11 January 2012

IMF Working Paper: 'Next Generation System-Wide Liquidity Stress-Testing'

The fact that liquidity risk turned out to be one of the key threats to financial stability throughout the recent financial crisis has lead to reconsideration, with a re-emerging focus on liquidity in industry as well as regulatory circles.

The purpose of this paper and the tool presented therein reflects this development and aims at providing stress-testers with a flexible and easy-to-use platform to assess the liquidity situation of banks top-down from different angles. The pre-defined tests can easily be adapted to bank-specific situations and/or specificities of banking systems to be assessed. A key objective was striking a balance in terms of data requirements and stress test sophistication, allowing for tests with parsimonious data on the one hand and more complex/demanding tests on the other.

While the obvious way to stress-test liquidity is the use of cash flow data, it is often not available (yet) at regulatory/supervisory institutions. One of the main contributions of this paper 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 regular data collection from banks. Once available, the cash flow module allows simulating detailed funding structures of single banks, which enables us 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, the paper contributes to existing work on liquidity by modelling the link to solvency stress (tests) explicitly. Although this should not be misinterpreted as the final solution to this highly complex problem, the inclusion of a module in the tool to account for this link in an easy-to-use fashion should facilitate practitioner’s work significantly.

Future research will focus on better understanding the link between banks’ solvency and liquidity strains. Both are inherently interrelated and stand-alone 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 in this paper 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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