Stress-testing banks under deep uncertainty

Abstract

Years of turmoil in the banking sector have revealed the need to assess bank performance under deep uncertainty and identify vulnerabilities to different types of risks. Banks are not the safe houses of old. Today, banks are highly uncertain dynamically complex systems that are permanently at risk due to internal and external stresses and uncertainties. Although external uncertainties and stresses cannot be controlled, internal design and policies can, and hence, offer opportunities for robust redesign. This paper illustrates a System Dynamics approach towards financial stress testing in view of making banks more robust, i.e. performing more appropriately in all plausible futures, especially in the most stressful futures. A System Dynamics model is used to represent the core operation of a bank. A variety of risks and shocks are applied to the model in order to generate insights into the plausible system behaviour under stress. The clustering of the different behaviours in turn aid in the understating and explaining the variety of bank runs exhibited by the model.