Publish Date:

Jul 12, 2024

Serial Number:

2020PA1001

Views: 213
Downloads: 6
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Rama Cont

@ramacont

Professor of Mathematics, Chair of Mathematical Finance, University of Oxford

Liquidity at Risk: Joint Stress Testing of Solvency and Liquidity

Key Findings


Our proposed framework provides a more realistic stress test framework which establishes coherence between design of solvency and liquidity stress tests. It also includes mitigating actions that can be extracted from the bank’s contingency funding plan and recovery plan.


Abstract


The traditional approach to the stress testing of financial institutions focuses on capital adequacy and solvency. Liquidity stress tests have been applied in parallel to and independently from solvency stress tests, based on scenarios which may not be consistent with those used in solvency stress tests. We propose a structural framework for the joint stress testing of solvency and liquidity: our approach exploits the mechanisms underlying the solvency-liquidity nexus to derive relations between solvency shocks and liquidity shocks. These relations are then used to model liquidity and solvency risk in a coherent framework, involving external shocks to solvency and endogenous liquidity shocks arising from these solvency shocks. We define the concept of “Liquidity at Risk”, which quantifies the liquidity resources required for a financial institution facing a stress scenario. Finally, we show that the interaction of liquidity and solvency may lead to the amplification of equity losses due to funding costs which arise from liquidity needs.

  • Allen, F., Gale, D., 1998. Optimal financial crises. J. Finance 53 (4), 1245–1284. Basel Committee on Banking Supervision, 2015. Making supervisory stress tests more macroprudential: Considering liquidity and solvency interactions and systemic risk. Working Paper. Bank for International Settlements. Baudino, P., Goetschmann, R., Henry, J., Taniguchi, K., Zhu, W., 2018. Stress-testing banks – a comparative analysis. Financial Stability Institute Insights on policy implementation No 12, Bank for International Settlements. Federal Reserve, 2019. August 2019 Senior Financial Officer Survey. Board of Governors of the Federal Reserve System. Fique, J., 2017. The macrofinancial risk assessment framework (MFRAF), version 2.0. Technical Report No. 111, Bank of Canada. Gorton, G., 2012. Misunderstanding financial crises. Oxford University Press.

  • #Stress Testing
  • #Risk Management
  • #Liquidity at Risk

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Category

  • Stress Testing

Author Type

  • Academic

Authors

  • Rama Cont
  • Artur Kotlicki