (2020o). The World Is at a Dangerous Crossroads on 'China Virus' and US 'Political
Virus' (October 17, 2020). Available at SSRN: https://ssrn.com/abstract=3713745 or
Taskinsoy, J. (2020p). A Move towards a Cashless Society Accelerates With the Novel Coronavirus
Induced Global Lockdown (December 12, 2020). Available at SSRN:
Taskinsoy, J. (2021a). Turkey’s Hidden Economic Disaster Fostered by Unorthodox Policies in
Isolation (February 8, 2021). Available at SSRN: https://ssrn.com/abstract=3781491 or
Taskinsoy, J. (2021b). Bitcoin Nation: The World’s New 17th Largest Economy (February 28, 2021).
54
Taskinsoy, J. (2021c). Bitcoinmania: A Ticking Time Bomb Waiting to Explode (April 13, 2021).
Taskinsoy, J. (2021d). The Famous New Bubbles of the 21st Century: Cases of Irrational Exuberance
(May 13, 2021). Available at SSRN: https://ssrn.com/abstract=3845422 or
Taskinsoy, J. (2021e). Turkey’s Melancholy Economic Indicators Camouflaged by Militarization as a
Foreign Policy (August 18, 2021). Available at SSRN: https://ssrn.com/abstract=3907590 or
Taskinsoy, J. (2021f). This Time Is Different: Bitcoin Has More Reasons to Reach the Price of
$100,000 (August 30, 2021). Available at SSRN: https://ssrn.com/abstract=3914299 or
Taskinsoy, J. (2021g). Bitcoin: A New Digital Gold Standard in the 21st Century? (October 13, 2021).
Taskinsoy, J. (2021h). Say Good Bye to Physical Cash and Welcome to Central Bank Digital Currency
(November 27, 2021). Available at SSRN: https://ssrn.com/abstract=3972858 or
Taskinsoy, J. (2022i). Turkish Lira’s Unprecedented Free Fall: Can a Financial Coup Reverse Lira’s
Fastest Devaluation in Turkish History Induced by a Decade-Long Unorthodox Economic,
Foreign and Defense Policies (February 1, 2022). Available at SSRN:
https://ssrn.com/abstract=4023696
Zandi, M. & Zemcik, P. (2014). Europe’s Stress Test: Good, But Not Enough. Economic & Consumer
Credit Analytics, Moody’s Analytics, October.
55

John Taskinsoy 2022 SSRN Stress Testing Financial Systems February

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

John Taskinsoy 2022 SSRN Stress Testing Financial Systems February

Uploaded by

Copyright:

Available Formats

Stress Testing Financial Systems: Macro and Micro Stress Tests, Basel Standards and Value-at-Risk

as Financial Stability Measures 

Keywords: Value-at-Risk; Stress Testing; Financial Stability; Microprudential; Macroprudential

1974 by the governors of the central banks of G-10.

Table 1: Arbitrary risk categories and risk weights under Basel I

Source: BCBS (1988)

Table 2: Revised risk weights and credit assessments under Basel II

AAA A+ BBB+ BB+ Below

Risk Weight 20% 50% 100% 100% 150% 100%

Option 2: Banks & Corporations

AAA A+ BBB+ BB+ Below

Risk Weight 20% 50% 50% 100% 150% 50%

Corporate 20% 50% 100% 100% 150% 100%

ECA Risk Scores 0-1 2 3 4-6 7

Risk Weights 0% 20% 50% 100% 150%

Source: BCBS (2004)

Source: Author; Taskinsoy (2018c)

Table 3: Selected features of stress tests in FSAPs

2000 – 2002 2003 – 2004

Source: IFM and World Bank (2005)

Source: Author; Pruski (2012)

Source: Adopted from Sorge (2004)

Year Objection to capital plan CET1 % Federal Reserve Comment

Ally’s capital plan was rejected because it failed to meet

Citigroup Inc. 6.5 Zion’s capital plan received quantitative objection as it

All three BHCs received qualitative objection to their

All three BHCs received qualitative objection to their

The Fed issued no qualitative objection according to the

Source: Federal Reserve

Table 6: Basel III phase-in arrangements

2013 2014 2015 2016 2017 2018 2019

Parallel run 2013 – 2017 Migration to

Capital buffer 0.625% 1.25% 1.825% 2.5%

Minimum total capital

Capital instruments that

Liquidity coverage ratio Observation

Net stable funding ratio Observation Introduce minimum

Source: BCBS (2010a, b)

2.1 Basel Standards Failed to Strengthen the Global Financial System

18 See remarks by the President Obama, available at http:// www.whitehouse.gov/the-press-office/remarks-president-

and capital flow (for more detail, see ECB, 2002).

Source: Author; BCBS (2004)

Output Increase in Monetary Fiscal Liquidity Peak

The U.S. 31.0 23.6 7.9 4.5 2.1 4.7 3.9

Source: Leaven and Valencia (2012), slightly modified by the author

Output Increase in Monetary Fiscal Peak Liquidity Peak

Central bank claims and % of total

Indonesia 69.0 67.6 4.5 56.8 23.1 17.2 32.5

Table 9: Individual bank minimum capital conservation standards

Minimum capital conservation ratios (expressed as a

4.5% - 5.125% 100

Source: BCBS (2010)

Leverage ratio = Tier 1 capital / Total exposure ≥ 3%

CET1 benefit Net

(Net benefit as % of GDP after 4-year implementation) % %

Study Method Reduction in Steady State Output

1 pp rise in capital ratios

25% liquidity requirement

50% liquidity requirement

1 pp rise in capital ratios 0.6% in total

0.22% after eight years

MAG (2010) 25%, 50% liquidity requirement 0.08%, 0.15% respectively

1 pp rise in capital ratios 0.09% (another 0.08% arises from

0.19% (US), 0.30% (Euro area), and