We present a novel approach that incorporates individual entity stress testing and losses from
systemic risk effects (SE losses) into macroprudential stress testing. SE losses are measured
using a reduced-form model to value financial entity assets, conditional on macroeconomic
stress and the distress of other entities in the system. This valuation is made possible by a
multivariate density which characterizes the asset values of the financial entities making up
the system. In this paper this density is estimated using CIMDO, a statistical approach, which
infers densities that are consistent with entities’ probabilities of default, which in this case are
estimated using market-based data. Hence, SE losses capture the effects of
interconnectedness structures that are consistent with markets’ perceptions of risk. We then
show how SE losses can be decomposed into the likelihood of distress and the magnitude of
losses, thereby quantifying the contribution of specific entities to systemic contagion. To
illustrate the approach, we quantify SE losses due to Lehman Brothers’ default.
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