Central Bank Stress Tests: Mad, Bad, and Dangerous

The methodology of regulatory stress testing is based on foundations that are indefensible and even risible. These include: (1) their dependence on discredited models of financial risk; (2) their reliance on a single scenario, against all good practice and common sense; (3) their tendency to rely on unstressful stress scenarios and very low pass marks; (4) their intrinsic lack of credibility because of regulatory capture, central banks’ own dismal forecasting records, and the politics that underlie and fatally undermine regulatory stress exercises; and (5) their reliance on “approved” models and risk management practices that increase systemic risk—and do so in a way that the models themselves cannot see.

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