New Framework for Measuring and Managing Macrofinancial Risk and Financial Stability

by Dale F. Gray, Robert C. Merton & Zvi Bodie

Overview — This paper proposes a set of leading indicators of macrofinancial distress that can be helpful to policymakers and regulators in preparing for, mitigating, and maybe even preventing a credit crisis. These early-warning indicators of crisis are based on modern contingent claims analysis (CCA), which are successfully used today at the level of individual banks by managers, investors, and regulators. The authors' ultimate objective is to provide new tools to help governments and central banks manage financial sector risks. Key concepts include:

Traditional approaches have difficulty analyzing how risks can accumulate gradually and then suddenly erupt in a full-blown crisis.
The CCA approach is well suited to capturing such "nonlinearities" and to quantifying the effects of asset-liability mismatches within and across institutions.
Risk-adjusted CCA balance sheets facilitate simulations and stress testing to evaluate the potential impact of policies to manage systemic risk.

Author Abstract

This paper proposes a new approach to improve the way central banks can analyze and manage the financial risks of a national economy. It is based on the modern theory and practice of contingent claims analysis (CCA), which is successfully used today at the level of individual banks by managers, investors, and regulators. The basic analytical tool is the risk-adjusted balance sheet, which shows the sensitivity of the enterprise's assets and liabilities to external "shocks." At the national level, the sectors of an economy are viewed as interconnected portfolios of assets, liabilities, and guarantees-some explicit and others implicit. Traditional approaches have difficulty analyzing how risks can accumulate gradually and then suddenly erupt in a full-blown crisis. The CCA approach is well-suited to capturing such "non-linearities" and to quantifying the effects of asset-liability mismatches within and across institutions. Risk-adjusted CCA balance sheets facilitate simulations and stress testing to evaluate the potential impact of policies to manage systemic risk.