Liquidity risks can be a primary source of bank failures. As such, there are arguments not to rely on a single metric for providing supervision.
In order to reinforce banks’ resilience to liquidity risks, the Basel Committee on Banking Supervision (BCBS) proposed the introduction of two harmonised liquidity standards:
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the liquidity coverage ratio; and
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the net stable funding ratio.
While the implementation of harmonised liquidity regulation across the globe is a unique and necessary step for supervision, one single metric cannot provide a complete picture of an institution’s liquidity risk profile.
Complementing the Pillar 1 standard, advanced stress tests are a useful instrument to analyse and understand an institution’s vulnerabilities. However, unlike capital for which harmonised stress tests are widespread, practices regarding liquidity stress-testing still differ, and often liquidity risk is only a small component of stress tests. For their recent stress test, the European Banking Authority, for instance, only accounted for liquidity risks as an assumed increase in funding costs, as opposed to actually testing the size and quality of institutions’ liquidity buffers. Also, in the US liquidity stress tests play only a subordinated role compared to capital stress tests. This column discusses two recent Bank for International Settlements working papers (BCBS 2013a and BCBS 2013b), which present current practices, identify gaps and suggest areas of further work regarding liquidity stress testing...
In Europe, the European Banking Authority has the opportunity to facilitate the process of integrating liquidity and solvency stress tests, and to increase both the role and the quality of liquidity stress tests when addressing their mandate to issue guidelines on supervisory stress-testing (Article 100 CRD IV).
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BCBS (2013a) confirms that liquidity risk is a complex and diverse matter. At the same time, however, the case studies clearly point to a number of patterns. Especially the importance of deposit insurance coverage, the difficulties faced by banks to stop leveraged and residential mortgage loan pipelines, the relevance of operational requirements for the effectiveness of liquidity buffers, as well as the important distinction between different types of repos, committed facilities, and derivative transactions, should receive increased attention when designing liquidity stress tests.
Liquidity risks can be a primary source of bank failures. As such, there are strong arguments not to rely on a single metric but to conduct serious Pillar 2 liquidity supervision with supervisory and firms’ own stand-alone liquidity stress as well as stress tests combining liquidity and solvency risks being the quantitative fundament of such a process.
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