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

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.