Abstract

In the aftermath of the financial crisis, stress-testing has become mandatory for banks. We propose a tractable model at the frontier of systemic risk stress-testing. Our theoretically-based stress-testing framework integrates credit risk, liquidity risk and contagion risk. We contribute to the literature in different ways. We first generalize the theoretical contagion results of Manz (2010) to an N-banks world, show the uniqueness and existence of an equilibrium in that context, and characterize the contagion dynamics. We then quantify the potential important contribution of information contagion to systemic risk and illustrates why ensuring that each bank is liquid when considered in isolation is not enough. Each bank must also be sufficiently liquid to resist to contagion effects. Finally, we illustrates how crucial are market participants’ beliefs about an eventual central bank intervention in the unfolding of events when the financial system is in a fragile state.