When banks punch back: Macrofinancial feedback loops in stress tests

In the presence of adverse macroeconomic shocks, simultaneous capital losses in multiple banks can prompt them to contract their balance sheets. These bank responses generate externalities that propagate in the form of macrofinancial feedback loops. This paper devel-ops a credit response and externalities analysis model (CREAM) that integrates a disaggre-gated banking sector into an otherwise standard macroeconomic structural vector autoregressive model. It shows that accounting for macrofinancial feedback loops can sig-nificantly affect macroeconomic outcomes and bank-specific stress test results. The hetero-geneity in bank lending responses matters: it determines how each bank fares under adverse conditions and the external effects that banks impose on each other and on eco-nomic activity. The model can thus be used to assess the contributions of individual banks to systemic risk along the time dimension. (c) 2022 Elsevier Ltd. All rights reserved.