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Liquidity at risk: Joint stress testing of solvency and liquidity

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  • Cont, Rama
  • Kotlicki, Artur
  • Valderrama, Laura

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.

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  • Cont, Rama & Kotlicki, Artur & Valderrama, Laura, 2020. "Liquidity at risk: Joint stress testing of solvency and liquidity," Journal of Banking & Finance, Elsevier, vol. 118(C).
    • Handle: RePEc:eee:jbfina:v:118:y:2020:i:c:s0378426620301370
    DOI: 10.1016/j.jbankfin.2020.105871
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    2. Aldasoro, Iñaki & Hüser, Anne-Caroline & Kok, Christoffer, 2022. "Contagion accounting in stress-testing," Journal of Economic Dynamics and Control, Elsevier, vol. 137(C).
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    4. Kotlicki, Artur & Austin, Andrea & Humphry, David & Burnett, Hanna & Ridgill, Philip & Smith, Sam, 2023. "Network analysis of the UK reinsurance market," Bank of England working papers 1000, Bank of England.
    5. Gersbach, Hans & Haller, Hans & Zelzner, Sebastian, 2023. "Enough liquidity with enough capital - And vice versa?," CFS Working Paper Series 714, Center for Financial Studies (CFS).
    6. Toloo, Mehdi & Tone, Kaoru & Izadikhah, Mohammad, 2023. "Selecting slacks-based data envelopment analysis models," European Journal of Operational Research, Elsevier, vol. 308(3), pages 1302-1318.
    7. David Aikman & Daniel Beale & Adam Brinley-Codd & Anne-Caroline Hüser & Giovanni Covi & Caterina Lepore, 2023. "Macro-Prudential Stress Test Models: A Survey," IMF Working Papers 2023/173, International Monetary Fund.
    8. de Bandt, Olivier & Lecarpentier, Sandrine & Pouvelle, Cyril, 2021. "Determinants of banks’ liquidity: A French perspective on interactions between market and regulatory requirements," Journal of Banking & Finance, Elsevier, vol. 124(C).
    9. Cristina Zeldea, 2020. "Modeling the Connection between Bank Systemic Risk and Balance-Sheet Liquidity Proxies through Random Forest Regressions," Administrative Sciences, MDPI, vol. 10(3), pages 1-14, August.
    10. Sydow, Matthias & Schilte, Aurore & Covi, Giovanni & Deipenbrock, Marija & Del Vecchio, Leonardo & Fiedor, Paweł & Fukker, Gábor & Gehrend, Max & Gourdel, Régis & Grassi, Alberto & Hilberg, Björn & Ka, 2021. "Shock amplification in an interconnected financial system of banks and investment funds," Working Paper Series 2581, European Central Bank.
    11. Valentina Macchiati & Giuseppe Brandi & Tiziana Di Matteo & Daniela Paolotti & Guido Caldarelli & Giulio Cimini, 2022. "Systemic liquidity contagion in the European interbank market," Journal of Economic Interaction and Coordination, Springer;Society for Economic Science with Heterogeneous Interacting Agents, vol. 17(2), pages 443-474, April.

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