“Liquidity at Risk” and Joint Stress Testing for Solvency and Liquidity Risks

The stress-testing of banks is a key element of banking regulation and supervision. While the Global Financial Crisis of 2007-2008 clearly showed that bank failure may result from a lack of short-term liquidity rather than solvency, supervisory stress tests in most countries continue to focus more on solvency. Traditionally, stress tests seek to assess banks’ capital adequacy by evaluating the exposure of their portfolios to macro-stress scenarios. However, banks that display a strong capital ratio may still fail stress tests due to a lack of liquidity. Reflecting this distinction, most central banks make emergency liquidity assistance available to “illiquid but solvent’’ banks.

Therefore, it is important to model various channels of liquidity stress for more effective stress testing. The Basel Committee on Banking Supervision also emphasises the need for introducing integrated liquidity and solvency stress tests. The Committee explains that the failure to model interlinkages between solvency and liquidity risks within and across banks may lead to a dramatic underestimation of the risks to financial stability.

Liquidity stress tests are usually applied in parallel to, and independently from, solvency stress tests. This means that scenarios used for one may not always be consistent with scenarios used in the other. As a result, the supervisory assessment of solvency and liquidity risks remains by and large fragmented. Highlighting the importance of understanding the interplay between solvency and liquidity, a recent IMF Working Paper titled “Liquidity at Risk: Joint Stress Testing of Solvency and Liquidity” proposes an operational framework for modelling liquidity and solvency risks and explaining their mutual interactions.

“Liquidity at Risk:” A Conditional Measure of Liquidity Risk

The IMF paper puts forward a novel way to quantify the impact of economic shocks on solvency and liquidity. It introduces the concept of “Liquidity at Risk” (LaR), which quantifies the liquidity resources required for a financial institution facing a given stress scenario. This goes beyond the traditional liquidity risk analysis, which is based on exogenous expected cash flows, and introduces the concept of liquidity stress that is “conditional on a stress scenario defined in terms of co-movements in risk factors.”

LaR measures a net outflow corresponding to the stress scenario, and is calculated as:

LaR = Maturing Liabilities + Net Scheduled Outflows + Net Outflow of Variation Margin + Credit-Contingent Cash Outflows

This means that liquidity shortfall in a stress scenario is given by the difference between LaR associated with the stress scenario and the liquid assets available during a stress scenario. This new concept is therefore portfolio-specific and forward-looking, unlike the Basel III Liquidity Coverage Ratio, which is based on historical data.

A Joint Stress Testing Framework for Solvency and Liquidity

The IMF paper proposes a joint stress testing framework for solvency and liquidity which addresses the interrelations among multiple channels including margin calls, credit downgrades, credit sensitive funding, funding costs, and fire sales. It seeks to integrate these mechanisms through which solvency and liquidity interact, and explores the implications of these interactions for the dynamics of a bank balance sheet under stress scenarios.

By capturing the mechanisms that underly the linkages between solvency and liquidity,  the proposed framework identifies the dynamic linkages between solvency shocks and liquidity shocks. Using these linkages, it models liquidity and solvency risks based on external shocks to solvency and corresponding endogenous shocks to liquidity.

The framework is quite coherent in that it recognizes that banks can become illiquid without being insolvent, insolvent while remaining liquid, or both illiquid and insolvent at the same time. The framework suggests that the interaction of liquidity and solvency may lead to the amplification of equity losses due to funding costs which arise from liquidity needs. It suggests that banks’ balance sheet composition matters for the interplay between solvency and liquidity.

Conclusion

While the traditional approach to the stress testing of banks omits the interaction between liquidity and solvency risks, the IMF paper introduces a novel framework for joint stress testing of these risks, introducing a number of policy implications for central banks and banking regulators. In particular, by showing that structural solvency risk models are insufficient to capture the interplay between liquidity and solvency risks, the framework advocates for supervisory authorities to  use granular balance sheet analysis when conducting stress tests.

The concept of LaR introduces a new methodology for quantifying the impact of economic shocks on liquidity. LaR does not refer to a specific statistical model for generating risk scenarios, so it can be applied to both historical risk scenarios and hypothetical stress scenarios. It has the potential to serve as a useful tool for calibrating policy responses to shocks such as the financial-stability concerns triggered by the ongoing COVID-19 pandemic.

Mete Feridun is a Professor of Finance at Eastern Mediterranean University and formerly a regulatory risk and strategy consultant at PwC UK, as well as a senior regulator at the Prudential Regulation Authority, Bank of England and the Financial Conduct Authority in the UK.

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