Stress Tests Based on Historical Financial Crisis Data

I recently revisited a book I’d read some time ago, This Time is Different: Eight Centuries of Financial Folly by Carmen M. Reinhart and Kenneth S. Rogoff (2011). To be honest, it’s not an easy read. The book delves into a comprehensive quantitative analysis of financial crises throughout history, with an abundance of charts, numbers, and data. It’s dense, to say the least. But despite the complexity, it reinforces some incredibly important insights about the patterns of financial crises and the human behavior behind them.

What makes this book even more valuable is that some of the most thought-provoking work presented in it was released earlier in the form of research papers before the book was published. One of these papers provides a set of data that is particularly useful for stress testing—something that’s especially pertinent in today’s financial landscape. This data is derived from a long series of observations across multiple countries and several financial crises, giving it a broad and deep historical context.

Reinhart and Rogoff highlighted a few key points related to the aftermath of financial crises that I think are particularly noteworthy. They made the following observations regarding average recovery times after major financial disruptions:

“First, asset market collapses are deep and prolonged. Real housing price declines average 35 percent stretched out over six years, while equity price collapses average 55 percent over a downturn of about three and a half years. Second, the aftermath of banking crises is associated with profound declines in output and employment. The unemployment rate rises an average of 7 percentage points over the down phase of the cycle, which lasts on average over four years.”

These findings are more than just historical analysis—they offer valuable data for practical application today. For instance, these averages could be used as a basis for stress testing in financial institutions, especially when considering the potential impact of market downturns. Housing price declines and rising unemployment are two key indicators that have historically been closely correlated with loan defaults.

By incorporating these averages into stress test models, we can gain a clearer understanding of potential risks and the lasting impacts of financial crises. It’s a reminder that while every financial crisis is unique in its own right, there are patterns that emerge time and time again, rooted in human behavior and the underlying structure of financial systems.

You can find that paper by searching

THE AFTERMATH OF FINANCIAL CRISES

Carmen M. Reinhart

Kenneth S. Rogoff

Working Paper 14656

https://www.nber.org/papers/w14656