Ebook Liquidity Stress-Tester A model for stress-testing banks’ liquidity risk
The recent financial crisis has underscored the need to explicitly take into account liquidity risk in stress-testing frameworks. The manifestation of liquidity risk can rapidly move the system into the tail of the loss distribution through bank runs, the drying up of market liquidity or doubts of counterparties about banks’ liquidity conditions. In these situations liquidity can evaporate, making a bank subject to multiple possible equilibria with very different levels of liquidity supply (Banque de France, 2008). Liquidity risk is not only a source of banks’ funding risk (the ability to raise cash to fund the assets), but also has a strong link to market liquidity (the ability to convert assets into cash at a given price). The originate-to-distribute model has made banks increasingly dependent on market liquidity to secure funding by issuing securities on wholesale markets and by trading credits. As a result, banks have become more vulnerable to macroeconomic and financial shocks that may engender liquidity risk.
Various regulatory initiatives in response to the credit crisis have highlighted that banks’ stress-testing practices usually do not incorporate liquidity risk scenarios sufficiently (FSF, 2008). Banks often underestimate the severity of market-wide stress, such as the disruption of several key funding markets simultaneously (e.g. repo and securitisation markets). Moreover, banks do not systematically consider second-order effects that can amplify losses. These can be caused by idiosyncratic reputation effects and/or collective responses of market participants, leading to disturbing (endogenous) effects on markets. Banks have insufficient incentives to insure themselves against such risks (FSA, 2007). This is because holding liquidity buffers is costly and may create a competitive disadvantage. Besides, liquidity stresses have a very low probability and market participants could have the perception that central banks will intervene to provide liquidity in stressed markets.
Macro stress-testing, i.e. testing the financial system as a whole, is an instrument of central banks and supervisory authorities to assess the impact of market-wide scenarios and possible second round effects. Such tests with regard to liquidity risk can enhance the insight in the systemic dimensions of liquidity risk. These exercises can also contribute to market participants’ awareness of systemic risks. However, liquidity risk is not included in most macro stress-testing models. A main reason for this is that the multiple dimensions of liquidity risk make quantification difficult (IMF, 2008). This could also explain the large variation in the extent to which supervisors prescribe limits on liquidity risk and insurance that banks should hold (BCBS, 2008).
This paper presents a stress-testing model which focuses on both market and funding liquidity risk of banks. Multiple dimensions of liquidity risk are combined into a quantitative measure. Section 2 describes related models by reviewing the literature. Section 3 outlines the model framework of Liquidity Stress-Tester and explains the model structure for the first and second round effects of shocks to banks’ liquidity. It also provides a parameter sensitivity analysis Section 4 presents model simulations for Dutch banks as an illustration, including an anecdotal back test. Section 5 concludes.
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