01 February 2012

VoxEU: Next-generation system-wide liquidity stress testing

Bank liquidity was traditionally viewed as of equal importance to solvency. Liquidity risks are inherent in maturity transformation, i.e. the usual long-term maturity profile of banks’ assets and short-term maturities of liabilities. Banks have commonly relied on retail deposits, and, to some degree, on long-term wholesale funding as supposedly stable sources of funding. Yet, attention to liquidity risk diminished in recent decades and was symbolised by the absence of consideration of liquidity risk in the 1988 Basel I framework.

One of the main contributions of this project consists in providing input templates for cash-flow–based tests that could also serve regulators/supervisors as a first step towards fully-fledged cash-flow analysis based on a regular data collection from banks. Once available, the cash-flow module allows simulating detailed funding structures of single banks, which enables one to draw some broader conclusions for the system-wide situation of banks and potential contagion effects, respectively. Moreover, the presented tool allows for easy peer comparisons that should always play an important role for liquidity stress tests and can readily reveal vulnerabilities. Finally, this project contributes to existing work on liquidity by modelling the link to solvency stress (tests) explicitly.

Future research will focus on better understanding the link between banks’ solvency and liquidity strains. Both are inherently interrelated and standalone stress tests that only examine either solvency or liquidity stress-testing potentially risk-producing downward-biased results. For example, a bank’s severe funding strain could swiftly mutate into solvency concerns with the market putting pressure on the bank to increase its capital. The focus here has been predominantly to analyse the link from solvency to stress-testing but the feedback loop can also originate with liquidity.

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